In 2021, cryptocurrency exchange Coinbase went public and achieved a market capitalization of more than $86 billion.
Though that valuation has come down substantially in recent months, the exchange is still a multi-billion dollar company, thanks in part to the rising popularity of cryptocurrency as an investment asset. Coinbase’s position as an intermediary between buyers and sellers of cryptocurrency allows it to profit any time a user completes a transaction. Other cryptocurrency exchanges like Crypto.com, Gemini, Kraken, Binance, and Bitstamp (amongst others) make money in exactly the same way — as do traditional stock exchanges and brokerages.
But a new breed of exchanges is emerging. Called decentralized exchanges (DEXs), these organizations aim to cut out middlemen like Coinbase and empower their users to complete transactions on a peer-to-peer (P2P) basis. In doing so, they aim to reduce transaction costs and increase transaction speeds.
One of the primary differences between a decentralized exchange and a traditional exchange is the fact that decentralized exchanges are purposely much more anonymous. While this is appealing to many users who value privacy, it also raises some important questions.
Namely, how will decentralized exchanges react if and when governments begin to regulate them? How can they comply with Know Your Customer (KYC) regulations when, by design, the customer is not meant to be known? These are important questions, the answers to which will shape the entire burgeoning industry.
Below, we take a closer look at decentralized exchanges and why it’s so important for them to begin considering KYC and AML regulations now so they will be prepared if and when they find themselves subject to the rules.
The basics
What is a decentralized exchange?
A decentralized exchange (DEX) is a specific type of cryptocurrency exchange designed to facilitate peer-to-peer transactions. Uniswap, SushiSwap, PancakeSwap, Kyber, and Balancer are among the most popular decentralized exchanges today, but there are many alternatives as well.
Because users transact directly with each other via blockchain and smart contracts technology, decentralized exchanges don’t act as an intermediary between the parties in the same way that traditional exchanges do. For this reason, decentralized exchanges typically boast much lower transaction fees compared to traditional alternatives.
Another key difference between decentralized exchanges and centralized exchanges is the fact that decentralized exchanges are non-custodial. This means they do not take custody of a user’s funds. Instead, the end user is always in control of their assets and keys.
In order to become a user on a decentralized exchange, all an individual must do is connect a cryptocurrency wallet to the exchange. Once connected, they can start trading via the exchange without the need to create a separate profile or provide background information like you would typically have to do when opening a bank account or brokerage account. This makes decentralized exchanges much more anonymous than their traditional counterparts — which raises questions around KYC and AML regulations, as mentioned above.
What is Know Your Customer (KYC)?
Know Your Customer (KYC) is a phrase used to describe the general idea that a business should know the identity of their customers or clients before doing business with them. KYC is also sometimes called:
- Know your client
- Customer due diligence
- Identity verification
In addition to simply being best practice, it’s a requirement for some industries. Financial institutions like banks, credit unions, payment companies, insurance agencies, cryptocurrency exchanges (and others) are all required to verify the identity of their customers and ensure that they are, in fact, who they say they are.
Why? At their heart, KYC regulations are meant to prevent cases of money laundering, identity theft, and other financial crimes.
What, exactly, this verification process looks like will vary from institution to institution. That being said, it typically involves collecting and recording certain information (the individual’s name, Social Security number, and address, amongst others) from verified sources, such as their driver’s license, passport, or government-issued identification card. In a way, it can be thought of as a sort of background check on the individual, ensuring that they are not lying about their identity
As a set of standards, KYC regulations are constantly evolving — in part due to changing regulations, and in part due to the evolution of criminals who seek to skirt past them.
What is Anti Money Laundering (AML)?
Anti-Money Laundering (AML) refers to laws and regulations that a variety of governments have in place specifically to limit the prevalence of money laundering activities in their jurisdictions.
These rules and regulations differ by location but universally establish guidelines as to what types of transactions might qualify as “suspicious activity.” They also outline the steps that financial institutions like banks must take if they suspect a transaction has the potential to be linked to money laundering.
One of the most important tenets of AML is ongoing customer due diligence. Sanctions reports and watchlists are constantly changing, with names being added and removed. Financial institutions need the capability to regularly audit their existing customers against these lists, or else they may be penalized.
Another main tenet is the idea that regulators must be able to “follow the money,” which should in theory allow them to identify whether a transaction is legitimate or tied to money laundering. With this in mind, AML and KYC go hand in hand, and the two terms (and sets of regulations) are often discussed alongside each other.
KYC and decentralized exchanges
Decentralized exchanges are not currently required to abide by KYC or AML regulations. That’s because DEX users complete transactions directly with one another using smart contacts, as opposed to a central trading desk like you might find in a cryptocurrency exchange.
Of course, a lack of KYC and AML regulations means that DEXs present an opportunity for unscrupulous actors to take advantage of the industry for money laundering purposes as well as other financial crimes. Because individual users don’t need to verify their identity or the source of their funds when they create an account with a decentralized exchange, it’s much easier for them to slip under the radar compared to traditional financial institutions.
For this reason, many industry experts believe that it’s only a matter of time before decentralized exchanges find themselves subject to such regulations.
On the other hand, there are those who don’t believe that decentralized exchanges can be subject to KYC and AML regulations because it would require the DEX to forfeit user anonymity — which is one of the big reasons that users prefer decentralized exchanges to begin with.
But this argument didn’t stop the SEC, FinCEN, and CFTC from issuing a joint statement in 2019 that made cryptocurrency exchanges (like Coinbase) subject to KYC and AML regulations — a decision which led to a lot of turmoil in the industry, as well as some substantial fines.
As just one example, in 2020, the cryptocurrency derivatives exchange BitMEX was charged with a number of regulatory violations, including some related to inadequate KYC compliance. The company ultimately settled the case by paying a $100 million penalty, as well as ensuring all existing users were verified and up to date with regulations.
It’s similarly unlikely that the privacy argument would prevent the regulation of decentralized exchanges.
With this in mind, it would be prudent for decentralized exchanges to recognize the potential for regulation and begin generating a framework for KYC and AML compliance in the event that it becomes required.
Benefits of KYC for decentralized exchanges
Even if decentralized exchanges do not become subject to KYC and AML regulations in the short term, embracing the key tenets of KYC compliance can lead to a number of powerful benefits for the space.
1. KYC can help build customer trust.
Decentralized exchanges are, by nature, designed to facilitate transactions between peers. But when you don’t know who the other individual is, it’s difficult to fully trust them because there’s no way of tracking the transaction if you are taken advantage of. This potential for fraud scares many potential DEX users away from signing up in the first place.
Implementing KYC protocols builds trust amongst users, as it demonstrates a layer of protection. Even if the user ultimately does not know who the other person is when they conduct a transaction, there is a certain peace of mind that comes from knowing that the exchange does know. This means in the event that fraud, miscommunication, or other error were to occur, the user has a path toward rectifying the situation, which builds trust in the entire process.
2. KYC can help reduce the misconception that DEXs are only for criminals.
Similarly, there is a common perception amongst the public that decentralized exchanges are only used by criminals due to the anonymity that DEXs provide. News headlines like “Criminals have made off with over $10 billion in ‘DeFi’ scams and thefts this year” do little to help that perception. Requiring identity verification reduces the appearance that the space is only used by criminals, and works to rehabilitate the image of the industry.
3. KYC can further the DEX industry as a whole.
Both of the points mentioned above work together to further the DEX industry as a whole. By removing the uncertainty that keeps many individuals (including institutional investors) out of the space, KYC compliance increases the likelihood that decentralized exchanges will gain widespread adoption. The end result is that the entire industry grows.
4. KYC can help reduce legal risk.
Finally, all decentralized exchanges must come to terms with the fact that as long as the space is unregulated, there will be legal risk that comes from the unknown. Regulators can abruptly change course, redefining DEXs in such a way that makes them subject to KYC and AML regulations much as they did with cryptocurrency exchanges.
Implementing KYC policies early — or at least having a framework in place to implement them quickly and seamlessly when they become necessary — reduces this legal risk.
Implementing KYC for your DEX
Once you’ve accepted the fact that your organization needs KYC policies in place, the next step becomes implementing those policies. While it’s possible to handle this completely in house, doing so requires a significant investment of time, energy, capital, and other resources. That’s why most organizations choose to work with an external partner to implement their KYC policies.
With Persona, you gain access to a single platform that helps you meet KYC and AML standards so you can focus on scaling your business.
Verify your users’ identity according to your unique needs. Automate as much or as little of the process as you see fit. Screen individuals against a variety of reports (such as sanctions lists, watchlists, etc.) to reduce the risk of fraud, money laundering, and other financial crimes. Build internal processes for when manual review and investigation become necessary. And do all of this knowing that your users’ data and privacy is protected by multiple layers of security and encryption. Start for free or get a demo today.
