Regulation is coming: How prepared is the crypto industry?
The recent events surrounding Tornado Cash, a decentralized privacy protocol, have once again put US crypto regulation into the spotlight. The service was blacklisted by the US Treasury Department in August after it alleged Tornado Cash had been used to launder over $7 billion in cryptocurrencies. The blacklisting effectively led to the service being shut down completely, as the domain was subsequently taken offline and the code repository removed from GitHub.
Inevitably, the Tornado Cash incident has created substantial turmoil among operators in the crypto sector. While we wouldn’t pass any comment on the incident itself, it has caused us to reflect upon how the cryptocurrency sector can take steps towards compliance, even in the absence of a concrete regulatory framework to offer certainty.
In Europe, the EU Markets in Crypto Assets Regulation will alleviate some of that uncertainty when it comes into force next year, creating a set of provisions for asset issuers and service providers to abide by. However, US lawmakers have so far seemed unwilling to deviate from the regulation by enforcement approach, leaving many crypto operators wondering how they can avoid falling foul of the SEC.
Crypto's compliance conundrum
Until now, compliance in crypto has been managed largely by centralized entities like an exchange, which typically carry out a traditional KYC check when onboarding new users. However, introducing compliance to DeFi involves finding solutions that minimize the involvement of centralized entities. As always in the blockchain sphere, innovation abounds, and there are several ways that blockchain projects are tackling the challenge of compliance in Web3 and DeFi.
One method for assessing counterparty risk has emerged as a result of shifting the focus from verifying the identity of the address owner to analyzing transaction risk. Often referred to as “Know Your Transaction” or KYT, it involves performing complex on-chain analytics on a target address to ensure that transaction history is clean of any activity that could be interpreted as fraudulent or an attempt to engage in activities like money laundering.
It’s also possible to apply these checks at a pool level before or after a transaction takes place, which can be extremely useful in staking or providing liquidity to pools on decentralized exchanges and lending protocols.
Another way to introduce compliance at the pool level is to apply permissions to the pool, so entities need to undergo a full KYC identity check to become whitelisted before they can participate.
However, there are even more cutting-edge ways to introduce compliance using NFTs.
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Introducing Dynamic NFT's
At the recent Crypto Valley Summit held in Zug, Switzerland, our Co-Founder Rachid Ajaja participated in a panel discussion where he spoke of the transformative potential of Dynamic NFTs.
If you haven’t yet seen the video, you shouldn’t miss it!
Rachid also expanded on this concept in a recent tweet thread, introducing the idea of “meta-NFTs” – a brand-new innovation that allows mutable, or changeable, data to be layered onto an NFT. He lays out how a user can mint a “blank” meta-NFT, and then layer properties onto it that attest to the person’s activities. They can get verified for KYC, and add this as a property to their NFT, enabling them to participate in DeFi, for which transactions can also be added to the NFT. Ultimately, it can be used to create a kind of decentralized identity attesting to the person’s activities and reputation on the blockchain.
As Rachid says in the video, “These NFTs offer a legal way to achieve compliant DeFi, and this is where we think the future is going.”
Summary
We always knew that regulation in DeFi was a matter of when, not if, it would arrive. The lack of a clear US regulatory framework unarguably makes it more challenging for operators; however, by demonstrating a commitment to compliance and anti-money laundering regulation, cryptocurrency projects can protect themselves. Nevertheless, at AllianceBlock we remain committed to finding ways of demonstrating compliance without compromising on the pledge to maintain decentralization.
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That’s all from us. Thanks for reading and remember, stay #NoMercy!
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