The case for regulated DeFi

The US Treasury recently alleged that North Korean hackers have used Tornado Cash, a popular Ethereum privacy service, to launder proceeds from cyber crimes and placed more than 40 USDC addresses on the US sanctions list. This is a stark reminder that crypto can be used for illicit purposes,leading to renewed calls for its regulation or even an outright ban. The former is appropriate; the latter would be a huge mistake.

What is missing from the current conversation is a pragmatic view of the genuine benefits the technology being built on crypto rails is beginning to unlock. Beneath the headline-grabbing speculation, gambling, and cybercrime, there is real innovation occurring on public blockchains with the potential to materially improve the financial system.

An emerging set of decentralised financial applications (DeFi) already replicates and, in some cases, improves on the existing financial system including payments infrastructure, a universal and auditable transaction settlement layer, better digital money (stablecoins), borrowing and lending services, derivatives and trading platforms and much more.  

The benefits of DeFi

DeFi holds promise for many. The most obvious is open access to finance. We take this for granted in Australia, but for those living in oppressive regimes or developing nations, the ability to access and use globally competitive financial products is an important step towards financial inclusion.

Even in developed nations, DeFi already offers some advantages: financial services are available 24/7, an account generally takes seconds not days or weeks to set up, you can get paid hourly and immediately, and retailers can avoid giving away 2-3% for the privilege of accepting an electronic payment.

And in contrast to the traditional financial system, when you use DeFi you are in complete control of your own data. This means, for example, your bank does not own your transaction history - you can take it with you and switching costs are non-existent. If you’ve been through the pain of changing mortgage or credit card providers, you understand the appeal of doing so in seconds online. DeFi also offers more opportunity to switch: international borders are irrelevant meaning competition for your business is global.

Even for law enforcement, DeFi offers unique benefits. The traceability (by anyone) of all transactions on the blockchain allows for much more rigorous audit and investigation of financial crime and tax evasion than in the traditional financial system. 

Despite all its promise, DeFi is far from ready for mainstream use. Most products are less than two years old, experimental at best, and only suited to the most tech-savvy. They have clunky user interfaces, require  you to self custody your funds, and offer no recourse if you make a mistake.

Regulatory grey zone

Moreover, DeFi currently operates in a regulatory grey zone. DeFi users tend to resist know your customer (KYC) standards used to verify customers in investment and financial services on privacy grounds. They argue that because all blockchain transactions are traceable, KYC would be akin to making their bank statement public. This is the most critical impediment to its mainstream adoption

The absence of KYC in DeFi also increases the likelihood of non-compliance with anti-money laundering and countering the financing of terrorism (AML/CFT) obligations.  This is where the DeFi naysayers have valid concerns.

zkKYC

The solution is not to ban DeFi and stifle innovation. Instead, we should look to an emerging development in cryptography called “zero knowledge proofs” to solve some of the challenges around this new paradigm. This technology tackles the privacy vs traceability tradeoff head-on by allowing you to KYC yourself and prove to a financial services provider that you have passed the necessary regulatory checks while simultaneously not giving away your personal details (zkKYC).

This will be a material improvement on the existing system - you’ll only need to zkKYC yourself once (for all financial services!). You’ll maintain your privacy as well as control and ownership of your personal and financial data. In seconds, you will be able to open a new account anywhere in the world and import your transaction and credit history. Hooray for competition!

KYC’d DeFi will be a huge step forward - it will encourage financial innovation, competition and better products for consumers. However, it will be different to the existing system and therefore requires a suitable regulatory framework that captures the nuances of zkKYC.  As we saw when China prohibited bitcoin mining, bans are ineffective when it comes to decentralised technologies. Instead, financial regulators should focus on understanding zkKYC and developing a framework that balances innovation with legal compliance. 

DeFi’s promise of an upgraded global financial system with open access, a universal and auditable transaction settlement layer, and better digital money is too good to pass up. It is time for the sector to grow up and lean into solving AML/CTF compliance, educate regulators, help them develop appropriate frameworks and prepare for mainstream use.

(NB: this post originally appeared in the Australian Financial Review on 9 September 2022)