How is CeFi and DeFi Going to Address KYC (Know Your Customer) in the Coming Years?

Centralized Finance (CeFi) exchanges — act as intermediaries to manage the crypto transactions and activities of users.

Decentralized Finance (DeFi) exchanges — which eliminates the need for the custodianship of assets — allows blockchain technology to take over and users having the authority to manage their transactions and activities directly on-chain.

KYC or ‘Know your customer’ is a regulation imposed by jurisdictions that has been historically initiated by the residents/citizens of the related jurisdiction.

Any businesses investing or operating while needing access to capital markets needs to establish some kind of banking relationship; CeFi and DeFi are no different.

These rules are imposed worldwide and are geared towards ensuring that businesses, and now DeFi protocols, act as money exchange and/or transmitters that obtain ‘suitable’ information on every customer they serve.

This makes it trivial for chain surveillance firms to be used by companies and governments to potentially:

  • Track spending habits:
  • Prevent individuals and now even artificial intelligence (AI) from using other regulated services
  • Confiscate crypto and digital assets
  • Come after any centralized entity or representative for tax liabilities
  • Generally, know more about these entities and individuals than necessary

What Information Needs to be Provided?

To buy a crypto or digital asset from a KYC CeFi or DeFi, users/entities and even AI will need to provide individual user/entity information. How much information is needed will vary from one jurisdiction to the next, some jurisdictions may require a simple name (e-mail) for small amounts (you could easily supply an alias) while others may require more detailed information. Most will ask for any combination of the following:

  • Name
  • Address
  • Phone number
  • Driver’s license
  • Government ID
  • A selfie holding a piece of paper with the name of the exchange and the date
  • A video call with the exchange

Addressing KYC in CeFi is a Nontrivial Task

It’s a nontrivial task because it’s basically mimicking the existing legacy centralized financial KYC infrastructure being used worldwide. Also given the nature of being centralized or having an entity that can be summoned or be enforced to comply, makes it nontrivial since the main players are recognizable.

Addressing KYC in DeFi is a Consequential and Challenging Task

Consequential because it brings:

  • Extreme resource costs to companies and governments trying to comply and to enforce it
  • Misinformation and abuse by the same entities that are trying to provide control over its citizens and users including AI

Challenging because of:

  • The decentralized nature of the protocols / infrastructure
  • Trust minimization characteristics
  • Its design to provide censorship resistance features
  • The pseudonymity as a feature (not a bug) as part of the protocol
  • It is open source & open collaboration as core to most projects

To address these basic secondary results and challenges we must first understand the OSI model as a point of reference.

OSI Model

The Open Systems Interconnection model (OSI model) is a conceptual model that characterizes and standardizes the communication functions of a telecommunication or computing system without regard to its underlying internal structure and technology. Its goal is the interoperability of diverse communication systems with standard communication protocols; the OSI model draft was published by the ISO in 1980.

Just like the OSI model standardizes the communication model, there should be a model that standardizes the different blockchains and Decentralized Ledger Technologies (DLT)s interoperability.

Blockchain and DLTs as Infrastructure

  • The initial infrastructure compared to Internet’s TCP/IP
  • Application layer that provides rails for industry applications
  • Similar to the OSI model application layer 7 i.e., SMTP, DNS, HTTP, etc.

Internet of Value and Where Would KYC Apply?

On layer 1 Store of Value (1), KYC would not be applicable simply because it would destroy fungibility and remove its value proposition. KYC could be introduced in the upper layers and basically become a central bank digital currency (CBDC) or a fiat token type of design.

“Institutional DeFi” it’s a new name for CeFi even though still governed by decentralized consensus.

“Institutional DeFi” platforms will add a whitelisting layer onto its smart contracts to ensure that only “institutions, corporates, and FinTechs” that have passed platforms 3rd party compliance procedures “Know Your Customer verification” can access the “Institutional DeFi” platform. 3rd party centralized systems will also be tasked with implementing Anti-Money Laundering and anti-fraud controls for these “Institutional DeFi”.

“Institutional DeFi” or CeFi solutions will provide:

  • Certified audited smart contracts and a layer of whitelisting so that only KYC participants can access the “Institutional DeFi” services
  • Only approved digital assets will be provided by the “Institutional DeFi” based on demand
  • “Institutional DeFi” participants will be vetted institutions by 3rd party that provides KYC and compliance on them
  • Perform compliance and anti-fraud controls on “Institutional DeFi” by these 3rd party

Conclusion

In the coming years KYC will go through different iterations and tests for several CeFi and especially DeFi platforms and protocols in different jurisdictions globally. Each jurisdiction will have to use “OSI model” type standards that characterizes and standardizes the communication functions or value transfer of information between participants on its respective platforms, without regard to its underlying internal decentralized structure and innovation. Its goal is the interoperability of diverse decentralized value transfer systems/protocols using industry standard value transfer protocols. If KYC is applied to any Layer 1, 2 or 3 DeFi infrastructure, by definition it can no longer be called Decentralized Finance (DeFi) exchanges.

Founder & CEO, C4 CBP at PrivKey LLC, Blockchain strategist, cybersecurity