With the continual developments in blockchain technology, the adoption and use of decentralised finance (DeFi) is becoming more and more common. Broadly defined as any peer-to-peer financial service that does not require the regulation of a centralised intermediary, the use of DeFi enables one to engage in financial services (such as normal transactions) without the risks associated with traditional financial service providers.
The Benefits of using DeFi
As DeFi is built off blockchain technology, users of DeFi get to enjoy the benefits that come with the adoption of blockchains. From being able to retain anonymity in the system to ensuring that the recorded transactions remain immutable (immune to changes), DeFi allows for financial systems to be more secure.
At the same time, due to the decentralised nature of a blockchain system, DeFi allows everyone to access financial services while ensuring that the entire financial system remains transparent and trustable.
However, the adoption of DeFi isn’t completely risk-free.
The Risks of DeFi
A spokesperson for the Monetary Authority of Singapore (MAS) aptly pointed out, “Cryptocurrencies could be abused for money laundering, terrorism financing or proliferation financing due to the speed and cross-border nature of the transactions”.
Due to the ability for DeFi participants to remain anonymous, there are cases of criminals that take advantage of DeFi to engage in illicit activities. According to Rachel Woolley, Head of Financial Crime at Client Management Solutions Provider Fenergo, “Cryptocurrencies are currently being used to channel the earnings of everything from ransomware proceeds, the sale of narcotics to some of the most horrific crimes, including human trafficking”.
Apart from money laundering, the anonymity of DeFi participants and the lack of a third-party mediator can also mean that scams and frauds can be more common, as it would be more difficult to track down the culprits of these crimes.
As such, in order to prevent illicit activities from happening through DeFi platforms, regulations have to be put into place.
The Role of KYC
To prevent activities like money laundering, regulators in the US have classified cryptocurrency exchanges as money service businesses (MSBs). Similarly, in many other parts of the world, regulators have classified DeFi related platforms as financial service providers).
With this classification, DeFi related platforms will have to adhere to the prevailing AML regulations and conduct KYC procedures on their clients.
By forcing the platforms to collect and verify identification data from users, DeFi platforms will be able to reduce the potential of identity theft and fraud. With proper KYC and AML protocols, the risk of a DeFi platform becoming a hotbed for illegal funds drops significantly.
KYC vs Decentralisation
Of course, the need for KYC forces the platform to become ‘more centralised’ as the platform now has to become a third party that controls the inflow of new users. Some also argue that the collection of data undermines the anonymous nature of DeFi while making the system less secure (due to the possibility of a data leak if these platforms were hacked).
Even though the nature of KYC makes DeFi less decentralised, many of the benefits of blockchain technology adoption remain on these platforms. All transactions remain unchangeable and all the transaction data remains decentralised.
By reducing the possibility of identity fraud and scams with adequate KYC protocols, DeFi platforms are making their platform safer and more secure for all users. In the long run, the presence of proper KYC protocols might even benefit DeFi as it can help convince new users that DeFi is secure, encouraging DeFi adoption as an alternative for traditional financial services.