Regulatory risks grow for DeFi as a 'money laundering haven'

The rapid growth in decentralized finance and yield farming is likely to attract greater regulatory attention according to a recent report.

A joint research paper by global management consulting firm BCG Platinion and Crypto.com has indicated that the rapid growth in DeFi in 2020 has created the potential for money laundering which will bring it under the radar of regulatory authorities.

Since the beginning of the year, the dollar value of crypto collateral locked across DeFi platforms has increased over 1200% to reach $9 billion according to data provider DeFi Pulse.

DeFi by design is permissionless and decentralized which means, unlike centralized exchanges, there are no KYC (know your customer) requirements for users. It operates largely beyond the realms of government and regulatory control which raises concerns about illegal access to financial services according to the report.

Commenting on the report in its newsletter, Ciphertrace noted:

“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 believe they can escape the threat of regulation by moving to full decentralization including governance, meaning regulators would be unable to shut the platforms down even if they wanted to.

However the scale and governance of DeFi protocols varies greatly 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.

There is a fear global regulators could turn their attention to DeFi as it grows in scale. This may involve using decentralized identity and address checking services in order to blacklist certain users.

Fiat also needs to enter the ecosystem at some point, which is usually via traditional centralized exchanges which are increasingly regulated. Financial Action Task Force (FATF) regulations include the ‘Travel Rule’ which requires 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 users. If fiat onramps, such as centralized exchanges, are prevented from transferring crypto 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 therefore 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."