Regulators in Europe, the United States, and elsewhere are busy hammering out details about how to identify decentralized exchanges as “brokers,” agents for transaction or similar entities that effect a transfer and work with one another. In its executive order on responsible development of digital assets, the United States called for multilateral cooperation. The European Union’s Financial Stability and Integration Review also called for multilateral cooperation. This is what’s publically available.
The whispers of regulation are becoming louder behind the scenes. Did you notice that all Know Your Customer (KYC), requirements were placed on smaller, centralized exchanges in exotic locales over the past two-months? This was the stumbling block in the coal mine. The aforementioned cooperation and designation will allow DEXs to start to feel regulator heat very soon.
Yes, regulations are coming. But the main reason DEXs won’t survive is their declared inability to identify and contribute to liquidity pools. Traditional financial circles consider rendering services without proper KYC procedures a no-no. Regulators are rightfully concerned about DEXs because Russian oligarchs were able to anonymously transfer millions of dollars using the Hawala payment system without tracking their identity. KYC is a derogatory term for most DEX enthusiasts. It’s something that DEXs are fundamentally incapable of doing. But is that true?
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Actually, DEXs are quite central
Let’s look at the anatomy of a DEX. We’ll see that they’re not as decentralized as we might think. DEXs are powered by smart contracts. However, the person who uploads the code to the chain usually has special admin-level privileges. A centralized, known team typically handles the front end. Uniswap Labs has recently added the ability for hackers to remove tokens from their wallets. Although DEXs claim they are pure code, there is still an ethereal developer team that controls the DEXs. They also take any profits.
A deeper look at how users communicate with permissionless chains also reveals more central choke points. MetaMask, for example, was not available in certain regions last month. Why? Why? Because Infura is a centralized service provider that the Ethereum API relies on to provide an on-chain wallet with an Ethereum API. Things can always work out the same way with a DEX.
Some believe that DEXs are more distributed because they are open-source. This means that any community can fork the code to build their own DEX. You can have as many DEXs you like, but it is important to know which ones bring more liquidity and where token holders actually trade their tokens. This is what exchanges were created for.
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An entity that facilitates such trades can be considered a broker or transfer agent from a regulatory perspective, regardless of its open source status. This is the direction most regulations are going. If DEXs are not able to comply with many requirements, they will be identified as such and face a lot of criticism. They would need to obtain a license, verify user identities, and report suspicious transactions. They would have to adhere to the Bank Secrecy Act in the U.S. and also be required by the authorities to freeze their accounts. DEXs will likely go under without all this.
The identity-and KYC issue
DEXs claim that they are decentralized and are therefore technologically inept at implementing KYC controls or identity verification. However, KYC is not synonymous with pseudonymity from a technological perspective. This attitude is at best lazy or unhinged in a push for lower costs and at worst, a desire profit from dirty money being circulated around.
Technical merit and imagination are lacking in arguments that a DEX cannot do KYC without creating an information honeypot. Many teams have already created identity solutions using zero-knowledge proofs. This cryptographic method allows one party to prove that it has certain data, but not reveal that data. A green checkmark can be used to prove identity. However, it does not reveal any personally identifiable information. This ID can be shared with a DEX to verify the identity without the need for a central repository.
DEXs are part of the ransomware puzzle because they don’t require users to complete KYC. Hackers use them to move bounty. The lack of ID verification means that DEX teams can’t explain the “source” of funds. This means they can’t prove that the money didn’t come either from sanctioned territories or money laundering. Banks will not issue DEX accounts without this evidence. Banks need to know the origins of money in order not to be fined or lose their license. DeFi is easily used for criminal activity and makes crypto less popular.
DEXs have an exclusive, single-purpose suite, Automated Market Making, or AMM. This allows liquidity providers to match buyers and sellers and determine or pull in a price for an asset. This software is not intended to be used for multiple purposes, as BitTorrent’s P2P protocol does. It moves bits fast and efficiently for Twitter and Facebook, Microsoft, and video pirates. AMM is a tool that serves a single purpose, and makes a profit for the team.
It helps to protect against cybercrime by verifying user identities and ensuring that money and tokens do not have any illegality. This makes DeFi more secure for users, and easier for policymakers and regulators to implement. DEXs must eventually acknowledge this in order to survive and implement a level of identity and money laundering prevention.
DEXs can still deliver the DeFi promise by implementing some of these solutions. They can be kept open to users for liquidity and fees. Users won’t have to rely on banks or other central entities, but they remain pseudonymous.
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It is possible for DEXs to choose not to comply with regulatory pressure. Either more legal platforms will continue to adapt to increasing government scrutiny and growing demand for crypto from more mainstream investors who require usability, security and usability, leaving stubborn DEXs to perish, or unadaptable DEXs may move into the gray markets of far-flung jurisdictions, tax-havens and unregulated cash economies.
There are many reasons to believe that the former scenario is more likely. Either DEXs will grow up and be regulated like the rest of us, or they will continue to suffer from the darker ghosts of crypto’s past.
This article is not intended to provide investment advice. Every trade and investment involves risk. Readers should do their research before making any decision.
These views, thoughts, and opinions are solely the author’s and do not necessarily reflect the views or opinions of Cointelegraph.
Bob Reid is the current CEO of Everest and co-founder. Everest leverages blockchain technology to provide a safer and more inclusive multi-currency account and digital/biometric identity, payment portal, and eMoney platform. Everest is a registered and licensed financial institution that provides end-to-end financial services, including eKYC/AML and digital identity, as well as regulatory compliance related to money movement. Kai Labs’ general manager of BitTorrent licensing, as well as vice president of strategy at Neulion and DivX, was he’s advisor?