Are DeFi and KYC a contradiction?

DeFi , KYC and Crypto – A mighty triumvirate? Learn more about KYC in a decentralized world.

DeFi, the next big thing in crypto? 

DeFi or decentralized finance is one of the hottest buzzwords in fintech and crypto right now. Together with NFTs (Non-Fungible Tokens) it’s dominating the news since 2021. But what is the noise all about, and why is the criticism from the regulators so loud? 

What is DeFi? 

Decentralized finance means financial services or instruments which are not managed by a central company or authority, but rather operated on a form of blockchain or DLT. Essentially, DeFi allows users to directly interact with a product or service without any intermediaries. By being open, borderless and permissionless, DeFi wants to democratize financial services and make them accessible for everybody in this world. 

Limitless potential: The future of finance. 

DeFi means much more than just cryptocurrencies and payments. It is expected that DeFi will replicate all forms of assets, financial instruments and contracts that exist in traditional finance today. Furthermore, the advanced technologies are creating the opportunity for entirely new financial services and products.  

The risk: When AML meets anonymity. 

In the beginnings of crypto, many of the early crypto exchanges did not require a KYC check. Not without reason, crypto had and for some parts still has a negative stigma around money laundering and cyberfraud. What’s more convenient than an anonymized and fully digital cryptocurrency with little to no AML monitoring? 

Is DeFi the new wild west? 

The unregulated times of crypto are long gone, at least for central providers. Following the rising popularity and increasing mass adoption, the financial authorities caught up and included crypto into existing laws. Some countries even created new rules, such as the crypto custody license in Germany. However, through the rise of DeFi, the industry is on the best way of turning back into the wild west.

How is DeFi different from other crypto services? 

The straight answer is: control. While the offered services might be the same at first sight, there is a huge difference in governance. While a crypto exchange like Coinbase or Bitpanda is operated by a company with a legal entity, decentral exchanges, like Uniswap, are not controlled by a central company or entity. In consequence, there is no single entity to be governed or sued. 

How unregulated DeFi puts the image of crypto at risk. 

Open, borderless, permissionless – for the same reasons DeFi offers limitless opportunities, it brings along the same amount of risk of money laundering and fraud. In our traditional financial systems, central institutions and governing authorities were created to prevent fraud and ultimately create trust. 

Regulators are struggling to comprehend and process DeFi applications without institutions or intermediaries. In consequence, the international Financial Action Task Force (FATF) published a new guidance for virtual asset service providers (VASP) with a new focus on DeFi. In their guidance, the FATF is essentially recommending its members to crack down on DeFi without a KYC check and proper AML monitoring. 

KYC does not mean centralization. 

Critics say that any form of KYC would transform a DeFi application into a centralized service. However, that is not necessarily true, as the KYC check does not need to be performed by a central entity. Instead, DeFi protocols could create the mechanisms to allow trusted third parties, like identity providers, to perform the KYC and verify the holder of a crypto wallet. Based on the successful identity verification and AML screening, a wallet address could be whitelisted. This way a DeFi protocol could remain decentralized, but the trust and security would increase tremendously. 

DeFi is global, but regulation is local. 

One of the key benefits of DeFi is it being borderless and accessible to everybody on the internet. At the same time, traditional finance is centralized and financial and AML regulations highly local. To onboard and service customers from all around the world, you not only need partners that can handle a large variety of identity documents, but also comply with the respective country-specific AML regulations. 

How KYC could boost DeFi mass adoption. 

Corporate users and institutional investors require compliant solutions in order to comply with their own regulation. For example, big players like PayPal and Robinhood are asking Uniswap, the largest decentralized exchange, as well as OpenSea, the leading NFT marketplace, to implement mandatory KYC checks before they can integrate the services. Therefore, complying with KYC and AML regulation would open up DeFi to new user groups and hence boost mass adoption. 

The light side: DeFi plus KYC & AML. 

Ultimately, the discussion about KYC or not, will split DeFi into a light and a dark side. It’s now upon DeFi protocols and their developers to decide on which side they want to play. Those who intend to join the light side should look into implementing KYC checks into their protocols, before the regulators will crack down on DeFi for good. Furthermore, a lot is happening in the area of NFTs and anti-money laundering.

To learn more about how IDnow can fulfill your KYC needs in a decentralized world, visit our Crypto industry page. Make sure to read our blog posts on why buying crypto without a KYC check is an immense risk for both users and platform operators, and ‘Gaining trust during uncertain times – How KYC crypto solutions can lead the way’.

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Are DeFi and KYC a contradiction? 1

Jonathan Bluemel
Senior Content & SEO Manager at IDnow
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