How DeFi Platforms Can Overcome Compliance Challenges

Decentralized finance (DeFi) platforms represent a revolutionary shift in the financial world, removing traditional intermediaries and offering services without centralized authority. Unlike traditional financial institutions or centralized exchanges such as Binance, Coinbase, or Crypto.com, DeFi platforms operate without a clear leadership structure, fixed location, or central governance.

While some DeFi platforms have been exploited for illicit activities like money laundering through coin mixers, the majority are legitimate projects that simply embrace decentralization. However, this decentralized structure introduces a new set of compliance challenges that traditional financial systems don't face.

This article will examine the key compliance challenges DeFi platforms face, including their cross-jurisdictional nature, the pseudonymity of users, governance complexities, and the risks associated with smart contracts. It will also outline practical solutions for addressing these issues, such as leveraging blockchain analytics tools, implementing flexible KYC processes, and mitigating risks tied to AML and CFT requirements—all essential steps for navigating the evolving regulatory landscape.

Cross-Jurisdictional Challenges in DeFi: Navigating Global Compliance

DeFi platforms transcend national boundaries and jurisdictions, which is a notable distinction from centralized exchanges but one that poses special compliance challenges.

Challenge: Centralized exchanges maintain an official headquarters and a base of operations. If they want to do business in another country, they must seek appropriate licensing for that regulatory environment. They can therefore scale their regulatory practice on a country-by-country basis, expanding only as resourcing allows. 

In contrast, because DeFi platforms are decentralized, they are available across many jurisdictions at once. To solve this problem, many DeFi platforms simply ignore local regulations, a strategy that typically ends up backfiring. Flouting local policies tends to place DeFi platforms in hot water, subjecting them to immense regulatory scrutiny that can threaten the very viability of the business. 

Solution: Centralized exchanges regularly employ solutions in blockchain analytics for their regulatory compliance. DeFi platforms should standardize this practice as well. In particular, DeFi platforms should target blockchain analytics solutions that allow for a nuanced approach to each market.  

This granularity is not to be overlooked. Some blockchain analytics solutions are based primarily around blacklists: The tools will aggregate different addresses that have been banned globally and ensure the platform does not do business with them. DeFi platforms need the blockchain analytics tools that go further. These tools empower the DeFi platform to set custom behavior-based rules for different countries or regions, effectively enabling them to develop a unique compliance strategy that aligns with the market’s risk profile. With the right compliance tools, DeFI platforms can be global in ambition but local in execution. 

User Pseudonymity and KYC: Compliance Challenges for DeFi Platforms

Compared to centralized exchanges, DeFi platforms want to preserve the pseudonymity of users, which creates compliance challenges relating to KYC processes. 

Challenge: Centralized exchanges have robust know-your-customer (KYC) procedures. Such KYC workflows may involve subjecting multiple forms of government ID, verifying payment or withdrawal methods, providing selfies or video recordings, and even going through an interview process. Any KYC procedure will require significant resources. A manual KYC process will require a significant number of agents and man-hours. A primarily eKYC process will require the development or provision of said technology. 

While some DeFi platforms overlook KYC procedures in the spirit of decentralization and anonymity, there are others that do not invest into these procedures due to the necessary resourcing. They instead require the bare minimum from users, which again places them in regulatory jeopardy with authorities. 

Solution: KYC solutions do not need to be cost-prohibitive. DeFi platforms should cast a wide net when canvassing for eKYC solutions, focusing not only on features but on pricing. Ideally, the provider should not require a heavy upfront investment, which would be impractical for the vast majority of DeFi platforms. Instead, the solution should have flexible pricing. 

With flexible pricing, such as cost based on monthly volume of users processed, DeFi platforms can implement eKYC procedures from the very beginning. This ease of use ensures the DeFi platform can scale its compliance strategy for KYC from one user to one million, all while maintaining the privacy and security of their users. With the right eKYC solution, there does not need to be a trade-off between compliance and cost. 

Mitigating Smart Contract Risks: Ensuring AML and CFT Compliance in DeFi 

While smart contracts represent a major innovation in blockchain, they bring numerous compliance challenges, such as those relating to anti-money laundering (AML) and counter-terrorism financing (CFT). 

Challenge: Centralized exchanges are run by the regular instruments of business: meetings, negotiation, correspondence, and other forms of collaboration. DeFi platforms, in contrast, typically operate through smart contracts, which are self-executing code designed to “automate blockchain functionalities like the creation, destruction, swap, or transaction of digital assets based on predefined conditions.”

Smart contracts are prone to a wide range of security vulnerabilities. Some of these have been documented in the OWASP Smart Contract Top 10, such as reentrancy attacks, unchecked external calls, timestamp dependence, integer overflow and underflow, and insecure randomness. 

Hackers could leverage any one of these vulnerabilities to obtain illicit funds and then launder them across the blockchain. Moreover, due to the decentralized nature of DeFi platforms, mounting an enforcement action to seize or recover the funds is difficult. These attributes may make DeFi platforms prone to money laundering and terrorist financing, undermining compliance in these areas. 

Solution: DeFi platforms need to mitigate AML and CFT risks through the right blockchain analytics solution. Unfortunately, many solutions in this space only focus on major blockchains and do not provide support for smart contracts. 

DeFi platforms need to specifically find a solution that is optimized for both DeFi in general and smart contracts in particular. With the ability to monitor, track, and investigate smart contracts in real-time, DeFi platforms can reduce the risk of their solution being used for money laundering or terrorist financing. This mitigation lessens their exposure in those areas and keeps them compliant with necessary preventive measures for AML and CFT. In short, smart contracts present inherent dangers, but the right tool can keep these within acceptable limits of the regulatory environment. 

DeFi Governance and Compliance: Addressing Accountability in Decentralized Systems 

DeFi platforms have various methods for governance, including decentralized autonomous organizations (DAOs), governance tokens, and other voting and proposal processes and procedures. While each of these is different, they share the same risks: Developers and members can be held accountable in the case of non-compliance with the application of regulations and laws.  

Challenge: Because DeFi platforms are organized and governed in a decentralized manner, their developers and leaders often mistakenly believe they are absolved of any compliance requirements. Nothing could be further from the truth. Whether an organization establishes itself as a centralized exchange or as a DeFi platform, they must comply with the regulatory environment. 

There are many such examples of DeFi leaders being held accountable for non-compliance. For example, in August 2022, a developer of coin mixer Tornado Cash was arrested in the Netherlands for the platform’s role in facilitating money laundering and eventually sentenced to 64 months in prison. Similarly, the founder of decentralized exchange EtherDelta was hit with a more than $300,000 penalty in November 2018 for operating as an unregistered securities exchange. The fact that even a business with a benign purpose (i.e. a decentralized exchange) faced punishment just goes to show: Every DeFi platform that does not meet regulatory requirements will be held accountable by authorities and regulators. 

Solution: To prevent any similar issues, developers and leaders do not have the luxury of being reactive, or they run the risk of facing potentially severe or even crippling punishments. They must implement a blockchain analytics solution from the moment they launch operations, and this tool must itself be equipped with proactive features in compliance. 

In particular, DeFi platforms should seek solutions equipped with real-time and continuous transaction monitoring based on both blacklists and patterns of suspicious behavior, eKYC for users and due diligence on partner exchanges, and the ability to categorize individuals and groups into different risk buckets. With these modules, DeFi platforms will maintain regulatory compliance and the sanctity of their decentralized structure. 

Conclusion: Blockchain Analytics and Compliance Solutions for DeFi Platforms 

Developers of DeFi platforms have long been focused on product innovation: They aim to decentralize and automate various finance functions for their users. They need to approach compliance the same way, innovating it through their use of blockchain analytics.

With the right blockchain analytics tool, DeFi platforms can adopt a unique compliance approach to each market, employ an eKYC procedure that protects users while meeting regulatory standards, reduce smart contract vulnerabilities and thus exposure to AML and CFT, and enhance proactive governance.

DeFi platforms interested in finding just this solution should consider Merkle Science, which offers a suite of products fit for DeFi projects, including transaction monitoring solution Compass and crypto investigation tool Tracker. 

Get in touch today to schedule a demo.