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Why KYC/AML May Be the Key to Connecting DeFi and TradFi

Written by: Coinpedia

June 3, 2022

Financial systems have been used for illegal purposes since they became widespread, including financing terrorist organizations and laundering money. Because of that, many financial regulators around the globe decided to impose specific processes to put an end (or at least minimize) illegal transactions.

With the introduction of decentralized finance, some of these processes became impossible to implement. This is still a significant issue for DeFi today, making it challenging to connect traditional finance with its decentralized counterpart.

DeFi and TradFi Explained

DeFi stands for decentralized finance, encompassing all services and projects based on distributed ledger technologies. It all started with Bitcoin but grew into a vast industry.

On the other hand, TradFi is used for traditional finance, which we’re all very familiar with. It includes banks, governments, fiat money, and more.

The two types of finance are currently not working hand-in-hand, posing significant challenges for those who opt to use both.

SEC’s Biggest Concerns About DeFi

The US Securities and Exchange Commission (SEC), along with many other financial regulators around the globe, is facing a considerable challenge — regulating DeFi. 

Namely, after Bitcoin was launched, the main narrative was that it provided complete anonymity for those who use it. This was an advantage for those who wished not to be connected with their wealth and what they do with it, but it was also a setback as cryptocurrencies posed a threat of being misused for terrorist financing and money laundering.

The sheer nature of decentralized finance is not relying on a single person or team for governance, meaning it’s all in the hands of those running decentralized networks. In that process, it’s impossible to put names to faces, and the SEC doesn’t like that at all.

The good news (or the bad news, depending on your philosophical perspective on money) is that the traditional Know Your Customer and Anti-Money Laundering procedures can be implemented up to an extent for decentralized finance. The bad news (or the good news, once again, depending on the point of view) is that those processes still cannot reach every branch of DeFi.

Deep Audits Matter, Including KYC/AML

We’ll all agree on one thing: unless you’re a terrorist or a mafia boss trying to launder illegal money, you won’t mind sharing at least some of your information with official institutions. Imagine a world where no KYC and AML procedures are in place — it could lead to anarchy, or it could lead to complete freedom and liberation from financial institutions. We’ll never know, but one thing is certain: KYC/AML are necessary to keep things functioning at the moment, and deep audits matter, precisely because of the people who don’t have honest intentions with their digital funds.

It’s Not All That Bad

You have figured it out by now: DeFi platforms and enthusiasts don’t like regulations. TradFi is all about regulations. If the regulators do not agree on some kind of compromise, there won’t be easy ways for DeFi and TradFi to communicate.

That said, it doesn’t mean the two things cannot coexist on some occasions. A famous example is SOMA. It’s a decentralized exchange where you can trade cryptocurrencies. However, it stands out from the pack because you can also trade tokenized equities, STOs, NFTs, and ETFs, as it holds licenses from the SEC and FINRA. Most importantly, the platform follows all KYC and AML guidelines and still offers some DeFi features, such as yield farming and liquidity providers.

Final Thoughts: Will DeFi and TradFi Ever Blend?

You might side with DeFi or TradFi, but you must admit that most everyone in finance will put aside all divisions once you mention profit. Therefore, it’s safe to say that DeFi and TradFi will eventually find a way to communicate, but it remains somewhat unclear what path we need to take to cross that bridge. 

The first one is for the SEC to propose further regulations that will help incorporate DeFi as it is into TradFi, provided everyone agrees on the rules. Alternatively, we can count on crypto experts to develop workarounds. We already have such attempts, including stable coins pegged to the value of fiat currencies, tokenized assets, and more.


Crypto Journalist and Editor of guest articles in CoinPedia. I am also handling Outreach & Partnerships Manager. Contact me:

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