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What are the new KYC requirements for a Decentralized Exchange.

Uniswap, Sushiswap and many others are all examples of decentralized exchanges (DEX).   These DEX often charge no gas fees and have fewer  requirements for their users, but require more technically, from each individual user.  Now, normally, these requirements are no big deal for the average user.  But, some are quite adamant about protecting their identity.   So, it only seems appropriate that there be some standard.   Thus, at least for some countries, there are KnowYourCustomer (KYC) requirements before somebody can trade on that platform. 

To solve this conundrum, some are opting for an e-KYC solution.   Think of this as an escrow service.   But, instead of checks being circulated, the escrow agent is there to confirm all aspects of a client’s identity.   Then, when any exchange inquires, that 3rd party  effectively says, “It’s all good, this is a real person.”  This is a very interesting approach because it takes the onus off of the exchange.  Though, the obvious question presents itself: How does one know they can trust the 3rd party?  It would seem that we have to wait for this answer, as most entities appear to be in an early series of rounds of raising capital.  None appear to be mature at all.

So, what exactly ARE KYC regulations?

These are Know Your Customer requirements.   Most of these revolve around knowing that the wallet number refers to a single person.    Other identifying information is required and furnished, to include pictures of Driver’s Licenses or other identification papers.  These are required by all centralized exchanges like Coinbase or Binance.  But, as you might remember, there is another kind of exchange too,the decentralized exchange or the DEX/  

First, DEX is a bit of a misnomer.   The exchange does run based upon smart contracts and other code, this is true.  But, there has to have been at least a small corps of coders who put the exchange together.   You can bet your bottom dollar that these coders continue to profit based upon their work.  Regardless, some people do prefer the “lighter touch” of this type of management.   What they have to be aware of is that if more people are incentivized to use the exchange (by making it easier to use) the more likely they are to derive a profit from that exchange.  That said, a DEX is considered to be decentralized as it is neither a financial intermediary or a counterparty to the transaction.  For this reason, they can bypass most KYC regulations.

Second, it is undeniable that almost all exchanges are facing more stringent KYC requirements from governments.   (Binance added KYC requirements to comply with regulations in the U.K. and Japan.)

So, where in the world are we now?

Well, as it refers to cryptocurrency, many people would claim that location is irrelevant.  But, this appears to be not true.   In a study by CipherTrace, the Seychelles are notably poor at enforcing KYC requirements.  In fact, one person in the BitMEX case opined that local officials there could be bribed with “a coconut.”

As it relates to the U.S., it appears to many that over the long run, the DEX within the U.S. will be forced to shut down.  If they chose to comply with the Bank Secrecy Act (BSA), they would give up the decentralized nature that makes them attractive in the first place.  Arguments that a DEX is unable to do KYC without creating a honeypot of personal information lack technical merit and imagination. Multiple teams are already building identity solutions based on zero-knowledge proofs, a cryptographic method that allows one party to prove it has certain data without revealing that information

DEXs also have a unique and single-purpose suite of software, Automated Market Making or AMM, which allows liquidity providers to match with buyers and sellers, and pull in or determine a price for a given asset. This is not general-purpose software that can be leveraged for multiple use cases, as is the case with BitTorrent’s P2P protocol, which moves bits quickly and efficiently for Twitter, Facebook, Microsoft and video pirates. An AMM has a single purpose and produces a profit for teams.

Verifying user identities and checking that money and tokens are not illegal helps ensure some level of protection from cybercrime. It makes DeFi safer for users and more feasible for regulators and policymakers. To survive, DEXs will have to eventually admit this and adopt a level of identity verification and prevention of money laundering.

By implementing some of these solutions, DEXs can still deliver on the promise of DeFi. They can remain open for users to contribute liquidity, earn fees, and avoid relying on banks or other centralized entities while remaining pseudonymous.

If DEXs choose to ignore the regulatory pressure, it can end in one of two ways. Either more legitimate platforms can continue to adapt to growing government scrutiny and rising demand in crypto from more mainstream investors, who require usability and security, thereby leaving stubborn DEXs to die, or alternatively, unadaptable DEXs will move into the gray market of far-flung jurisdictions, tax havens and unregulated cash-like economies.

 REFERENCES

DEXs and KYC: A match made in hell or a real possibility? (cointelegraph.com)

What Is KYC and Why Does It Matter For Crypto? (coindesk.com)

Identity is the antidote for DEXs’ regulation problem (cointelegraph.com)

Editor’s Note: Please note that the information contained herein is meant only for general education: This should not be construed as Tax Advice.   Personal attributes could make a material difference in the advice given, so, before taking action, please consult your tax advisor or CPA.

 

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