KYC identity verification may become a necessity when DeFi is regulated

Regulators have gradually turned their attention to the world of DeFi. Participants who have experienced explosive growth and reaped the benefits in the past year should perhaps consider regulatory factors in their future investments.

Some leading DeFi projects have also responded in a shorter time and in a more compliant way: the decentralized world is not a free place in the gray area, and it will gradually move towards being restricted following the pace of CeFi.

Measures such as limiting front-end access, requiring KYC, and requiring users to comply with regulations are being implemented...Users are also arguing about whether it is decentralized enough and whether it violates the original intention of encryption technology. Let's take a look at how the project side responds to changes in the environment:

To restrict front-end access:

In order to adapt to the new regulatory environment, Uniswap restricted access to 129 tokens on the app.uniswap.org website front-end on July 24. The original Uniswap contract was not modified.

Although these tokens only account for a small part of Uniswap's trading volume, this decision was not approved by a vote of community members, which led to many users' dissatisfaction, saying: "And that's the end of Uniswap." They believe that Uniswap is no longer decentralized enough, and if token purchases can be blocked from the front end, other functions can also be changed.

KYC identity verification required:

In order to adapt to the regulatory environment and open the door to DeFi for institutions, AAVE is about to launch AAVE ARC, a DeFi platform specifically for institutions, to provide a private funding pool.

No longer permissionless, both borrowers and lenders using AAVE ARC need KYC to use the lending protocol. Due to limited participation, the final returns of private pools may also be different from those of public pools.

AAVE CEO Stani Kulechov said: “The larger vision of Aave Arc is to enable financial institutions to better adapt to risks before participating in decentralized finance. Users who participate in both private and public pools can arbitrage between them, which will also help ensure that private pools maintain similar high interest rates.”

Require users to comply with regulations:

dYdX proactively requires its users to comply with regulations. General Counsel Marc Boiron said in an email: "We have proactively and voluntarily communicated with the CFTC before all protocols were deployed. We have always carefully considered the laws that apply to dYdX. The first protocol developed by dYdX will require US users to comply with the CFTC's retail commodity trading rules."

Founder’s statement:

Kain Warwick, founder of Synthetix, believes that global regulation is inevitable. He also tweeted: "Everyone supports a fairer, open and efficient market, so the goals of DeFi regulators are actually highly unified. Now it is necessary for DeFi participants to coordinate on this unified goal." He also called on everyone to change from fear of regulation to a more optimistic and peaceful attitude.

Is DeFi about to be “de-Americanized”?

More and more leading DeFi projects are making advance declarations and proactively responding to the tightening policies. The regulatory details are also beginning to exert pressure around steps such as "taxation, KYC, and anti-money laundering" to measure whether they involve illegal financial activities or threaten monetary sovereignty. In the Western Hemisphere, the control wind from the United States is even stronger, and some people even joked that this time DeFi will be completely "de-Americanized."

On August 7, the U.S. Securities and Exchange Commission (SEC), the highest institution in the U.S. securities industry, accused two Florida men of using smart contracts and "so-called DeFi" technology to sell more than $30 million in securities without registration. The securities here refer to tokens, which have voting and income rights after purchase, and the focus of the accusation is "unregistered."

On August 19, SEC Chairman Gary Gensler pointed out that "regulators may first intervene in some P2P trading and lending projects, no matter how 'decentralized' they say they are." He also made more radical remarks at the Aspen Security Forum before: "In terms of the use of (cryptocurrency), it is often to circumvent anti-money laundering, sanctions and tax laws."

According to Gary Gensler, even though many DeFi project developers are anonymous and claim that there is no centralized corporate entity, it has ways to incentivize user participation and issue cryptocurrencies, and has not achieved complete "decentralization", which also means that it should be regulated by the SEC.

Gary Gensler, Chairman of the U.S. Securities and Exchange Commission

Expanding the scope of vision, the infrastructure bill recently voted in the U.S. Senate has caused a bigger stir. This bill seems to have nothing to do with cryptocurrency, but two amendments aimed at solving cryptocurrency transaction reporting and taxation directly affect DeFi participants.

The bill hopes to increase taxes on "Brokers", but the definition of "brokers" here is very vague, implying that cryptocurrency participants (miners, LPs, developers, etc.) need to report every transaction to the IRS. This is obviously impossible at the moment, especially for DeFi participants. Although the transaction itself can be traced, it is unknown who is behind the transaction.

Coinbase CEO Brian Armstrong responded by sending dozens of tweets, calling on everyone to oppose the bill, arguing that DeFi participants should not be included in the scope of "Broker brokers" and should not be obliged to actively file taxes. Smart contracts are just programs that run automatically on the blockchain, not companies, which is of course not conducive to the democratization of finance.

He also retweeted Musk's remarks: "There is no need for a bill to determine the winners and losers in cryptocurrency technology."

Questions like "What kind of roles are DeFi participants classified into?" or "Is the old regulatory approach applicable to innovative technologies?" are constantly being raised. Most DeFi supporters believe that regulation should focus on the purpose of new technologies, not the technology itself. In early August, Galaxy Digital CEO Mike Novogratz criticized U.S. politicians and regulators for not doing their homework on cryptocurrencies before enacting laws and regulations.

However, financial security and prevention of illegal financial risks will always be the gap before innovation. In its working draft in March 2021, the International Anti-Money Laundering Financial Action Task Force (FATF) updated the definition of DeFi:

To determine whether an organization is a virtual asset service provider (VASP), it is necessary to consider the entire life cycle of its products. If an organization provides virtual asset services, then even if this service can be operated independently from the organization in the future, the organization still belongs to the virtual asset service provider and needs to be subject to supervision.

Similar to the remarks made by SEC Chairman Gary Gensler, the “virtual asset services” here can be understood as smart contracts on the chain. According to the draft, even if smart contracts can be separated from the organization and the engineers behind them are all anonymous, they still need to be regulated to protect the security of the financial system and prevent money laundering. In more extreme cases, any user who uses the DeFi protocol to conduct transactions needs KYC identity verification.

Unlike the United States, Singapore has become a country that bravely embraces change. On August 5, the Monetary Authority of Singapore (MAS) said it had received 170 applications for payment cryptocurrency licenses and notified 89 companies that if they meet MAS's requirements for licensed operations, they will receive official licenses.

The move also gives Singapore the opportunity to become Asia's first place to cultivate cryptocurrencies. Since 2017, the Singaporean authorities have expressed optimism about distributed ledger technology, believing that blockchain technology can actually improve the settlement efficiency of cross-border financial transactions.

Recent trends from CeFi indicate that more regulatory requirements will gradually penetrate DeFi, starting from institutions to ordinary individuals, and mandatory KYC may become the first step.

For this encryption technology that has not been controlled by a single force since its inception, how to better cooperate with regulators to enforce existing regulations on the DeFi platform without affecting the confidence of participants is one of the biggest challenges facing its development.