Have you heard about the term DeFi KYC before? Here we bring a complete guide on DeFi KYC with its importance.

The applications of decentralized ledger technology have shown promising potential in recent times for different sectors, especially financial services. One of the most recent interventions of blockchain technology has been identified in the world of finance with decentralized finance. DeFi has completely revised the precedents for financial inclusion and opened up new roads leading to innovative financial services ecosystems. 

Without the need for any identity proof, DeFi ensures that people with a smartphone and internet connection could get financial services. So, what is the need for DeFi KYC? Asking for KYC (Know Your Customer) processes in the world of DeFi might seem unnatural as DeFi primarily focused on reducing the need for KYC processes in banking and financial institutions. However, the relationship between DeFi and KYC has far-reaching implications for the broader picture of DeFi. Let us shed some light on the need for KYC for DeFi. 

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The Equation between Regulations and Blockchain-based Financial Solutions

Blockchain technology has been successful in achieving profound levels of progress in terms of recognition by authorities. After the introduction of updated guidance by the Financial Action Task Force or FATF, a global regulatory authority, in June 2019, the tides have changed in how authorities view the use of blockchain technology. 

Blockchain has found prolific applications in building decentralized applications that allowed users to sell, purchase, hold and exchange digital assets, tokens, and virtual currency. However, the lack of regulations for blockchain-based financial applications had far detrimental impacts on the adoption of blockchain

Slowly, blockchain-based financial service solutions are being molded in the form of traditional financial institutions. In what way are blockchain-based financial service solutions changing? The scope of decentralized KYC largely rests on this transformation as decentralized financial services are gradually coming under the umbrella of KYC and Anti-Money Laundering (AML) laws and regulations. 

Many of the blockchain-based companies in this domain, like wallet custodians and digital asset exchanges, will have to comply. The rules will be the same for decentralized companies and traditional financial institutions. The regulations of FATF for bringing Virtual Asset Service Providers and traditional financial institutions on the same page in terms of regulations for AML and KYC have set the stage for regulatory reforms. National regulators are also joining the trend and setting new benchmarks in their law codes for adapting to changes. 

While the new KYC and AML regulations are relevant for the platforms and entities working with crypto, there is no specific mention of DeFi platforms. Decentralized Finance KYC does not seem probable as it does not come under the category of the transmitter, exchange, or custodian. However, the recent updates in FATF’s guidance point out imminent possibilities for regulation of DeFi space.

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Brief Reflection on DeFi

Prior to an overview of DeFi KYC, it is important to understand the meaning of DeFi. Decentralized finance has enabled the recreation of conventional financial instruments with a decentralized architecture. The distinct highlight of DeFi refers to the lack of any intervention by the government, financial institutions, or companies. The potential and breadth of DeFi use cases are way beyond the scope of centralized finance or CeFi. 

Why do You Need DeFi KYC?

The freedom from government and financial intermediaries implied open access for anyone to financial services. However, this aspect turns into one of the most crucial setbacks for DeFi. The concerns of data security and compliance with the potential of new regulations for introducing new risks mean a lot on the table for DeFi. It is not about a question of ‘Is KYC needed for DeFi’ and more about ‘what can KYC do for DeFi.’ The extent to which a DeFi solution provider wants to address compliance has a profound impact on their decisions for implementing KYC on a DeFi solution. 

Any entrepreneur or newly initiated firm in the DeFi landscape will obviously want to be on the good side of the law. It will help them bring in institutional as well as corporate customers by citing compliance with new regulations. However, will the DeFi and KYC combination break down the foundation of DeFi? 

As a matter of fact, there are many reasons for which this might not be a problem. The new KYC and AML regulations do not necessarily imply that DeFi would lose its inherent value. Here are the reasons which can show how KYC can work in DeFi while retaining its capabilities in the form of a decentralized approach for carrying out financial services. 

  • Bring In Customers

The DeFi space is new, and many enterprises are actually interested in investing in the domain. However, the lack of regulations might drive away from the interests of such enterprises in DeFi. With the facility of a comprehensive KYC process in their AML protocols, DeFi solutions could invite the trust of private as well as institutional customers. When you showcase a strong DeFi KYC protocol, you could easily expand your customer base. Does it seem reasonable to discourage potential customers without KYC in a DeFi solution?

  • Security of Personal Data

One of the foremost concerns about decentralized KYC comes in the form of the vulnerability of personal data. The transparency in decentralized finance could be a prominent deterrent for people to offer their KYC data. However, innovative KYC technology can come to your rescue in such situations. 

It is important to note that personal identifier data would not have to be transferred to or stored on a DeFi app, portal, or VASP. For example, KYC-Chain could carry out end-to-end KYC assessments of potential customers. Interestingly, the customer data never enters the own database of the DeFi provider.

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  • The Centralization Myth 

Suppose you think that decentralized finance KYC would introduce centralization. With KYC, a DeFi platform could continue to offer decentralized financial transactions. At the same time, it could also secure access to the platform for users with verified identities. So, it is basically DeFi within the boundaries of identity verification without losing its essence. 

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Downsides of Failing to Bring KYC in DeFi

The mass adoption of unregulated DeFi has been responsible for creating many pitfalls for the future of DeFi. As DeFi platforms look to expand the scope of their use cases, FATF is continuing with its resolve to prevent any operations of DeFi platforms and exchanges without KYC. A report by CipherTrace showcasing some of the notable DeFi hacks in 2020 showcases the need for DeFi KYC. The various prominent DeFi hacks included top names such as,

  • Uniswap
  • Balancer
  • Finance
  • OUSD
  • Axion Network
  • Harvest Finance
  • Value DeFi
  • Pickle Finance

The report has also pointed out some notable aspects which answer “Is KYC needed for DeFi” effectively. It indicated that the massive growth in capital and limited regulatory safeguards had introduced malicious agents in the DeFi ecosystem. The lack of regulations has been identified as one of the prominent causes for the majority of DeFi hacks annually. 

DeFi was responsible for adding almost $129 million to the total amount compromised in crypto thefts in 2020. So, it is quite clear that the lack of KYC protocols would not support the ability of DeFi to achieve commercial as well as legal sustainability. 

On the other hand, one prominent question still remains in the adoption of KYC in DeFi. How will you regulate DeFi, which was basically designed for immunity from regulations? 

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Regulatory Authority for Decentralized KYC

The growth of DeFi platforms and solutions in terms of popularity and use cases has been the topic of attention for FATF. Presently, it is not a regulatory authority. However, it offers a set of guidelines dictating the operations of DeFi solutions with KYC. FATF has shown promising resolve in maintaining the DeFi space within regulatory control. 

The perspective of FATF clearly showcases illustrations of the approaches followed by national governments for regulation alongside their impacts. FATF emphasizes bringing DeFi and KYC together to fight off the possibilities of using DeFi as an instrument in money laundering and other illegal financial activities. 

Most recently, the US Commodities and Futures Trading Commission (CFTC) has passed sanctions for crypto exchange BitMEX. This is a clear indication of the eagerness of regulators to ensure KYC compliance in DeFi platforms and exchanges. FATF holds the impression that decentralized finance KYC offers regulation while fabricating efficient AML and Counter-Terrorism Financing protocols. The global authority on DeFi, FATF, wants to use KYC for regulating DeFi just like in other domains of the financial industry. 

Now, the primary concern of bringing KYC into DeFi is the decentralized aspect. The decentralized traits of DeFi have made it appealing for enterprises and individuals as a favorable instrument for managing and using finances in the first place. No individual is in charge in a decentralized framework, thereby leading to the question of ‘who do you choose to regulate’.

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KYC and Decentralized Compliance

Democratization is one of the fundamental tenets of decentralized finance. Many of the early players in the domain of DeFi focused on offering financial services and capabilities to individuals uniquely. They aimed at creating an ecosystem that is completely independent of the conventional financial industry and other centralized intermediaries. 

Furthermore, the concept of DeFi KYC has also opposed another fundamental trait of DeFi, i.e., anonymity. DeFi users could stake, exchange and carry out many other financial service functions without any centralized authority knowing their information. 

On the contrary, FATF, alongside the associated regulatory regimes, consider the anonymity of financial transactions and activities as potentially dangerous. FATF also perceives that anonymous financial transactions could also be highly vulnerable to exploitation by malicious agents. So, FATF has emphasized considering DeFi platforms and apps and VASPs in its updated draft guidance which arrived in March 2021. It is reasonable to ask about the approach FATF would follow for addressing the challenge of decentralized compliance. 

The arrival of decentralized finance KYC would imply that FATF would not classify the underlying software or technology as VASP. On the other hand, FATF would hold owners or users of the DeFi platform, service, or exchange as VASPs. Actually, FATF has updated the definition of VASPs in its updated draft guidance released recently. 

Owners of DeFi platforms and services basically need a KYC process for users to admit them on the network to avoid regulatory sanctions. Therefore, DeFi project owners and innovators can look at a wide assortment of technical and possibly ideological challenges. For example, some crypto analysts point out that DeFi and KYC may split up the world of DeFi. The first section of the world would be a regulated ecosystem, while the other section of DeFi would remain unregulated and anonymous. 

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Where to Look From Here?

As you can notice, discussions on ‘Is KYC needed for DeFi’ revolve around the need for preserving decentralization. However, the actual focus should be on the importance of maintaining compliance with regulations. Following the law is a basic societal norm, and any DeFi solution provider looking for opportunities in an emerging market wouldn’t want the ‘bad boy’ tag. Regulatory sanctions can be a massive deterrent for companies and institutional investors interested in the DeFi space. 

In the case of DeFi projects, owners and users need to work continuously in jurisdictions with a prominent track record of enforcing FATF guidance diligently. The application of KYC processes is a reasonable option for the DeFi projects operating in FATF-compliant environments. In the long run, DeFi projects aspiring to be involved in the financial ecosystem must ensure KYC processes. 

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Bottom Line 

Weak KYC processes could be a profound setback for DeFi. Even if DeFi opens the gates to financial services for everyone, it can turn into a platform for money laundering. The lack of regulations and anonymity gives opportunities for criminals to use DeFi services without KYC proof. So, they can easily evade money laundering rules and regulations easily. 

What if they are using the finances for supporting illegal activities such as drug trafficking or terrorism? All the consequences of having DeFi without KYC clearly showcase why DeFi KYC will be the next norm in decentralized finance. Keep exploring to learn more about DeFi and how KYC can change its conventional precedents altogether. Enroll in the DeFi course to enhance your knowledge about the DeFi KYC.

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*Disclaimer: The article should not be taken as, and is not intended to provide any investment advice. Claims made in this article do not constitute investment advice and should not be taken as such. 101 Blockchains shall not be responsible for any loss sustained by any person who relies on this article. Do your own research!