Bridging the Gap between Regulation and the Need for Growth

The issue of the regulation of cryptocurrencies is still a hotly disputed topic. Many governments across the world are either outright banning them or letting them exist unregulated, which leaves out the majority of old money, institutional financiers, investors, and the mainstream. With the emergence of decentralized finance (DeFi), the stakes went up even higher as the regulators now have to deal with an entire ecosystem for managing financial transactions as opposed to individual currencies. After the years of polarizing opinions, has the time come to allow the cryptospace and DeFi to have their cake and eat it too by introducing regulation-compliant options as a compromise?

What Does Old Money Want?

“Compliance” is the only word that may sound slightly more palatable to crypto audiences compared with the dreaded “regulation”. While essentially treading the same path, compliance evokes the sense of a compromise and a new middle-ground approach to regulating the cryptoverse without robbing it of its identity. Now, sticking to your guns in this world is an admirable quality, but cryptocurrencies and decentralized finance can hardly allow themselves to adopt an isolationist mindset. That would mean ignoring the palpable demand for the solutions that offer compliance as a compromising solution.

We have come a long way from the days of baseless claims that cryptocurrencies will be mainly used to fund terrorism, money laundering, and all things illegal. Equally wrong is thinking that these things do not happen. Yet, they surely put off institutional investors, big banks, and other players that come from the world of traditional finance but do not want to miss the opportunity to dip their toes in the enticing and brand new cryptocurrency pool. The pool that only in August 2021 was worth more than two trillion US dollars. And, yes, they want guarantees that their investments will be safe and put against other enterprises on a perfectly level playing field. In other words, they are after compliance.

Regulated vs. Unregulated Solutions

The magic word that opens the cave of treasures in which happy regulators sit next to satisfied customers is “trust”. Moneyed people want to leave their capital with trusted and secure products. If the world of DeFi hopes to supplant banks and other aging financial institutions, it will have to prove itself as a safe harbor for inter-institutional lending, borrowing, and asset transfer. The tantalizing goals at the end of these roads are broader participation of more stakeholders and wider mainstream adoption. Yes, the two things that remove obstacles to achieving faster growth in this segment.

While the introduction of the legal side of regulatory compliance will have to come in coordination with the external authorities, the most promising solutions now come from the inside, i.e. from the developers that build technologies that support fully regulated and compliant protocols. It is a sign of the maturing of the crypto and DeFi markets as a whole, but also of the more exciting times ahead. 

Regulated protocols will allow for the removal of a regulatory loophole which is frequently exploited in the world of DeFi. Unlike banks or brokers, DeFi platforms cannot be said to “hold” any money, thus neatly removing themselves from the crosshairs of the regulators who want to go after intermediaries. So, the main benefit and reputation boost for regulated protocols will be the introduction of “know your customer” (KYC) obligations that will stand guard against money-laundering practices, yet provide just enough shade of anonymity for the customers to feel comfortable in it.

Will This Leave Unregulated Solutions Out of Work?

While predicting the future of the new push for more regulated solutions in the cryptoverse is a thankless task, their success will surely depend much on the quality of their underlying technologies. In other words, their success will rest on the degree to which they will be able to uphold trust as part of what now goes under the buzzword of “Institutional DeFi”.

One of the proposed solutions is making sure that transactions are done only with the known parties that have completed KYC and whitelisting procedures. While some degree of anonymity will be retained, the custom compliance tools will be developed to identify parties in financial arrangements. 

At the same time, asset pools will be split, with the addition of pools in which only whitelisted addresses are allowed to make transactions. Also, the companies will be required to prepare reports with the help of approved transaction tracking tools. All of this should deliver the fulfillment of the long-standing promise that dates to the early days of Bitcoin – banking the unbanked will be made possible only if a provider passes necessary checks. Those who still prefer the shadier unregulated DeFi options will have to take the risks on themselves, so the coexistence of the two models is highly likely at least for the time being.

Trust Is an Asset

Now for some concrete examples of the approaches to repairing the “outlaw” reputation of modern-day DeFi. Instead of studying legal precedents and countless court decisions, these providers found their solution to the regulation puzzle in trusted technology.

Since its inception in 2018, Alkemi Network has worked on creating a KYC-permissioned digital asset pool feature that is supposed to work in parallel with reporting and risk management features. As a way to bridge the gap between DeFi and CeFi and draw big capital, CeFi institutions, and mass individual participation, the Alkemi Network focused on making individuals and institutions (such as custodians and exchanges) co-exist as part of a single network/ecosystem.

Alkemi Network serves as a liquidity platform for financial institutions and individuals to access professional DeFi via fully compliant bridges and earn yields on their digital assets. Alkemi utilizes a bank-grade KYC/AML procedure for checking all liquidity providers and delivers simplified borrowing and lending protocol and code.

“The question is not 'regulated vs. unregulated' but rather trusted counterparty vs. untrusted counterparty. It all boils down to the trusted counterparty problem. DeFi, as it is, is currently open to anyone, nefarious actors included. This makes institutional capital nervous. Their brands live and die by the trusted counterparty...They need comfort that when they are onboarding to a pool, no funny business is going to occur there. This is what Alkemi Earn solves for them", says Brian Mahoney,  Cofounder/CSO of Alkemi Network.

Lending Credence to Compliance

KILT protocol approaches the issue of regulating trust by imitating the veracity of old-school credentials, such as passports and driving licenses, in the world of blockchain. KILT does this by providing a protocol for creating, issuing, and verifying digital credentials, with the focus on supporting business models that require mediation of trust. With it, individuals and organizations present sets of attributes which are relevant to their identification, and these get attested by trusted parties. These entities can, in turn, get paid for their attestation work in the trust market.

The protocol supports issuing verifiable credentials and decentralized identifiers (DID). Verifiable credentials are verified by trusted parties while the DIDs serve to provide unique identification for a person or a device. All of this is supposed to promote the concept of self-sovereignty over one’s identity, in which you get to keep your digital credentials with you, not with a platform or an institution.

“DeFi regulation is coming and DEXs will be pushed to identify their users, sometimes even with KYC. Regulation is not necessarily a bad thing because it would open up the regulated finance world for the crypto sector, bringing huge new resources. And we could avoid what we see today in the regulated sector -- banks with large files of centralized data. DEXs don’t need (and don't want to know) their customer. Instead, they could partner with trusted KYC providers and use infrastructure like KILT, that allows an institution or individual to share an element of their identity, without forcing the DEX to establish centralized data stores. If the user could prove their KYC with each transaction, it would be even safer than before, with less work for the DEX, happier consumers, and more satisfied regulators. Also, for KYC providers, this is a great chance to establish additional business”, says Ingo Ruebe, founder of KILT Protocol and CEO of BOTLabs GmbH.

Wrap-up

Regulation in the world of cryptocurrencies and DeFi is no longer a scary word, but a promising avenue for resolving various technological, compliance, and reputational issues with these ecosystems and technologies. In the end, the issue of regulation will have to be resolved if both are to achieve further growth and deliver on their initial promises of global coverage. Emerging solutions seem like steps in the right direction, as long as they are made on the bridges that link two worlds whose coming together holds much promise.  

Disclaimer: This article is provided for informational purposes only. It is not offered or intended to be used as legal, tax, investment, financial, or other advice.