One of the most contentious issues in the decentralized finance (DeFi) space is that of regulatory compliance and the sacrifice of anonymity that comes with it. But, whether you like it or not, know your customer (KYC) regulations are becoming increasingly common. They are even beginning to enter the traditionally permissionless world of DeFi.
In this article, we will explore what KYC regulations are and how they have impacted the distributed ledger industry. Then, we will take a look at how Radix is working to create a solution that allows permissionless systems and regulation-compliant ones to exist in harmony together within the same ecosystem.
The early days of distributed ledgers promised anonymous, permissionless movement of capital. However, this was quickly met with the reality of existing banking regulations that required financial institutions to gather personal information about their customers. These laws all fall under the umbrella of anti-money laundering (AML). The most well-known of these is the KYC law, introduced in the US in 2001 as part of the Patriot Act.
KYC dictates that banks and other financial institutions must gather essential personal data on each of their customers. The goal is to prevent fraud, money laundering, and the funding of terrorist organizations.
As an end-user of any centralized exchange or blockchain-based service that is subject to KYC regulations, you will likely have experienced this. When signing up to purchase, sell, or trade cryptocurrencies, you must first verify your identity using your driver’s license, passport, social security number, or a combination of documents.
KYC vs Decentralization
The requirements of KYC create an inherent problem for the permissionless promise of distributed ledgers. While users can transact directly with each other without identifying themselves, moving money in or out of decentralized networks without completing KYC verification has become increasingly difficult.
The vast majority of cryptocurrency holders use a centralized exchange as an on-ramp into the crypto ecosystem. Many of them remain in a centralized exchange to transact and trade, and most use them as a way to exit back into fiat currency when they need to. This means going through KYC if they are in a region that is subject to that regulation.
Enter DeFi. Decentralized exchanges (DEXs) and other decentralized applications (dApps) offer an alternative solution. Using a single wallet address and the private key that controls it, users can access a vast network of financial services through what amounts to a “single sign-on” for finance.
However, the current model is still not a perfect solution. Single-key entry to the DeFi ecosystem is efficient at the moment, but, it only works if all the dApps within that ecosystem remain permissionless. Many DeFi services, such as Aave, are already exploring permissioned offerings such as Aave Pro. As this becomes more common, we will be back where we started — with individual KYC processes for each dApp that requires it.
For DeFi to grow to mainstream levels of adoption, it must reckon with KYC. While some services will prefer to remain in a permissionless ecosystem, many institutional investors will require KYC as they move their capital (and that of their clients) into DeFi. As it stands, there are only two imperfect solutions available: either avoid KYC altogether or force everyone to continually provide their KYC/AML information to every single service provider they need to interact with, just like with traditional banks. A different solution is needed.
The Future of DeFi Compliance
Radix believes in the value of permissionless systems. However, it is important to recognize that KYC is not going anywhere. This means that for DeFi to become mainstream, new and adaptable solutions must be found that prevent regulatory compliance from becoming a barrier to innovation.
Radix has approached the problem with the goal of recreating the “single sign-on” experience of Ethereum and modern DeFi in a solution that can accommodate the shifting regulatory requirements of KYC for dApp developers.
That solution is Instapass. After a single KYC verification process, Radix users can connect their off-ledger identity to their crypto wallet. They will then be in complete control of that information, choosing which applications on the network to share it with, or not. There will be no need to go through the process again for any service on the Radix Network that needs to comply with KYC rules and uses Instapass.
For developers, it will mean frictionless integration of KYC with their dApps from day one. Or they can start as a permissionless service and add a pro option with KYC later. Developers should be focused on creating the best products, not building bespoke solutions to regulatory requirements. Instapass will make that possible.
Most importantly, users on the Radix Network that do not want to go through KYC will never have to. The fundamental pieces of the Radix infrastructure will always remain permissionless. In this way, Radix can preserve the essence of DeFi while taking it to a mainstream audience.
For DeFi to service the entire global financial market, it will have to accept a certain level of regulation. KYC is not going anywhere, and mainstream adoption will never happen without the support of institutional investors and retail customers who expect a level of regulatory controls.
The Radix team understands this and has been working to create a solution that preserves the essence of DeFi while making life easier for users and developers that need to adhere to KYC laws. That solution is Instapass: a fully optional single sign-on KYC system that requires just one verification process to unlock permanent access to every KYC-compliant dApp to be built on the Radix Network.