Pragmatic Decentralization: How IDEX Will Approach Industry Regulations

Last week we announced that IDEX has begun blocking access to NY IP addresses. I want to apologize for releasing this information via a tweet without much additional context. On the plus side, the response has given our team insight into what the broader community cares about most, and what topics to address in the following post.

TL;DR

• Decentralization exists on a spectrum, and unless your system or application lacks any centralized parts it can be subject to regulation
• Aurora is working to create a fully-decentralized financial system, but the path to getting there requires significantly more control and centralization than the end state
• In addition to IP blocking, IDEX will be implementing KYC/AML policies in order to comply with sanctions and money laundering laws

The Aurora Vision

Our goal is to create an open and transparent financial system, one that is governed not by ourselves, but by the consumers and businesses that use the system and make it valuable. IDEX represents the start of this vision, an exchange where:

• Forgoing custody is not a requirement for accessing the network’s liquidity, and users and institutions are free to choose a model that suits their needs.
• The system has increased transparency and auditability, and anyone can confirm that it is honest and fair.
• Businesses and consumers can operate part of the system themselves and get paid for doing so, creating a virtuous cycle of activity.

Clearly the IDEX of today does not yet meet this full vision, but we are well on the path to getting there. The use of a smart contract allows anyone to trade through self custody or a third-party solution. And the first iteration of AURA staking is under development, the start of our work to bring greater transparency and encourage community participation. Decentralization is one tool in the toolkit that we are using to help us achieve this broader vision.

The Word “Decentralized” is Just a Platitude

A lot of great commentary has been written about the misuse of the word “decentralized.” The reality is that decentralization exists on a complicated, multi-faceted spectrum. However, many view the concept with absolutism. In turn, a degradation of discourse has arisen, making the word decentralized all but meaningless.

Instead of labeling something “centralized” or “decentralized,” the community should describe projects by their specific product attributes that arise due to some often-imprecise levels of decentralization. In the context of exchanges, decentralization can be used to create a platform that is:

• Non-custodial — the exchange does not hold or manage any funds
• Censorship resistant — no one person or individual can shut down the exchange or prevent others from using it
• Transparent — open source and verifiable code
• Auditable — all trades are written into the blockchain and history is retained into perpetuity

Everything in Moderation

From the beginning, we adopted the ethos of “pragmatic decentralization” — incorporating blockchain technology where it benefits the customer (custody and settlement), but using traditional technologies where it does not (orderbooks and trade dispatch). Here is a more detailed look at how we created this balance within the current design of IDEX. By decentralizing a select group of features, we were able to build the world’s first exchange that not only provided the security of blockchain custody, but also allowed for the real-time, continuous trading that was only ever available on traditional centralized exchanges.

An overview of IDEX’s current on/off-chain architecture

This hybrid approach has brought tremendous value to all types of traders. One of our favorite things to hear is when users are unaware they are trading on a non-traditional exchange. For market makers the benefits of a hybrid approach are even more obvious as they rely on instant confirmations and settlement to run their trading strategies and provide exchange liquidity. They are wary of parking millions of dollars on a centralized exchange due to the growing number of exchange hacks, and our blockchain-based custody provides them the security they need to sleep at night.

These features are why IDEX continues to hold the #1 Ethereum Dapp spot for 8 months and counting.

The Word “Dapp” is Equally Misunderstood

While you’ll find IDEX on the top of any Dapp (decentralized application) tracker, many argue that we are not a true Dapp. After all, our company has an address. I have a name and birth certificate and we may have even shaken hands at an industry event. You may have run into an issue and spoken to one of our support staff.

None of this would be possible without some points of centralization. Not every project can be successfully launched in the shadows by Satoshi Nakamoto. So, we’ll call a spade a spade and address the semantics that seem to be driving this confusion. IDEX is not a “DEX” in its current state. At this point the best way to describe IDEX is as a “non-custodial” or “hybrid-decentralized” exchange.

But this semantics issue is by no means unique to IDEX. We believe that no DEX is decentralized. As long as a project has a website, off-chain orderbook, or known team, they are not “fully decentralized.”

Why Does this Matter?

The definition of decentralization is of particular importance because of one of the properties described above — censorship resistance. The operations of a truly censorship resistant DEX would be unstoppable even in the face of pressure from nation states. None of the existing DEXs are censorship resistant — with DNS records that can be hijacked, and GitHub repositories to take down (certain elements of the stack are resistant, such as 0x & EtherDelta smart contracts, but there are non-resistant components that bring liquidity together). This means that at the end of the day, smart contract or not, every project may be subject to pressure from regulators.

This is not just a fleeting opinion. It is a conclusion we have reached after several months of rigorous legal review. The decision to block New York state IPs to ensure compliance with the BitLicense regulation is something we believe is necessary for the long-term success of IDEX and all those who support it.

Just go “Fully-Decentralized”

Aurora remains committed to the original vision of a decentralized financial system, but it takes time to do it right. What would IDEX look like if we were to decentralize it to the point of censorship resistance using today’s technologies?

• Orderbooks would be entirely on-chain; placing and canceling orders would be slow and cost gas
• There would be no website to visit; users would be required to download (from a P2P system like BitTorrent) and compile a front-end interface locally
• There would be no customer support; users would be on their own to troubleshoot issues
• There would be no fees (a temporary benefit to the user but one that prohibits further development)

These changes would certainly kill both the product and the business. Most everyone acknowledges that “DEXs” with on-chain orderbooks are currently impractical, while the other changes would make the UX too complex for anyone but advanced users.

But Even That Might Not be Enough

Many have argued that the steps above are a possible path to shielding the product itself from the impact of regulation. However, recent comments from one of the CFTC commissioners shed light on how at least one U.S. regulator views decentralization: It won’t protect the project from liability. The Commissioner argued that smart contract developers can be held accountable for illegal activity if they “could reasonably foresee, at the time they created the code, that it would likely be used by U.S. persons in a manner violative of…regulations.” Additionally, he hinted that the CFTC could even go after individual users of the platform.

The commissioner’s comments are of particular concern to those like us who want to see the space progress as rapidly as possible. If engineers have to consult an attorney before deploying code it will drastically reduce the amount of innovation. Regardless, the intentions are clear. Those creating Dapps need to understand whether or not their product could be used to violate existing laws and regulations, and those who do so without consideration to regulators risk enforcement action.

Our Stance

In our view, the endgame of decentralization is not about zero compliance, it’s about setting a new standard of governance.

Today our users realize many of the other benefits of decentralization, but we still live in a world where the governance of our service is centralized and the standards against which our service is judged are becoming increasingly clear.

Other forward-thinking companies like ShapeShift have recognized this as well. It’s not about lacking the principles or the gumption to stand up to governments, but about having the foresight and restraint to understand that the best way to do this is to convince regulators why their position is outdated and needs to evolve with the economy. Perhaps the regulatory standards will change, but in the meantime we’re working diligently towards meeting our understanding of what’s right while pioneering a new approach of turning governance — the judgment of whether those standards are valid or not — over to the community.

Changes on IDEX

IDEX has begun taking steps to bring the operation in line with rules that we believe apply to our platform. In addition to blocking IPs in NY, North Korea and Iran, we will also be rolling out IP blocks to Cuba, Syria, Crimea and Washington state.

Over the next few months IDEX will begin instituting KYC procedures for all users to comply with both AML and sanctions laws. Like other exchanges, IDEX will have tiers which correlate with the amount of funds users are able to move through the service. Those trading a small amount of funds will be required to provide a minimal amount of information, while those who wish to trade larger amounts will need to undergo additional KYC steps.

Our goal is to implement these policies with as little friction as possible for users. The pseudonymous nature of blockchain-based transactions, like those on IDEX, make it a pretty poor vehicle for money laundering, as transactions are forever recorded in a public ledger. Our program will account for this and use the same blockchain analytics systems to understand which transactions are higher risk and maintain a light touch wherever possible.

Why Now?

In recent months we have seen regulatory engagement increase. The SEC has continued enforcement activity, while also encouraging companies to proactively engage it through its FinHub. OFAC has promised to publish blocked digital currency addresses. FinCen has signaled its commitment to its anti-money laundering (AML) mandate. And an international body, the Financial Action Task Force on Money Laundering (FATF), has announced that it too will begin crafting global AML standards. All of this suggests that the use of a smart contract will not make one exempt from KYC/AML.

Looking on the Bright Side

It’s not all bad news. There are benefits to compliance, too. By embracing the inevitable future, IDEX will be poised to maintain its position as a leading DEX. Our forward-thinking approach combined with the brand recognition and trust built through continued operations bodes well for the long-term success of IDEX and AURA staking.

These changes will also bring many benefits in the short term. We frequently hear from large crypto funds who want to trade on IDEX but cannot due to the lack of KYC. These changes will allow them to participate, creating more liquid markets that benefit all customers.

These changes also position us for the upcoming security tokens boom. For IDEX to onboard security tokens we must have a broker dealer license, and to get that license users who are trading the security tokens must be KYC’d. In the end, the onboarding of institutional funds and opening up the new market of security tokens is a good thing for both IDEX and AURA stakers.

Closing Thoughts

While we realize the information above might be met with resistance, especially among those with more dogmatic expectations of decentralization, we firmly believe that being mindful of regulations is key to the long-term health and adoption of decentralized projects worldwide.

If you have any ideas or suggestions, please let us know. We are eagerly listening. We know we can’t get there without the continued support of our community, and as the AURA staking components grow over time so will the importance of your voice and participation.

Thanks to Phil Wearn, Forrest Whaling, Jason Ahmad, and our legal team at Experience Legal for reviewing drafts of this post.

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