Keeping it Clean, or how to comply with AML in DeFi

In March 2021, the global anti-money laundering body FATF (Financial Action Task Force), consisting of 37 county members, has published a draft regulation for virtual asset service providers (VASP). The focus of the published guidance is on the non-fungible tokens (NFTs) and Decentralized Exchanges (DEXs), which highlights how the regulators acknowledge the rising popularity of both. This has intensified the race among the Decentralized Finance (DeFi) market participants to become clean.

The owners of DEXs and others decentralized (dApps) are considered VASPs, so they are responsible for complying with international AML and KYC laws. Despite the absence of the central body in the DEXs, the FATF still acknowledges that the exchange operator facilitates the transfer of assets between the two parties through a distributed ledger.

The draft regulation highlights the elevated risks that are associated with DeFi transactions. The document hints that the DEXs operators need to think about how to de-anonymize the participants of the transactions and create record-keeping to eliminate the systematic Money Laundering risks.

Decentralized Finance does not fit with the existing regulatory framework, or it can’t be compared to what we have seen historically. Regulators across the globe are puzzled about what or who to regulate, the software, the developers of software, as there is no central body. Unlike the Centralized Exchanges (CEXs), the DEXs do not have an order book where the transactions records are kept. Instead, the transactions are executed thanks to the matching engine. The price is determined through the oracles that allow bringing the market price of an asset on-chain.

However, because DeFi is a new phenomenon and a revolution in the world of finance, it requires a new type of regulation, as innovative and technologically powered as the DeFi itself.

The regulation is still a draft, and the regulators are looking for feedback from the market participants. In July, the group representing DeFi market lobbyists have published an open letter addressing the FATF guidelines, suggesting that the regulators should collaborate with the technology leaders to find mutually beneficial solutions that will help reduce the ML risks in the industry.

Following FATF draft regulation, the Swiss-based World Economic Forum (WEF) has published DeFi Policy Maker Toolkit in June 2021. The document is not a regulation but a White Paper with guidelines that aim to educate regulators across the globe about DeFi and NFTs. WEF hopes that by better understanding the nature of the DeFi, regulators will come up with relevant laws. The focus of the white paper is on the risk associated with decentralized finance and, most importantly, on the money laundering risks.

Art-washing

Art is a recognized asset in the alternative investment space. For decades it has been surrounded by the veil of secrecy as it is usually bought by the ultra-rich and kept in the warehouses in freeports. Sometimes the transactions are anonymous, which has raised urgent attention from the regulations with concerns over money-laundering.

The NFT (non-fungible tokens), the digital art stored on the ledger, are even more perfect for the funds-washers, as it usually involves cryptocurrency to make the transaction. Moreover, the party can buy the cheap NFT, sell and buy it to himself several times, pumping the price to whatever is desired and selling to another party eventually., or any other manipulation. This makes it a clear case for money laundering.

However, as NFTs are making it to well-established auction houses such as Sotheby’s and  Christie’s, they voluntarily adopt AML and KYC procedures. Nevertheless, most NFT marketplaces are non-custodial, meaning they do not possess the art at any time but facilitate the transfer of the token from one party to another.

Institutional Investors

The regulators’ attention to NFTs and DeFi does not mean the sector will stop growing in popularity. It is the contrary- the more precise rules and confidence that the AML and KYC requirements are met means more interest from the institutional investors, and this is where the real money is. Once institutional investors have a clear understanding of the compliance procedures in the DeFi market, it will give them the green light to funnel the funds. This, on the other hand, will provide the next growth push.

Large investors more and more embrace digital assets. Several Hedge Funds specialize exclusively in crypto assets. By the end of 2020, their assets under management (AuM) have increased to $3.8 billion from $2 billion the year earlier, according to the PwC Annual Crypto Hedge Fund Report. This is not surprising as the median return for such funds was +128%, comparing to +30% in 2019. Currently, the investors in such funds are High Net Worth Individuals and Family Offices.

Crypto Hedge Funds have not only shown interest in buying Bitcoin. Around 40% have participated in staking, lending (38%), and borrowing (24%). Around a third of crypto hedge funds have traded on Decentralized Exchanges, with Uniswap being among the most popular ones.

Interestingly, around one-fifth of the traditional hedge funds also invest in crypto assets, usually for diversification purposes. Almost all respondents plan to increase their allocation into digital assets by the end o 2021. And around 82% who are not investing cited that regulatory uncertainty is the major obstacle.

Hedge Funds are more suitable for investors with a higher risk appetite and are considered an alternative investment vehicle. So, if the regulation is precise, more institutional investors such as mutual funds, endowment funds, and even pension funds might get involved in investment in the crypto world. The German financial watchdog BaFin already allowed pension funds to allocate up to a fifth of its assets to crypto. However, the funds are still too cautious due to the high volatility of Bitcoin and altcoins.  Given such development, the flow of funds into the DeFi ecosystem is not far away, which means more money coming in. But first, it is vital to solving the compliance issues.

What Can Be Done?

The solution to the AML procedures is as innovative as the DeFi market itself. The technology that helps to bring off-chain data on-chain is called oracles. There are providers, like  PureFi, that have already developed the smart contracts that feed the blockchain with information regarding the money laundering risks. The smart contract is executed if the ML risks are low. This can apply to the liquidity pools of the DEXs, to the peer-to-peer transactions, or NFTs. All market participants can prove the purity of the funds they transfer, receive, or the NFTs artwork they acquire with the certificate.

The certificate can prove that the user did not take in the dirty money trail—the best thing about that the zero-knowledge protocol allows anonymity to be kept without compromising AML compliance.