Preparing for DeFi Regulation: The Role of Portable KYC

The passage of MICA legislation in the EU is already putting pressure on DeFI firms to start KYCing their users due to the fact that only “truly decentralized” projects are exempt from MICA when in reality most DeFi applications do have an organization or individual ultimately controlling them. Additionally, the EU commission has a target date of EOY 2024 to produce their full report on the risks and recommendations for DeFI. In the U.S., the SEC has started an enforcement action against the largest DEX in the world, Uniswap.

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As the number of individuals engaging in Decentralized Finance (DeFi) continues to grow (as shown in the chart), regulators are increasingly scrutinizing this sector. Although the specifics of future regulations are still unclear, it’s reasonable to expect that fundamental Anti-Money Laundering (AML) and Know Your Customer (KYC) requirements will be extended to DeFi.

Generally, established organizations tend to adhere to a consistent Know Your Customer (KYC) procedure to fulfill their regulatory obligations.

As an analyst, I’m observing that in traditional finance, each institution where I maintain an account independently reiterates the Know Your Customer (KYC) process. This means I have to submit the same documents and information multiple times, although opening a new bank account isn’t something I often do. The repetitive nature of KYC doesn’t usually cause immediate discomfort due to its infrequent requirement. However, in the Decentralized Finance (DeFi) landscape, an individual might engage with ten to fifteen protocols daily. Repeating KYC across multiple platforms leads to frustration and transforms DeFi into a digital replica of the conventional financial system, which I find less efficient and user-friendly.

There’s an alternative: portable KYC.

DApps currently benefit from the flexibility to incorporate identification procedures, both in the present largely unregulated state and as DeFi-focused AML/KYC regulations are introduced. In an unregulated environment, users can submit their identity documents, undergo name verification against AML databases, have their on-chain activities assessed for AML risks, and store records of each check in their digital wallets. These verified users can then engage with DApps whose smart contracts can screen out those who haven’t completed the KYC process. This way, public blockchain technology ensures a secure and compliant user experience.

As a seasoned developer who has spent countless hours dealing with tedious documentation requirements and navigating complex regulatory landscapes, I can attest that this method is a game-changer for both individuals and decentralized applications (dApps). It saves individuals from the tiresome process of repeatedly submitting documents, providing a smoother, more efficient user experience. For dApps, it offers a triple advantage:

DApps that follow Anti-Money Laundering (AML) and Know Your Customer (KYC) rules can utilize portable KYC solutions to meet some of their regulatory requirements, much like unregulated dApps. However, these regulated dApps require complete access to their users’ original documentation for making onboarding decisions. Since customer documents cannot be kept on a public blockchain, regulated entities are allowed to work with service providers to help fulfill AML/KYC obligations. This way, portable KYC service providers can store and transmit the user’s documentation to the entity, allowing them to decide whether or not to accept the user.

The move towards controlled Decentralized Finance (DeFi) systems emphasizes the importance of creative solutions for compliance. A mobile KYC (Know Your Customer) system presents a feasible method to reconcile user-friendliness with regulatory requirements, allowing dApps (decentralized applications) to lower compliance expenses and lessen risks. By getting ready ahead of time, DeFi entities can facilitate an effortless transition towards a more regulated era, promoting trust and robustness within the community.

Disclaimer: The opinions expressed within this article belong solely to the writer and may not align with those held by CoinDesk, Inc., its managers, or associated entities.