What DeFi Must Sacrifice to Appease Regulators

The “internet financial system” is a pro-compliance, but pro-privacy framework to build crypto protocols which satisfy regulators and consumers.

AccessTimeIconApr 17, 2023 at 1:12 p.m. UTC
Updated Apr 17, 2023 at 4:27 p.m. UTC
AccessTimeIconApr 17, 2023 at 1:12 p.m. UTCUpdated Apr 17, 2023 at 4:27 p.m. UTC
AccessTimeIconApr 17, 2023 at 1:12 p.m. UTCUpdated Apr 17, 2023 at 4:27 p.m. UTC

Decentralized Finance (DeFi) has emerged as a revolutionary force in the financial industry. When traditional banks narrowly avoided a systemic bank run, and centralized exchanges (CEX) collapsed spectacularly, DeFi kept working, providing trustless financial services to people around the globe.

Markus Maier is the founder and managing director of Violet, a privacy-focused DeFi platform.

Success, however, brought with it bad actors and illicit financial transactions that troubled regulators worldwide. An unusually successful algorithmic stablecoin soared and then collapsed, whipping out billions in dollars of capital and the loss of retail enthusiasm. Hackers stole nearly $4 billion by exploiting crypto protocols in 2022 alone (with North Korea as the prominent perpetrator). To say there’s been a loss of regulatory goodwill is an understatement – the U.S. Treasury Department now considers DeFi a national security threat.

These problems have kept most traditional financial institutions out of DeFi, which is detrimental to long-term growth and adoption of crypto. In the depth of crypto winter, the industry must find a solution to spark the next cycle and bring mass adoption.

The solution is called the “internet financial system,” or IFS, which combines the best of DeFi and traditional finance (TradFi) in one unified network. An idea championed first by Chris Burniske, IFS is built on open crypto rails and preserves blockchain’s most important attributes such as decentralized settlement, self-custody, transparency and composability.

However, the IFS tries to be genuinely inclusive, enabling the billions of people already part of TradFi and financial institutions to benefit from on-chain innovation. Connecting crypto to TradFi will not only bring more users, but also unlock trillions of assets that are currently trapped in these siloed financial systems.

To achieve this feat, the IFS must square the circle: It must be built on top of decentralized architecture while still mapping TradFi compliance and national regulatory requirements (all without giving up on privacy). It’s a monumental effort that requires new tech, standards and laws. Thankfully, this second revolution has already begun, charging ahead on three fronts:

  1. Programmable compliance: Illicit finance is a national security issue, and lawmakers reasonably expect a new IFS to improve upon the compliance sophistication in TradFi, not jettison it entirely. The IFS must find a way to map rigorous anti-money laundering (AML) compliance in a programmatic, on-chain execution environment. Effectively, this means adopting programmable on-chain compliance, which can handle ongoing AML checks and differentiate between different laws by national origin.
  2. Regulation: The IFS’ long-term success hinges on regulatory acceptance. We understand the DeFi community’s frustration with regulators. However, if we engage in good faith and show policymakers solutions to illicit finance problems – e.g., technology that stops bad actors before they enter the system – policymakers will craft smart, workable guidelines that balance investor and consumer protections. It has already happened years ago: the Cayman Islands included decentralized exchanges in its initial VASP [virtual asset service provider] law, signaling the country felt AML rules needed to be compatible with decentralized finance. The EU is following suit, working on comprehensive crypto regulation called MiCA.
  3. Privacy-preserving Identity: In the IFS, compliance must not come at the expense of user privacy, even if it adheres to strict know-your-customer rules. For instance, smart contracts must not intake or expose personal data on an immutable blockchain. Smart contracts can readily accept composable access tokens that provide binary answers (yes or no) to any compliance risk a project needs to address, leaving the wallet’s on-chain anonymity intact. Standards for those privacy-preserving identity credentials have been developed for years and are now ready for prime-time in the IFS.

Consumers, institutions and regulators demand more compliant, more secure and regulatory-friendly decentralized services – and that’s precisely what we will continue striving to build.

Solving regulatory and compliance concerns in a privacy-protective way will usher in a new era where the IFS delivers on DeFi’s original promises – running all financial applications on-chain and enabling new use cases. As a result, we will make tokenized real-world assets more liquid and composable, benefit from cheaper and faster remittances, and make finance as a whole more robust and accessible.

We invite everyone to join this collective effort, which needs the best and brightest minds from various disciplines: crypto, tech, law, policy, finance and more. It will be about breaking new ground, making some compromises and delivering the future of finance.

Edited by Daniel Kuhn.

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Markus Maier is the founder and managing director of Violet, a privacy-focused DeFi platform.