The rapid growth in decentralized finance or DeFi and yield farming will possibly attract greater regulatory attention to avoid money laundering.
A joint research paper by global management consulting firm BCG Platinion and Crypto.com has shown that the rapid growth in DeFi in 2020 has created the potential for money laundering which will attract greater regulatory attention.
Since the beginning of the year, the dollar value of cryptocurrency collateral locked across DeFi platforms has increased over 1200% to reach $9 billion according to data provider DeFi Pulse.
DeFi is permissionless and decentralized which means, unlike centralized exchanges, there is no need for KYC (know your customer) for users. It operates largely beyond the realms of government and regulatory control which makes concerns about illegal access to financial services according to the report.
Ciphertrace reported: “Since DeFi protocols are designed to be permissionless, anyone in any country is able to access them without any regulatory compliance. As a result, DeFi can easily become a haven for money launderers.”
DeFi protocols are built in a way that they can escape the threat of regulation by moving to full decentralization including governance, meaning regulators cannot shut the platforms down even if they wanted to.
However, the scale and governance of DeFi protocols are different in terms of full decentralization. Some protocols, such as Uniswap, have had substantial venture capital backing by highly centralized corporations, Andreessen Horowitz and Union Square Ventures in this case.
Global regulators may turn their attention to DeFi as it grows in scale. This can involve using decentralized identity and address checking services in order to blacklist certain users.
Fiat money needs to enter the ecosystem at some point, which is often via traditional centralized exchanges which are highly regulated. Financial Action Task Force (FATF) regulations include the ‘Travel Rule’ which needs Virtual Asset Service Providers (VASPs) to collect and transfer customer information during transactions.
This may end up with the mass whitelisting and blacklisting of blockchain addresses associated with certain tokens, exchanges, protocols, and even traders. If fiat onramps, such as centralized exchanges, are prevented from transferring cryptocurrency to DeFi-associated addresses, then DeFi protocols may be forced to adopt KYC and other regulations.
The research noted that the current FATF recommendation is that if the DeFi protocol is sufficiently decentralized and the entity behind it is not involved in daily operations, it may not be classified as Virtual Asset Service Providers (VASPs) and so it will be immune from the Travel Rule.
But as Ciphertrace noted: “Judging by the current regulatory trends of greater KYC and other compliance requirements such as the FATF Travel Rule, DeFi could eventually fall under the scope of global regulators as it grows in scale.”