DeFi Compliance — Building Transparent Business Relationships
Digitisation is contagious. It has normalised online marketplaces and stirred a new wave of consumer interest. As people tend to shift towards convenient and real-time digital solutions, decentralised finance (DeFi) plays a key role in making transactions and payment gateways protected from identity thieves. DeFi offers an effective security mechanism for peer-to-peer exchanges and businesses alike, encrypting transactional data for foolproof security. Since these distributed systems are highly complex and emerging, DeFi is currently subject to existing regulatory laws.
Financial regulators are concerned over the increasing risks of money laundering and related financial crime being carried out through platforms providing blockchain-based solutions and crypto services, which one way or the other fall under the DeFi regime.
What are Financial Services Today?
A few years back top-tier financial institutions like banks carried out Know Your Customer (KYC) procedures to screen and validate customer identities. Although it usually depends upon the service provider, the KYC process for a single customer took an average of 2 to 3 days to properly verify before onboarding. With the world becoming smarter and business tech-savvy, financial services have seen a new dawn of virtual currencies and investor appetite towards them.
Third parties and central authorities are no longer responsible for engaging customers and businesses for financial agreements, since they can now directly make payments with their digital wallets instantly. A quick method to track the growth of DeFi systems is by considering the Total Value Locked (TVL), which was 93.13 billion USD as of September 2021. This staggering amount of revenue generated by the crypto sector drives home the fact that DeFi has a promising future despite the regulatory burden and increasing cybercrime.
The Advent of Decentralised Systems
Cryptocurrency has been the centre of attention for investors given the surge in popularity among consumers and its soaring economic value. With Non-fungible tokens (NFTs) and their artwork becoming a great source of income for digital users, businesses now tend to be open towards innovative payment methods supporting crypto transactions. The total value locked by cryptocurrency is in fact the aggregate value of all tokens stored on the public ledger. TVL also acts as a security interest, which means that transactions are not only encrypted but backed by DeFi protocols.
When we talk about where DeFi will stand in the coming years, it is hard to give a figure or definite prediction. What investors and experts believe is that DeFi is here to stay and needs to be regulated as per the same regulation for financial institutions like banks, insurance firms, credit unions, and mortgages. In this regard, global watchdogs like FinCEN, FATF, and the EU have issued certain guidelines regarding DeFi compliance that will bring the all-important transparency and trust in business relations.
Why is DeFi Compliance so Important?
Blockchain systems are the backbone of decentralised financial services. These systems are high-end and relatively hard to understand, which is why regulating these services is not an easy job. Since decentralised exchanges (DEXs) use DLT — Distributed Ledger Technology — criminals use the pseudonymity aspect to their advantage. This is the main concern of regulatory authorities when developing and implementing Anti Money Laundering (AML) compliance policies and procedures throughout organisations.
The 6th AML Directive by the European Union specifically targets Virtual Asset Service Providers (VASPs) which are an integral part of the DeFi landscape. As per the text of the regulation, crypto exchanges, digital currency wallet providers, crypto dealers, and all types of DEXs are obligated to contribute their due share in mitigating money laundering risks through decentralised financial platforms. The 6AMLD lists 22 predicate offences and is relatively more stringent towards non-compliance violations when compared to its earlier versions.
FATF on DeFi Compliance for VASPs
The financial supervisory body, Financial Action Task Force (FATF), is as concerned as global regulators over the increasing risks related to DeFi systems. To timely cater to this dilemma, FATF proposed the Travel Rule in 2019 according to which VASPs should develop a viable approach towards identifying crypto transmitters and make information sharing transparent. This AML/CFT compliance obligation is an update to Recommendation 16, which was previously only for global and domestic bank transfers, and is applicable to 37 of the member states. Although DeFi exchanges are developing protocols for user identification, they need to advance efforts given customer data security challenges.
DeFi Compliance is the Way Forward
To bring decentralised finance under regulatory scrutiny and keeping bad actors at bay requires crypto-related businesses and blockchain service providers to stay compliant with global regulations. This will not only bring greater transparency between businesses and potential clients but will also strengthen global AML/CFT efforts, in the long run, ensuring compliance across the board.
