Regulators from Europe, the United States, and elsewhere are busily working out details on how decentralized exchanges (DEXs) can be referred to as “brokers,” transaction agents, or similar entities that transmit and cooperate with each other. The US called for multinational cooperation in its executive order on the responsible development of digital assets, as did the European Union with its recent Financial Stability and Integration Review. And this is exactly what is publicly available.
Behind the scenes, the whispers of regulation are getting louder and louder. Has anyone noticed that all Know Your Customer (KYC) requests have been made to smaller centralized exchanges in exotic locations over the last two months? That was the canary in the coal mine. With the above designation and collaboration, DEXs will soon be feeling the heat of the regulator.
Yes, regulations are coming, and the main reason DEXs are unlikely to survive the coming storm is their alleged inability to identify the users using and contributing to liquidity pools. In conventional finance circles, providing services without proper KYC procedures is a huge taboo. The lack of identity tracking allowed Russian oligarchs to use the hawala payment service to anonymously move millions of dollars in the run-up to the war in Ukraine, so regulators are rightly concerned about DEXs. To most DEX enthusiasts, KYC sounds like an insult, or at least something a DEX is fundamentally incapable of. But is that really the case?
Related: Crypto Impact on Sanctions: Are Regulators’ Concerns Legit?
DEXs are actually pretty central
Let’s start with the anatomy of a DEX, and we’ll see that they’re not even as decentralized as one might think. Yes, DEXs run on smart contracts, but the team or person uploading the code to the chain is usually given special admin-level privileges and permissions. In addition, a well-known, centralized team usually takes care of the front end. For example, Uniswap Labs recently added the ability to clean known hacker wallets and remove tokens from their menu. While DEXs claim to be pure code, in reality there is still a more or less centralized development team behind this ethereal entity. This team also takes away any winnings to be made.
Additionally, a close look at how users communicate with permissionless chains reveals more centralized bottlenecks. For example, last month MetaMask was not available in some regions. Why? Because Infura, a centralized service provider that the on-chain wallet relies on for an Ethereum API, decided so. Things can always play out similarly with a DEX.
Some people say that DEXs are more decentralized because they are 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 is which ones manage to bring more liquidity to the table and where users are actually going to trade their tokens. After all, that is what the exchange is for in the first place.
Related: DEXs and KYC: A Game Made in Hell or a Real Possibility?
From a regulatory perspective, a company facilitating such trades may be considered a “broker” or “transfer agent” whether open source or not. That is what most regulations aim for. Once identified as such, DEXs will suffer greatly if they cannot meet a variety of needs. This includes obtaining a license, verifying user identities, and reporting transactions, including suspicious transactions. In the US, they would also have to comply with the Bank Secrecy Act and freeze accounts by order of the authorities. Without all of that, DEXs will likely go under.
The identity and KYC problem
Because DEXs claim that they are decentralized, they also claim that they are technologically incapable of performing identity verification or KYC controls. But the truth is that KYC and pseudonymity are not mutually exclusive from a technological point of view. Such an attitude betrays at best laziness or an awkward pursuit of lower costs, and at worst a desire to profit from dirty money being passed around.
Arguments that a DEX is unable to perform KYC without creating a honeypot of personal information lack technical merit and imagination. Several teams are already developing identity solutions based on zero-knowledge proofs, a cryptographic method that allows a party to prove that they hold certain data without revealing that information. For example, the proof of identity may include a green tick stating that the individual has passed KYC but is not disclosing any personally identifiable information. Users can share this ID with a DEX for verification purposes without the need for a central repository of information.
Since their users are not required to pass a KYC, DEXs become part of the puzzle when it comes to ransomware: hackers use them as the main hub for moving rewards. Due to the lack of identity verification, DEX teams cannot explain the “source of funds”, meaning they cannot prove that the money did not come from a sanctioned territory or from money laundering. Without this proof, banks will never issue a bank account for DEXs. Banks require information on the origin of the funds to avoid being fined or having their own license revoked. If DeFi can easily be used for criminal activity, it gives crypto a bad name and pushes it further away from mainstream adoption.
DEXs also have a unique and dedicated suite of software, Automated Market Making or AMM, that allows liquidity providers to match buyers and sellers and collect or determine a price for a particular asset. This is not general purpose software that can be used for multiple use cases like BitTorrent’s P2P protocol, which shifts bits quickly and efficiently for Twitter, Facebook, Microsoft, and video pirates. An AMM has a single purpose and produces profit for teams.
Verifying user identities and verifying that funds and tokens are not illegal helps ensure a level of protection against cybercrime. It makes DeFi safer for users and more viable for regulators and policymakers. Eventually, to survive, DEXs will have to admit this and implement a level of identity verification and anti-money laundering.
By implementing some of these solutions, DEXs can continue to deliver on the promise of DeFi. They can remain open to users to contribute liquidity, earn fees, and not rely on banks or other centralized entities while remaining pseudonymous.
Related: Want to weed out ransomware? Regulate crypto exchanges
If DEXs ignore regulatory pressure, it can end in two ways. Either more legitimate platforms can continue to adapt to increasing government scrutiny and increasing demand for crypto from mainstream investors who need ease of use and security, causing stubborn DEXs to die, or alternatively, non-adaptable DEXs will encroach into the gray market of vast jurisdictions, tax havens and unregulated cash-like economies.
We have every reason to believe that the former is a much more likely scenario. It’s about time DEXs grew up with the rest of us or risk being regulated to death along with the more shady ghosts of crypto’s past.
This article does not contain any investment advice or recommendation. Every investment and trading move involves risk and readers should do their own research when making a decision.
The views, thoughts, and opinions expressed herein 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 leveraging blockchain technologies for a more secure and comprehensive multi-currency account, digital/biometric identity, payment platform and e-money platform. As a licensed and registered financial institution, Everest offers end-to-end financial solutions that facilitate eKYC/AML, digital identity and regulatory compliance related to money movement. He was an advisor to Kai Labs, General Manager of Licensing at BitTorrent and Vice President of Strategy and Business Development at Neulion and DivX.
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