Decentralized Finance (DeFi) is being adopted and used more frequently thanks to the ongoing advancements made in blockchain technology.
DeFi, which may be broadly described as any peer-to-peer financial service that is not governed by a central middleman, enables one to engage in financial services (such as typical transactions) without the dangers connected to conventional financial service providers.
DeFi has the potential to gain widespread acceptance and provide financial empowerment to individuals all around the world. DeFi ensures that the entire financial system is transparent and reliable while enabling everyone to access financial services.
DeFi adoption isn’t entirely risk-free, though. Without rules and identity checks, it can quickly turn into a hub for fraud, scams, and money laundering.
The contradiction is that the sector loses its “decentralization” quality by tightening restrictions on who can use DeFi goods. After all, this is what initially distinguished it from conventional centralized finance (CeFi).
Why is KYC Essential For DeFi?
Cryptocurrencies could be used for money laundering, financing terrorism, or financing nuclear proliferation, as a Monetary Authority of Singapore (MAS) spokeswoman rightly noted, “owing to the rapidity and cross-border nature of the transactions.”
There are instances where criminals use DeFi to carry out illegal actions since it allows participants to stay anonymous.
Cryptocurrencies are currently being used to channel the gains of anything from ransomware proceeds, the sale of narcotics, to some of the most heinous crimes, including human trafficking, claims Rachel Woolley, Head of Financial Crime at Client Management Solutions Provider Fenergo.
In addition to facilitating money laundering, the lack of a third-party mediator and the anonymity of DeFi players may make scams and frauds more prevalent because it will be more challenging to identify those responsible.
Regulations like KYC must therefore be implemented in order to stop illegal activity from occurring through DeFi systems.
What is KYC in DeFi?
The Know Your Customer (KYC) process is a set of steps to determine whether a customer, investor, or developer poses a risk of fraud or money laundering.
The majority of financial organizations and companies in traditional finance implement KYC processes for their customers and users. For this reason, while creating a bank account, you must pass a certain check and present identification.
In other words, the organization guarantees that you won’t engage in unlawful activity that would have an impact on its financial records.
User anonymity has been a core tenet of the cryptocurrency industry since its inception. To put it simply, anyone can enter the decentralized financial sector without the permission of a centralized authority, government, or institution.
Sadly, despite the anonymity principle’s benefits, it has a number of shortcomings. The key one is that, in addition to trustworthy investors and enterprises, the aforementioned gates are open to scammers and hackers.
Unsurprisingly, these evildoers have seriously harmed society by defrauding victims, hacking security systems, and stealing huge sums of money.
Following multi-million dollar frauds, the DeFi industry has come to the conclusion that too much of anything, including anonymity, is bad. As a result, it has turned to using KYC procedures through outside experts like auditors and KYC specialists.
Nowadays, the majority of development teams need KYC services for their members. They give their name and the precise source of their funding. In this approach, potential investors can have a better understanding of the protocol they want to support.
Additionally, KYC procedures also function the other way around. Before funding or using a DeFi project’s services, investors and users must successfully complete KYC verification. The developers are aware that they are not working with potential con artists as a result.
How KYC Works in DeFi
Regulators in the US have designated crypto exchanges as Money Service Businesses (MSBs) in order to prevent actions like money laundering. Regulators have categorized DeFi-related platforms as financial service providers in many other regions of the world, too.
Due to this classification, DeFi-related platforms will be required to comply with current AML laws and carry out KYC procedures on their customers.
DeFi platforms will be able to lower the possibility of fraud and identity theft by requiring the platforms to gather and validate identification data from users.
The likelihood that a DeFi platform will serve as a hub for illicit funds decreases dramatically with effective KYC and AML measures.
KYC vs Decentralisation
Naturally, the demand for KYC compels the platform to become “more centralised,” as it must now act as a gatekeeper for new user registrations. Others contend that data collecting weakens DeFi’s anonymity and decreases the system’s security (due to the possibility of a data leak if these platforms were hacked).
DeFi is less decentralized due to the nature of KYC, however many advantages of blockchain adoption are still present on these platforms. Both the transactions themselves and the transaction data are still completely decentralized.
However, there are more advantages to utilizing KYC in decentralized finance than disadvantages.
For instance, it draws more clients to the DeFi area. Now, investors who are on the fence about making a purchase can rely on KYC-verified projects, which provide them typically secure investment alternatives.
Additionally, the third-party auditors only evaluate potential clients’ KYC. They are not required to transfer, keep, or use the data in any other way. Therefore, those who are undertaking KYC have professional assurances that their private information won’t go into the wrong hands.
Finally, DeFi loses a little of its centralization but gains more investment attractiveness and security. All the additional advantages of employing blockchain-based projects continue to exist.
Even with KYC verification requirements, fully decentralized services and products can still be provided. Above importantly, they are no longer at risk from scammers and online crooks.
DeFi had to deal with a lot of scams, frauds, and money-laundering activities before KYC became a requirement. Furthermore, because there is a general lack of faith in decentralized applications, honest projects have a difficult time attracting funding and community support.
With sufficient KYC protocols, DeFi platforms are making their platform safer and more secure for all users by lowering the potential of identity fraud and frauds.
Purists in DeFi may disagree with the use and significance of KYC procedures. But thus far, their presence has made the area more attractive and safe. So, the only logical conclusion is that KYC will quickly establish itself as the standard in decentralized finance and stay that way for a very long time.
In the long run, having appropriate KYC standards in place can potentially aid DeFi since it can persuade new users that it is secure, promoting DeFi adoption as a substitute for conventional financial services.