Regulators from Europe, the U.S. and elsewhere are scrambling to hammer out details on how to designate decentralized exchanges (DEXs) as “brokers,” trading agents or similar entities that influence transfers and cooperate with each other.U.S. calls for multinational cooperation its executive order Responsible digital asset development, like the EU’s recent financial stability and integration review. And that’s exactly what’s publicly accessible.
Behind the scenes, calls for regulation have grown louder. Has anyone noticed over the past two months that all know-your-customer (KYC) requirements have been put on exotic small centralized exchanges? That’s the canary in the coal mine. With the above designation and cooperation, DEXs will soon start to feel the heat of regulators.
Yes, regulations are coming, and the main reason DEXs will struggle to survive the coming storm is their stated lack of ability to identify users who use and contribute to liquidity pools. In traditional financial circles, providing services without proper KYC procedures is a big no-no. Do Not Track Identity allowed Russian oligarchs to use hawala payment services to transfer millions of dollars anonymously, leading to war in Ukraine, so regulators have reason to worry about DEXs. To most DEX enthusiasts, KYC sounds like an insult, or at least something that DEXs simply cannot do. However, is it really so?
DEX is actually very important
Let’s start with the anatomy of DEXs, and we’ll see that they’re not even as decentralized as one might think. Yes, DEXs run on smart contracts, but teams or individuals uploading on-chain code are often given special administrator-level privileges and permissions. Also, a known centralized team will usually be responsible for the front end. Uniswap Labs, for example, recently added the ability to clean wallets of known hackers, removing tokens from their menu. While DEX claims to be pure code, in reality there is still more or less a centralized development team behind this ethereal entity. The team also accepts any profits.
Additionally, digging into the way users communicate with permissionless chains reveals more centralized chokepoints. For example, last month, MetaMask was unavailable in some regions. Why? Infura, a centralized service provider whose on-chain wallet relies on the Ethereum API, decided to do so. With a DEX, things can always work in a similar way.
Some say that DEXs are more decentralized because they are open source, which means that any community is free to fork the code and build their own DEX. Of course, you can have as many DEXs as you want, but the question is which DEXs bring more liquidity to the table, and where users actually go to trade their tokens. After all, that’s the purpose of exchange in the first place.
From a regulatory perspective, an entity facilitating such transactions can be considered a “broker” or “transfer agent,” whether or not it is open source. This is where most regulations are going. Once identified as such, unless DEXs can meet a wide range of requirements, they will be on fire. These include obtaining licenses, verifying user identities and reporting transactions, including suspicious transactions. In the United States, they must also comply with the Bank Secrecy Act and freeze accounts at the request of the authorities. Without all of this, DEXs are likely to fail.
Identity and KYC issues
Since DEXs claim that they are decentralized, they also claim that they are technically unable to implement any authentication or KYC controls. But actually, KYC and pseudonyms are not mutually exclusive from a technical point of view. This attitude shows at best laziness or an unhinged push to reduce costs, and at worst a desire to profit from moving dirty money.
The argument that DEXs cannot perform KYC without creating a personal information honeypot lacks technical merit and imagination.Multiple teams are already building zero-knowledge proof, an encryption method that allows a party to prove that it possesses certain data without revealing that information. For example, proof of identity can include a green checkmark to indicate that the person has passed KYC, but does not reveal personally identifiable information. Users can share this ID with the DEX for verification without the need for a centralized repository of information.
Because their users don’t have to pass KYC, DEXs are part of the ransomware puzzle: hackers use them as a primary hub for mobile bounties. Due to the lack of identity verification, the DEX team could not explain the “source of funds,” meaning they could not prove that the funds did not come from a sanctioned region or money laundering. Without this proof, the bank will never open a bank account for the DEX. Banks need information about the source of funds so they don’t get fined or have their licenses revoked. When DeFi is easily exploited for criminal activity, it discredits cryptocurrencies and drives them away from mainstream adaptation.
DEXs also feature a unique single-purpose software suite, automated market making or AMM, which allows liquidity providers to match buyers and sellers and pull or fix the price of a given asset. This is not general software that can be used for multiple use cases, as is the case with BitTorrent’s P2P protocol, which moves bits quickly and efficiently for Twitter, Facebook, Microsoft, and video pirates. AMM has a single purpose and is to generate profits for the team.
Verifying user identities and checking that money and tokens are not illegal helps ensure some degree of protection against cybercrime. It makes DeFi safer for users and more viable for regulators and policymakers. In order to survive, DEXs will eventually have to admit this and employ some level of authentication and money laundering prevention.
By implementing some of these solutions, DEXs can still deliver on the promise of DeFi. They can remain open, allowing users to contribute liquidity, earn fees, and avoid reliance on banks or other centralized entities, while remaining anonymous.
If a DEX chooses to ignore regulatory pressure, it can end up in one of two ways. Either the more legitimate platforms can continue to accommodate increasing government scrutiny and the growing demand for cryptocurrencies from more mainstream investors who need usability and security, so that die-hard DEXs die, or the ill-adapted DEXs will go into the distance grey market jurisdictions, tax havens and unregulated cash-like economies.
We have every reason to believe that the former is more likely. Now is the time for DEXs to grow with the rest of us, or risk being regulated to death along with the shadowy ghosts of crypto’s past.
This article does not contain investment advice or recommendations. Every investment and trading move involves risk and readers should do their own research when making a decision.
The views, thoughts and opinions expressed here are solely those of the author and do not necessarily reflect or represent the views and opinions of Cointelegraph.
Bob Reid Is the current CEO and co-founder of Everest, a fintech company that leverages blockchain technology to create more secure and inclusive multi-currency accounts, digital/biometric identities, payment platforms and eMoney platforms. As a licensed and registered financial institution, Everest provides end-to-end financial solutions that facilitate eKYC/AML, digital identity and regulatory compliance related to the movement of funds. He is an advisor to Kai Labs, general manager of licensing for BitTorrent, and vice president of strategy and business development for Neulion and DivX.