DeFi regulation must not kill the values behind decentralisation

The growth of DeFi platforms improves financial inclusion and should be allowed to flourish in a regulated and therefore protected environment.

The development of decentralised finance (DeFi) allows people who previously did not have a bank account to access financial services. Thanks to DeFi, these people are able to save money, use simple loans, derivatives and insurance products.

This innovation, which strengthens financial inclusion, should thrive in a regulated environment where individuals and institutions are protected and suspicious activity is identified and reported. But how to regulate these decentralised products without completely removing the core attributes of decentralisation?

Know Your Customer (KYC) procedures are a key function of the risk assessment and legal requirement to comply with Anti-Money Laundering (AML) laws, which vary from jurisdiction to jurisdiction. Most of these AML laws were introduced for good reasons: to deter criminals by making it more difficult for them to launder money obtained through illegal activities (e.g. human or drug trafficking, terrorism, etc.). AML regulations require financial institutions to know the true identity of their customers, to monitor transactions and to report suspicious financial activities.

Given that decentralised applications (DApps) do not have a central controlling entity, it is unclear who is responsible for ensuring that DApps, including DeFi apps, comply with applicable laws and regulatory requirements. 

Suppose someone uses a decentralised exchange (DEX) to launder stolen funds. Who is responsible for reporting such transactions? Who goes to jail or pays a fine for failing to report such information to the relevant authorities? The members of the decentralised autonomous organisation (DAO) who manage the DApps? The developers who developed the code?

While these questions remain largely unanswered, the global money laundering watchdog, the Financial Action Task Force (FATF) recently proposed guidelines that make it clear that the owner/operator of DApps will be liable for the unlawful use of its service.

This suggests that DApps (DEX and other DeFi applications) will be responsible for complying with national laws enforcing FATF, AML and counter-terrorism (CTF) standards.

Remember that the regulations are currently aimed at companies, not individuals. So your peer-to-peer transactions are not much of an issue for regulators, unless you have laundered millions of dollars in cryptocurrencies and are sending them through the cryptocurrency platform's payment network. At that point, the exchange would be obliged to identify the transaction as suspicious and alert the regulator in its jurisdiction.

At this lofty stage of the investigation, if law enforcement requests certain personally identifiable information correlated with a transaction, the exchange is obliged to provide it. This is why centralised exchanges require users to complete KYC - to have this personal information if required. However, the vast majority of DEXs do not have fully compliant processes. Will DEX exchanges have to destroy the freedoms of our decentralised revolution to meet evolving standards?

24-08-2021, Mr Advice TEAM

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