As regulators scrutinize DeFi more closely, participants need to improve compliance around AML and KYC and make the process easier for customers, says Thomas Gentle, Compliance Officer, Quadrata.  

The global cryptocurrency regulatory landscape has evolved rapidly over the past few years, and this swift pace of regulatory rulemaking is unlikely to slow down anytime soon. Lawmakers are increasingly shifting their focus from centralized cryptocurrency exchanges to decentralized finance (DeFi) protocols and applications (dApps). 

The passage of MICA legislation in the EU is already putting pressure on DeFI firms to start KYCing their users due to the fact that only "truly decentralized" projects are exempt from MICA when in reality most DeFi applications do have an organization or individual ultimately controlling them. Additionally, the EU commission has a target date of EOY 2024 to produce their full report on the risks and recommendations for DeFI. In the U.S., the SEC has started an enforcement action against the largest DEX in the world, Uniswap.

As the number of DeFi participants increases (as illustrated in the chart below), regulators are becoming more focused on DeFi space. While the exact nature of future legislation remains uncertain, it is safe to assume that the basic principles of Anti-Money Laundering (AML) and Know Your Customer (KYC) will become applicable to DeFi.

Regulated institutions typically follow a standardized KYC framework to meet their regulatory requirements:

Currently, all three steps of the KYC process are repeated at every institution where an individual holds an account. This requires individuals to submit the same documentation and information multiple times. Since opening a new bank account is not a frequent activity, the inconvenience of repeated KYC is generally not acutely felt by customers. In DeFi, however, someone might interact with ten or 15 protocols a day. Requiring individuals to complete KYC multiple times causes frustration and turns DeFi into a digital version of the traditional financial system.

There’s an alternative: portable KYC. 

DApps now have a unique opportunity to implement this, both in the current largely unregulated environment and, in the future, when DeFi-specific AML/KYC regulations are enacted. In a regulation-free setting, public blockchain technology allows users to submit their identification documents, have their names screened against AML watchlists, have their on-chain activity scanned for AML risk, and store proof of each check in their wallet. Users can then interact with permissioned dApps, whose smart contracts can filter out those who have not passed the KYC checks.

This method is advantageous for individuals, who do not need to endure the friction of repeatedly submitting documentation. It also offers significant benefits for dApps, ensuring  they don’t run the risk of violating sanctions and money laundering rules, while saving money on compliance personnel and systems, and providing resistance to sybil attacks..

DApps subject to AML/KYC regulations can use portable KYC to satisfy aspects of their regulatory obligations similarly to unregulated dApps. However, regulated dApps will need full access to their customers’ underlying documentation to make onboarding decisions. While customer documentation cannot be stored on a public blockchain, regulated entities are permitted to engage service providers to assist in fulfilling their AML/KYC obligations. Therefore, portable KYC service providers can store and transmit the customer documentation to the entity, enabling it to decide whether to onboard the user.

The coming shift towards regulated DeFi protocols underscores the need for innovative compliance solutions. Portable KYC offers a practical approach to balance user convenience and regulatory demands, enabling dApps to reduce compliance costs and mitigate risks. By preparing now, DeFi organizations can ensure a smooth transition into a more regulated future, fostering trust and resilience within the ecosystem.

- Thomas Gentle, compliance officer at Quadrata

Now that the tokenization industry is seeing investor demand, particularly for U.S. Treasury and money market products, on-chain issuers can start moving up the risk curve in the name of diversification. 

Tokenized short-term liquidity funds have found product-market fit across institutions, Web 3.0 investment firms, blockchain foundations, and other crypto-native organizations this year. Six products each reached $100-plus million and one reached the $500 million mark in July 2024, eclipsing $2 billion in collective flows.

Protocols are electing to diversify their own treasury holdings into real-world assets, with Ethereum Layer-2 Arbitrum deploying $27 million in ARB tokens into BlackRock’s BUIDL, Ondo Finance’s USDY, and products offered by Superstate, OpenEden, Backed Finance, and Mountain Protocol. MakerDAO opened the Spark Tokenization Grand Prix competition to tokenize and integrate $1 billion in real-world assets. Meanwhile, synthetic dollar protocol developer Ethena Labs is exploring allocating a portion of its $280 million stablecoin holdings and reserve fund to yield-generating real-world assets.

Prime brokers, market makers, and custodians have also been enjoying the benefits of professionally-managed liquidity products providing pass-through yield where existing stablecoins would not. One good example is prime broker FalconX accepting BlackRock’s USD Institutional Digital Liquidty Fund (BUIDL) as collateral for trading and swap positions from clients. That’s an immediate value-add for FalconX, its clients, and Securitize as the tokenized fund issuance platform alike. More FalconX clients will likely elect to swap stablecoin and cash holdings into BUIDL for the on-chain yield, which will drive additional capital and participants from the digital asset realm towards the Securitize ecosystem. As detailed in April 2024, onboarding capital to tokenization platforms through short-term liquidity funds is paramount to tokenized alternative assets seeing success.

Web 3.0 organizations and asset managers will begin shifting up the risk curve and building out diversified books after finding some level of comfort with tokenized liquidity funds. Private investment funds are ripe for an unlock. Singular commercial real estate and residential real estate assets have proven to be tough sells; they concentrate risk, are not very differentiated, and generally have less velocity than investment funds geared towards the same asset class.

Contrast that with the $14 trillion residential mortgage space and associated Mortgage Servicing Rights (MSR). Residential MSR have clocked an estimated $1 trillion in annual secondary trading volume during each of the last four years running through venues like Blue Water. Token-focused investors are typically seeking two-sided liquidity, an active market, and underlying asset velocity. Bringing an existing two-sided market to the tokenization space will alleviate current industry pain points, offering something attractive to the nearly $2 billion in liquidity fund capital that resides on-chain. As such, Blue Water sits as that bridge between digital asset capital markets and the ever-active mortgage industry.

Disclosures: Disclosure - Blue Water Financial Technologies (bluewater-fintech.com)

– Peter Gaffney, vice president, business development & strategy, Blue Water Financial Technologies Services

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