Beyond Anonymity: the Need for KYC in Onchain Finance
TL;DR
KYC procedures are necessary for some blockchain-based offerings, such as tokenized securities.
Institutional investors will play a big role in mass adoption.
Striking a balance between DeFi innovation and KYC compliance is crucial for sustainable growth.
The core concept of DeFi is to enable users to interact directly with a product or service without an intermediary, therefore not being managed by a centralised organisation or government, and instead use a financial service or instrument that operates on a blockchain.
Blockchain’s main feature is the distributed ledger technology which is transparent, open, borderless, and permissionless.
By nature, decentralised finance should not need users to undergo KYC (Know Your Customer) processes. But is this always the case?
The risk of AML and fraud
Open, borderless, permissionless: the trifecta of decentralised finance. Anyone can sign up or open an account on a DeFi platform, no questions asked. A freedom that comes as a double-edged sword as it can be used as a breeding ground for money laundering and fraud.
In a world where central institutions and governing authorities were created to prevent such activities and ultimately build trust, it is difficult to understand and shift to a new paradigm where anonymity is at the forefront - so much so that a new guidance for Virtual Asset Service Providers (VASP) was published by the international Financial Action Task Force (FATF), focusing on the licensing and registration of tools available for peer-to-peer transactions.
In short, the FATF recommends its members to crack down on DeFi without a KYC check and proper AML monitoring.
What is KYC?
It is the process through which a platform confirms the identity of the user via sources of identification such as ID card, passport, utility bills, or other means. This information is then verified by the platform to ensure that the customer is who they claim to be.
In essence, Know Your Customer (KYC) categorises the user as either an entity or an individual, and cross-references information provided with AML watchlists in order to ascertain whether they are of good standing, or enacts enhanced due diligence (EDD).
How it can boost mass adoption
As more and more regulations are issued by governing bodies, corporate users and institutional investors will require compliant solutions in order to fully operate.
Even established names such as PayPal and Robinhood are asking Uniswap, the largest DEX, as well as OpenSea, the leading NFT marketplace, to implement mandatory KYC checks before they can integrate the services.
What’s more, implementing Know Your Customer can help crypto, which is currently perceived in a negative light due to the above mentioned issues, to rehabilitate its image.
With an increased number of people having faith in crypto, KYC and AML open DeFi up to new user groups, which could boost mass adoption.
Know Your Customer does not equate centralisation
A common misunderstanding is that KYC immediately equates to centralised authorities. Though it may be the case in TradFi, it is not necessarily true in DeFi.
There are in fact a few solutions put forth where the identification process is carried out in a decentralised manner. A couple of these are:
- ZK Proof: zero knowledge proof are cryptographic methods that allow one party to prove to another that a specific statement is true without revealing any information about the statement itself. KYC is therefore carried out, but privacy remains paramount.
- “Anonymous traceable”: Victor Yim, the head of Cyberport, fintech at Hong Kong’s incubator for entrepreneurship, suggests a solution where individuals remain anonymous unless called upon by law enforcement, at which point KYC will be implemented.
Critics may still argue that these methods are not true to the decentralised philosophy.
Other possible solutions may see DeFi protocols potentially establish mechanisms enabling trusted third parties, such as identity providers, to execute KYC processes and authenticate the owner of a cryptocurrency wallet.
Following a successful identity verification and anti-money laundering (AML) screening, the associated wallet address could be added to a whitelist. This approach allows a DeFi protocol to maintain decentralisation while significantly boosting trust and security levels.
Why KYC is needed in DeFi
The rise of tokenization has significantly transformed the financial landscape, with traditional assets undergoing a paradigm shift. As tokenization takes center stage, we observe a surge in offerings that leverage blockchain technology to represent ownership in a digital format. Notably, the tokenization of securities has become a prominent use case, providing onchain exposure to more stable fixed-income assets. However, this evolution brings about a necessity for compliance with KYC regulations. The need for robust KYC processes is imperative to ensure regulatory adherence and maintain the integrity of the financial ecosystem.
As touched upon at the beginning, enabling users to transact in total anonymity can result in bad actors taking to DeFi to carry out their unlawful activities.
Exploitation, market manipulation, and fraudulent actions can be achieved by manipulating trades through the use of multiple wallets or automated systems, creating artificial volumes and prices that appear more favourable than their actual value.
Retail investors often lack the resources to hire technical experts for code reviews in DeFi, and the anonymity factor increases the risk of the manipulation of the market. This makes it challenging for investors to assess the legitimacy of trades, resulting in potential losses.
Many DeFi programmers advise new investors to proceed with caution, often found as a disclaimer such as “invest at your own risk”. In the absence of a common framework and a functional system to enforce these principles, the market is headed for corruption, characterised by fraud, insider trading, and asymmetric information. Over time, this can reduce investor confidence and investor engagement.
Knowing this, some countries have already begun to include cryptocurrencies, stablecoins and virtual assets in their financial and anti-money laundering regulations, including the U.S., Canada, and Germany. The implementation of two significant cryptocurrency regulations in 2023 and 2024 is poised to bring stability to the European cryptocurrency market, including MiCA and TFR.
Conclusion
The balance between DeFi and KYC is an ongoing challenge, but the need for Know Your Customer and Anti Money Laundering systems is fundamental if blockchain technology is to truly flourish.
A revolution in the industry, it has all the credentials to spur advancement in the technological and financial sectors if properly harnessed.
As the market continues to grow and new users are onboarded, adjustments need to be made in order to both remain compliant and accommodate clients’ needs. Failing to do so would mean facing stagnation in a very narrow DeFi narrative.
- Navigating Onchain Finance
- Know Your Customer