Newsflash: KYC won’t kill DeFi

KYC, which stands for Know-your-client/customer, is a tool used to associate people online with their true offline identities. This process is used for identifying potentially criminal activities and tracking suspicious transactions. This protocol is mandatory for organizations that offer financial services. Now that DeFi is gaining popularity, with more people investing in cryptocurrency, it demands the application of similar protocols to DeFi.??

Decentralized Finance or DeFi has created a stir in the traditional financial way. By introducing a novel structure for managing finances and performing financial transactions and investments, DeFi offers new avenues and opportunities for anybody seeking to expand and diversify their investments. DeFi also promotes financial inclusion since only a computer and internet connection is required to start investing rather than having the long process of creating bank accounts and due to the ease of conducting financial transactions. Thus, DeFi has the potential to provide financial services to various corners of the world.?

When it comes to financing, even the most conservative investment strategies have risks and may result in losses. For example, centralized exchanges have to offer some sense of security to their users by making KYC protocols necessary. The principle is to be transparent with your customers, not fraudulent, deceptive, or misleading.

Many are under the misconception that KYC may be killing the true spirit of decentralized finance, which relies majorly on anonymity. On the contrary, the concept of KYC is not necessarily to reveal or disclose the user's true identity but to give them security and assurance that each user is verified and is traceable in a fraudulent transaction or scam.?

Many say that installing KYC requirements across DeFi will kill the industry, justifying the need for anonymity and preserving decentralization. However, many forget that DeFi is not as anonymous as we claim it is. After all, each and every transaction one has ever made is stored on the blockchain, fully transparent and immutable. In CeFi, one knows your name but knows nothing of your account balance and financial history. So the question is, what anonymity o does one prefer??I guess it’s a cultural thing.?

Let’s talk about some good stuff that KYC can bring to DeFi.

Benefits of KYC

• Improves trust and transparency.

The decentralized sector is by nature designed to implement peer-to-peer transactions where the individuals are anonymous. However, when a person is not aware of the other person’s identity, it may become difficult to trust the authenticity of the transactions. Moreover, this anonymity brings in the possibility of scams and fraud.?

By incorporating KYC, decentralized projects guarantee the assurance of the genuineness of the person on the other side. Thus, implementing KYC protocols builds trust amongst users and demonstrates a layer of protection. The users do not necessarily need to know the true identity of the other person when they conduct a transaction. Still, just the fact that the data is securely stored with the decentralized project gives a level of satisfaction to the user. Thus, in the event of a fraud or scam, the user is able to rectify and take action accordingly.

• Lowers risk of financial crime.

When the concept of decentralization and DeFi started, the most appealing factors of it were the anonymity and independence to conduct financial transactions. Now that we have moved forward and a majority of the world is intrigued and involved in DeFi, the financial crimes in the sector have increased massively. Being anonymous makes the performance of such financial crimes trouble-free. Thus, birthing the common misconception that criminals mainly use DEXs to launder their money and for scamming innocent users.?

Therefore, using identification protocols, even under pseudonyms, gives a surety of being able to track down any financial criminals. Making KYC a mandatory protocol will reduce the perception that DeFi is only used for criminal acts and may eventually reduce the risk of financial crime as well.?

• KYC as a trust tool.

The crypto market volatility exists mainly due to the uncertainty of the population in investing in the market. A major roadblock in the mass adoption of cryptocurrencies is mistrust and lack of regulations.?

The users seek risk assessment and management protocols to build trust and widespread acceptance. KYC procedures exhibit risk prevention on the part of decentralized projects and thus, helps encourage users to participate in the crypto market. As a result, this would increase the popularity and adoption of cryptocurrencies and stabilization of the crypto market.

• Keep exchanges and custodial services compliant.

As long as the space is unregulated, there will be a legal risk attached to decentralization. However, the recognition of cryptocurrencies as an important advancement in the financial sector has now encouraged many countries to implement regulations, especially focusing on AML and KYC. AML and CFT regulations are important in preventing several financial crimes.?By incorporating these regulations in the decentralized industry and complying with them by introducing KYC, the decentralized projects will be able to assure their users of security and prevent hefty fines that the authorities may impose due to non-compliance. For example, under the AMLD5, non-compliant fiat-to-crypto exchanges and custodian wallets face fines up to 200,000 EUR per violation.

It is important to understand, as it seems to be an observation of many -?KYC is not public information. A licensed and regulated environment stores your personal information. However, they are also obliged to keep your personal information private and not share it with anyone (unless required by the authorities).?

When talking to DAO representatives, I often hear explanations that KYC is bad for DeFi as one cannot remain private anymore, unsure who’s going to obtain their personal information, etc.?

Sorry to be the one to break it to you, but if you are asking thousands of people to invest money in your vision and in your idea, the basic ‘thank you’ you can give them is by assuring them they have nothing to worry about, and that the potential rug pull is not around the corner, and even if it is -?they do have a way to try to recoup their investments.?

Looking at the millions lost in scams and rug pulls, it still amazes me that many do not understand that these things happen because there are no protection and security mechanisms in place to protect the investors’ assets.?

After a big rug pull, it is not uncommon to learn that the founder-scammer was behind another scammy project years ago in a different region.?

Having KYC in place can remove those issues?- if a scammer knows that somewhere his identity is stored, they will think twice before scamming or at least going for their next scam.?

Being KYCed doesn’t make your identity public, and I am personally against having the founders’ identities public to the community for various reasons. However, there needs to be accountability in place; otherwise, we won't survive too long -?either due to scams or because we are tagged as scammers.

KYC is a necessary component in decentralized blockchain projects. It is a simple feature to incorporate into the project rules in a manner that preserves the anonymity of the community members and assures protection in case of scams.?

What does the EU say??

The European Union was one of the first regulators to mandate KYC protocols. The Anti-Money Laundering Directive (AMLD) 5 and 6 have made it mandatory for decentralized exchanges or any other institution that offers crypto assets. AMLD5 extends AML requirements to all entities involved in exchange services between virtual currencies and cash, including those providing custodian wallets, tax-related services, and traders in works of art. AMLD 5 requires such entities to create and maintain records of KYC and keep them up to date. Within 6 months of the implementation of AMLD5, the EU extended the scope of Anti-money laundering directives with the introduction of AMLD6. The main focus behind AMLD6 was to increase the number of criminal offenses covered by the Directive and increase the penalties for money laundering.??

Conclusively, KYC can be beneficial to the DeFi sector as a whole. Any new technology requires lawmakers to catch up with the problems and find solutions that will help with the development and mass adoption of the technology. Similarly, with DeFi, the regulators need to develop regulations that keep the fundamentals and principles of DeFi intact and provide a solution to the problems that come with implementing DeFi.

Maybe we need a new solution for KYC? A solution that will remove the need for one centralized entity to hold our information.

?Could it be an NFT? There is a risk of a hack…?

A Web3 product that somehow decentralizes the data storing? Would be interesting to see how that would work and how one can update the information when needed, and it’s not too complicated for an average Joe to use it.?

A KYC passport? Too centralized and risky.?

Or maybe Web2 and Web3 can mature enough, become friends, and find a solution together. Perhaps there is a time when we won’t be in the mindset of ‘Web2 Vs. Web3’, and the two will collaborate and build together. Let’s see.?