Identity is the antidote for DEXs’ regulation problem

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Regulators in Europe, the United States and elsewhere are detailing how to designate decentralized exchanges (DEXs) as “brokers,” transaction agents or similar entities that effect transfers and interact with each other. cooperate with. The US called for multinational cooperation in its Executive Order on Responsible Digital Asset Development, as did the European Union with its recent Financial Stability and Integration Review. And this is what is publicly accessible.

The whispering of arrangement is getting louder behind the scenes. Did anyone notice that all Know Your Customer (KYC) requirements have been met on smaller centralized exchanges in overseas locations in the last two months? She was a canary in a coal mine. With the above designation and association, DEXs will soon start to feel regulatory heat.

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Yes, regulations are coming, and the main reason why DEXs will barely survive the coming storm is their lack of stated ability to access liquidity pools and identify contributing users. In traditional financial circles, providing services without proper KYC procedures is a big deal. Not tracking identities allowed Russian oligarchs to anonymously transfer millions of dollars leading up to the war in Ukraine to use the hawala payment service, so regulators are justifiably concerned about DEXs. To most DEX enthusiasts, KYC seems like a disgrace, or at least, something that the DEX is fundamentally unable to do. However, is it really so?

related: The Impact of Crypto on Sanctions: Are Regulators’ Concerns Justified?

DEXs Are Actually Too Central

Let’s start with the anatomy of a DEX, and we will find that they are not even as decentralized as one might think. Yes, DEXs run on smart contracts, but the team or individual who uploads the code on-chain usually gets special administrator-level privileges and permissions. Additionally, a known, centralized team usually looks after the front end. For example, Uniswap Labs recently added the ability to clear known hacker wallets, removing the token from its menu. While DEXs claim to be pure code, in reality, there is still a more or less centralized developer team behind this Ether entity. This team also takes in making any profits.

Furthermore, an in-depth look at the way users interact with the permissionless chain reveals more centralized choke points. For example, last month, MetaMask was not available in some regions. Why? Because Infura, a centralized service provider that on-chain wallets relies on for an Ethereum API, made such a decision. With DEXs, things can always go the same way.

Some say that DEXs are more decentralized by being open source, meaning any community is free to fork the code and create their own DEX. Sure, you can have as many DEXs as you want, but the question remains which ones manage to bring more liquidity to the table, and where do users actually go to trade their tokens. That is, which exchanges are in the first place after all.

related: DEX and KYC: A Match Made in Hell or a Real Chance?

From a regulatory standpoint, an entity facilitating such trades can be viewed as a “broker” or “transfer agent”, regardless of whether it is open source or not. That’s where most of the rules are headed. Once identified as such, DEXs will face major fires unless they can comply with a wide range of requirements. These would include obtaining a license, verifying a user’s identity, and reporting transactions, including suspicious ones. In the US, they also have to comply with the Bank Secrecy Act and freeze accounts at the request of the authorities. Without all this, the DEX is likely to go down.

Identity and KYC issue

Since DEXs claim that they are decentralized, they also claim that they are technically incapable of implementing any identity verification or KYC controls. But in reality, KYC and pseudonym are not mutually exclusive from a technical point of view. This kind of attitude manifests, at best, laziness or an adamant push for low cost, and at worst, a desire to profit from carrying dirty money around.

The rationale that a DEX is unable to perform KYC without creating a honeypot of personal information is lacking in technical competence and imagination. Several teams are already building identity solutions based on zero-knowledge proof-of-stake, a cryptographic method that allows a party to prove that it has certain data without revealing that information. For example, proof of identity may include a green checkmark that the individual has passed KYC, but does not reveal any personally identifiable information. Users can share this ID with a DEX for verification purposes without the need for a centralized repository of information.

Since their users are not required to pass KYC, DEXs become part of the puzzle when it comes to ransomware: hackers use them as a major hub for transferring bounties. Due to the lack of ID verification, the DEX team is unable to explain the “source of the funds”, which means they cannot prove that the funds did not come from the approved area or from money laundering. Without this proof, banks will never issue a bank account for the DEX. Banks require information about the origin of funds so that they are not fined or revoked their own licenses. When DeFi can easily be used for criminal activities, it creates a bad name for crypto and pushes it further away from mainstream adaptation.

DEXs also have a unique and single-purpose suite of software, Automated Market Making, or AMM, which allows liquidity providers to match buyers and sellers, and to draw or determine the price for a given asset. allows. It is not general-purpose software that can be leveraged for many use cases, as is the case with BitTorrent’s P2P protocol, which allows Twitter, Facebook, Microsoft, and video pirates to quickly and efficiently deliver bits. transfers from. AMM has only one purpose and it creates profit for the teams.

Verifying a user’s identity and checking that money and tokens are not illegal helps ensure some level of protection from cybercrime. This makes DeFi safer for users and more viable for regulators and policymakers. To survive, the DEX will eventually have to accept this and adopt a level of identity verification and money laundering prevention.

By implementing some of these solutions, DEXs can still deliver on the promise of DeFi. They can remain open for users to contribute liquidity, earn fees, and avoid relying on banks or other centralized entities while remaining pseudonymous.

related: Want to remove ransomware? Regulate crypto exchanges

If DEX regulators choose to ignore the pressure, it can end in one of two ways. Either more legitimate platforms can continue to adapt to increasing government scrutiny and increasing demand in crypto from more mainstream investors who need usability and security, leaving stubborn DEXs to die for, or alternatively, untraceable DEXs away. – Will go to the gray market of the drawer. Economies like jurisdictions, tax havens and unregulated cash.

We have every reason to believe that the former is a more likely scenario. It is time for the DEX to grow up with the rest of us or to control the risk of death along with the shadowy ghosts of crypto’s past.