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Decentralized finance (DeFi) has the potential to reach mainstream adoption and empower people worldwide financially. However, without regulations and identity control, it can easily become a platform for scams, fraud, and money laundering. The paradox is that by introducing stricter control on who can access DeFi products, the industry loses its “decentralization” factor. After all, this is what set it apart from traditional centralized finance (CeFi) in the first place.
This is where KYC (Know Your Customer) standards come in handy. For instance, they provide just enough insight into user/developer ID to reduce access to fraudsters. On the other hand, it maintains a specific level of anonymity that helps DeFi retain its decentralized value.
What is KYC in DeFi?
Know Your Customer (KYC) is a series of procedures to identify whether a user, investor, or developer poses a potential risk of fraud or money laundering.
In traditional finance, most financial institutions and businesses employ KYC procedures for their clients and users. That’s why you must pass a specific check and provide an ID when opening a bank account. In other words, the institution ensures you will not practice illegal activities that would affect its financial records.
The crypto sector has stated from its early days that user anonymity is one of its fundamental principles. Simply put, the gates to the decentralized financial world are open to everyone without the approval of a centralized authority, government, or institution.
Unfortunately, as positive as the anonymity principle is, it has several drawbacks. The main one is that the above gates are open to fraudsters and cybercriminals besides honest investors and businesses. Unsurprisingly, these malicious actors have caused severe damage by scamming people, hacking protocols, and stealing substantial funds.
Following multi-million dollar scams, the DeFi space has realized that too much of anything is not good, including anonymity. So, it has resorted to employing KYC procedures through third-party experts, such as auditors and KYC professionals.
Today, most development teams apply for KYC services to dox their members. They provide identification and an accurate source of their capital. This way, potential investors can have a clearer idea about the protocol they are ready to fund.
Furthermore, KYC procedures work the other way around, too. Investors and users may also pass KYC verification before funding or accessing a DeFi project’s services. As a result, the developers know they are not dealing with potential scammers.
How KYC Works in DeFi
In the United States, regulators have classified cryptocurrency exchanges as money service businesses (MSBs). Also, the authorities have identified DeFi platforms as financial service providers in other countries. Therefore, most DeFi projects must adhere to AML regulations and run KYC procedures on their clients.
Generally, platforms and projects do not conduct KYC verifications. Instead, they approach third-party auditors who use expert tools to verify clients. For example, audit and KYC companies like SolidProof, Certik or similar, help reduce the risk of fraud and money-laundering through their services. As a result, they help prevent DeFi from becoming a hotbed for illegal activities.
KYC vs. Decentralization
The “decentralized” part in DeFi turns blurry the moment a third party has to check and approve users, investors, or businesses. Some may even argue that data collection reduces the anonymity factor. Otherwise, this is the main reason many leave CeFi for DeFi. Moreover, a data leak could spill the beans on many participants, thus making the entire system less secure.
Nevertheless, using KYC in decentralized finance brings more benefits than downsides. For example, it attracts more customers to the DeFi space. People hesitating to invest can now rely on KYC-verified projects, providing them with generally secure investment opportunities.
Furthermore, the third-party auditors only conduct KYC assessments of potential clients. They don’t have to store, transfer, or use the data for any other purpose. So, those undergoing KYC have expert guarantees that their sensitive information will not fall into the wrong hands.
Lastly, DeFi loses a bit of its centralization but gains more security and investment appeal. Meanwhile, all the other benefits of using blockchain-based projects remain. The protocols requiring KYC verification can still offer fully decentralized services and products. Above all, these are now safe from fraudsters and cybercriminals.
The Bottom Line
Before KYC became a standard in DeFi, this sector had to deal with numerous scams, frauds, and money-laundering activities. Moreover, honest projects struggled to attract capital and community support due to the general lack of trust in decentralized applications.
DeFi purists may reject the use and importance of KYC procedures. However, their use has, so far, made the space safer and more appealing. So, we can only conclude that KYC will soon become the norm in decentralized finance and remain that way for a very long time.