Decentralized Finance aka DeFi is a rapidly-expanding and exciting space that is revolutionizing the way people and businesses approach and interact with financial services.
In many ways, DeFi has marked the point where blockchain technology shifted from just being a store of value – and into a source of value creation.
The premise is simultaneously simple, extraordinary and complex: by cutting out the middlemen (in most cases banks) through the use of decentralized, “trustless” blockchain verification systems – individuals and institutions can essentially perform all of the functions of a financial system autonomously – lending, borrowing and trading with one another.
As a result, DeFi has been the key conduit for blockchain’s evolution into one of the most powerful technological developments in a generation. And it’s growing exponentially.
From potentially opening access to loans and other financial services to the 1.7 billion unbanked people in the world, to providing new ways to stake against inflation and invest in crypto – DeFi is using blockchain technology to change the fabric of finance.
Unsurprisingly, the proliferation of DeFi platforms and services has also attracted the attention of global regulators whose task is to prevent financial systems from being exploited for money laundering, and other forms of criminal and terrorist activity.
One of the key areas of focus for global regulators has been our digital identities. More specifically, how to ensure that people who use traditional financial services, DeFi and other blockchain-based financial services do not hide behind walls of anonymity or false identities in order to exploit the system for illicit financial gain – or to perpetrate crimes and terrorism.
Global regulatory watchdog the Financial Action Task Force (FATF) – which develops much of the regulatory guidance that national financial authorities use for regulating their financial systems – updated its guidance in June 2019 to treat Virtual Asset Service Providers (VASPs) in the same way as traditional Financial Institutions (FIs).
Since then, regulators around the world have been adopting the changes into their law codes.
What this has meant in practical terms is that many DeFi platforms – which are broadly categorized as VASPs – are now subject to the same reporting requirements and Know Your Customer (KYC) rules as traditional Financial Institutions (FIs).
The problem is, the majority of VASPs, such as crypto exchanges and DeFi platforms – implement very loose KYC measures – if any at all. And while regulators have so far largely taken a lenient approach towards regulation of the space, all the signs are pointing to imminent, greater regulation as it rises in popularity.
At the same time, there are some blockchain proponents that view regulation of DeFi as entirely contrary to its core tenets, and a threat to its future.
However, in reality, there are many blockchain-based platforms that have shown that implementing KYC measures intelligently can strengthen DeFi networks’ resilience to cyberattacks, build trust among user bases, and ultimately facilitate their expansion and access to new users.
A decentralized internet and financial system does not need to be lawless – and it won’t be able to evolve in a substantial and beneficial way if it is.
KYC verification technology is therefore set to be a key factor for DeFi platforms to comply with evolving regulatory regimes, and to continue growing, innovating and providing new opportunities for people to access financial services.
The good news is that implementing robust KYC processes on DeFi platforms also has many advantages that can help make the space more secure, build trust among users, and ultimately grow their potential user base. Doing so also doesn’t need to be complex or resource-intensive.
Below, we outline some of the ways KYC technology can be used for DeFi platforms, before touching on some of the key factors to consider when choosing a KYC provider for your DeFi service. But first, let’s take a look at some of the problems associated with unregulated DeFi.
The dangers of unregulated DeFi
As DeFi platforms expand and innovate their offerings and applications, global regulators have demonstrated a steely determination in establishing standards that are designed to prevent exchanges and DeFi platforms from being exploited for illicit financial gain, money laundering and terrorist financing. These measures are largely based on the use of KYC.
However, beyond the risk of criminal exploitation for money laundering and terrorist financing, DeFi platforms – as networks where significant financial value is stored and distributed – are also significant targets for hacks that can drain steal the resources they provide access to.
According to a CipherTrace report notable DeFi hacks in 2020 included:
- Axion Network
- Bancor DEX
- Cheese Bank
- Harvest Finance
- Pickle Finance
- Value DeFi
Those hacks accounted for half of all cryptocurrency related thefts that year – or US$129 million. The report noted that the “explosion” of capital flows to DeFi had attracted criminals to target the space in droves, adding that the lack of “regulatory clarity” had seriously exacerbated the problem.
The threat of fraud and hacks are serious, and can be significantly combatted through implementing robust and efficient KYC.
KYC Benefits for DeFi Platforms
As most DeFi platforms have evolved in a period of regulatory ambiguity and complexity, many of them have taken a ‘wait and see’ approach when it comes to implementing Anti-Money Laundering (AML) and KYC processes.
Because of the complexity and constantly-changing spectrum of regulations, many DeFi platforms have also likely concluded that the costs and effort of implementing KYC/AML processes outweigh the benefits – namely compliance with regulations that have yet to be fully developed or implemented in their jurisdictions.
Some DeFi platforms also worry that asking their users for identity documents might discourage them from signing up.
However, in the vast majority of cases, these concerns are simply misplaced. Implementing KYC/AML on a DeFi platform does not only bring the benefit of compliance with regulations once they are codified into laws – it also provides DeFi platforms with immediate benefits.
Some of these include:
- Building Trust – Having a robust and seamless KYC process in place demonstrates that a platform is professional and takes issues of fraud and money laundering seriously. For platforms that rely on their customers staking capital – as well as lending – having a robust KYC / AML process demonstrates that the platform is serious about the services it provides.
- Expanding User Pools – By implementing a KYC onboarding process, DeFi platforms can ensure compliance with the regulatory regimes and standards of a wide range of jurisdictions around the world – all without the need for enormous human compliance teams. This can allow platforms to gain global user bases, expanding into customer markets that would previously be inaccessible.
- Secure Access – By obtaining verified customer data, platforms can more safely protect user accounts in the event of lost details – and also prevent the threat of accounts being compromised by hackers.
Another concern that some DeFi platform owners have is that carrying out KYC and collecting customer identifier data negates the entire decentralized ethos of DeFi.
However, KYC does not equal centralization. A DeFi platform or app can facilitate decentralized financial transactions, while ensuring that access to the platform is limited to genuine users whose identity is proven.
KYC-Chain’s recent partnership with Alkemi Network is a real-world example of how decentralized compliance can bring greater security and accountability to the space, while simultaneously expanding user bases.
KYC for DeFi: What does it involve?
DeFi platforms that implement an automated KYC onboarding system can carry out numerous checks that use a combination of database cross-checks, AI-driven verification tools, and if necessary – enhanced due diligence (EDD) processes.
A robust onboarding process for a DeFi platform would involve the following steps:
1. Categorize – Establish whether the user being onboarded is:
An institution – this will launch an institutional KYC process that involves checking an entity’s name against global corporate registry and commercial databases, ensuring that it is real, licensed, has a verified address and is active, or
An individual investor – this will establish an individual user’s identity using ID document verification (IDV) checked against government databases. KYC-Chain also uses a series of biometric verification and tampering detection technologies to ensure that uploaded ID documents are genuine. Our new Passive Liveness detection feature also allows for seamless verification of users from video chats or selfie uploads.
2. AML Watchlist screening – This step involves vetting the applicant for presence on global watchlists.
These include individuals and entities that are known to have been involved in illicit financial activity – as well as assessing the risk that they might be involved in such activity. For institutions this involves checking registered principals and Ultimate Beneficial Owners (UBOs) against global sanctions and watchlists. Both institutional and individual watchlist screening crosschecks names against global lists of Politically Exposed Persons (PEPs) and adverse media.
3. Crypto wallet screening – Applicants’ wallet addresses can also be screened for possible association with money laundering, terrorist financing and other AML risk indicators.
4. Risk Profile – Once these elements have been assessed and evaluated, the potential user can be assigned a risk profile based on risk assessment procedures, for a risk based approach. This can then determine whether they are granted access to the network/platform, passed on to a human compliance team for EDD – or rejected.
DeFi platforms are increasingly faced with a choice: to attempt to continue operating without adequate compliance measures in the hope that regulations (and fraudsters) don’t catch up with them – or to embrace the opportunities provided by advanced KYC technology to ensure compliance, build trust among users, and safeguard their networks from criminal exploitation.
KYC-Chain’s onboarding solution allows DeFi platform owners to achieve the benefits of compliance and verified customer bases while maximizing the incredible potential of decentralization to revolutionize the way the financial system works – and how people can benefit from it.
Need a trusted and experienced KYC provider for your DeFi project? Get in touch and we can start a conversation.