DEFI DILEMMA: BALANCING INNOVATION AND FINANCIAL INTEGRITY
Decentralized Finance (DeFi) is changing the way we think about money and financial systems. By using blockchain and smart contracts, it eliminates the need for traditional intermediaries like banks, offering more direct and transparent transactions. However, this new approach also brings challenges, especially when it comes to meeting regulations like Anti-Money Laundering (AML) and Countering the Financing of Terrorism (CFT). We examine how DeFi works, its growing impact, and the ongoing efforts to create rules that balance innovation with security.
Traditionally, the financial industry has relied on intermediaries to build trust among participants. These intermediaries act as central points of accountability, enabling regulatory authorities to directly engage with them during investigations or enforcement actions. This structure has often been described as a “bottleneck” for regulatory purposes. However, with the advent of blockchain technology, this model has been disrupted, as it enables the decentralization of financial infrastructure. This transformation eliminates the need for intermediaries, replacing them with smart contracts, which has given rise to what is now known as Decentralized Finance (DeFi). Smart contracts are self-executing digital contracts with the term of the agreement written directly into the lines of code. It runs on blockchain and automatically enforces, verifies and executes predefined conditions when certain criteria is met.
DeFi aims to replicate traditional financial systems and products without relying on central organizations such as banks or brokers. Instead, it deploys smart contracts, self-executing agreements with conditions encoded directly into software to automate and enforce financial transactions. This innovation facilitates direct peer-to-peer interactions, bypassing the need for third-party oversight.
The core principles of DeFi development include decentralization, transparency, accessibility, and open-source collaboration. By leveraging blockchain networks, DeFi platforms aim to make financial services accessible to anyone with an internet connection, regardless of geographic location. Users retain full control and ownership of their assets during all transactions, as no central organizations manage their funds.
Popular DeFi applications include decentralized exchanges (DEXs), which allow users to trade cryptocurrencies without central intermediaries, as well as platforms for lending, borrowing, stablecoins, yield farming, and liquidity provision. The sector has witnessed explosive growth, with the total value locked in DeFi reaching $124 billion, according to DeFiLlama. Despite this rapid expansion, DeFi remains in its early stages compared to traditional financial institutions, and its swift development comes with significant risks and challenges. These risks include issues related to AML and CFT, especially when dealing with unknown or pseudonymous parties.
To use DeFi applications, users need electronic wallets, which can be either custodial or non-custodial. Popular non-custodial wallets such as MetaMask, Phantom, and Keplr allow users to easily create and manage multiple wallets while maintaining full control over their private keys. This reduces risks associated with hacking centralized exchanges or mismanagement of funds. Unlike traditional bank accounts, non-custodial wallets do not require identity verification during setup, creating challenges for AML and CFT compliance. While centralized exchanges (CEXs) now offer electronic wallets, experienced cryptocurrency users often prefer self-custodial wallets, especially after high-profile collapses of centralized platforms like FTX, which resulted in significant losses of user funds.
One of DeFi’s most attractive features is its ability to enable seamless cross-border transactions. Cryptocurrencies allow individuals and businesses to transfer funds quickly across jurisdictions while bypassing traditional financial controls. However, this capability also complicates regulatory efforts, as the global regulatory landscape for cryptocurrencies and DeFi remains fragmented. Different countries adopt varying approaches to AML measures for DeFi platforms, creating significant challenges for businesses in the sector and hindering global efforts to achieve AML compliance.
The use of DeFi protocols raises both new and familiar questions about implementing AML measures. DeFi’s focus on permissionless and decentralized transactions challenges a central principle of AML policy, which traditionally relies on intermediaries to properly verify customers, maintain records, and file reports such as suspicious activity reports (SARs). While policymakers generally agree that increased AML compliance obligations should not apply to software itself, not all activities labeled “DeFi” fall under this exemption. This ambiguity highlights the need for specially designed regulatory frameworks that align innovation with financial integrity.
Regulatory development and challenges
The regulation of Decentralized Finance (DeFi) remains a complex and evolving challenge. Debates between regulators and industry stakeholders persist, driven by growing concerns over the illicit use of funds, including activities by sanctioned entities.
In October 2018 and June 2019, the Financial Action Task Force (FATF) introduced amendments to its international Anti-Money Laundering (AML) and Countering the Financing of Terrorism (CFT) recommendations. These updates clarified that the guidelines also apply to financial activities involving virtual assets, such as cryptocurrencies, and Virtual Asset Service Providers (VASPs). Building on this, in October 2021, the FATF published detailed guidance based on a risk assessment approach. The European Union (EU) has proposed similar measures, particularly extending the requirements for information transfer in traditional financial transactions to crypto-asset transfers. Proposed actions include mandatory customer identity verification for crypto-asset service providers, full traceability of transactions, and a ban on anonymous crypto wallets.
Within the EU, activities involving crypto-assets, whether centralized or decentralized, are governed by the Markets in Crypto-Assets Regulation (MiCA), which takes a technology-neutral approach with the principle of „same risks, same rules.“ MiCA explicitly addresses crypto exchanges, trading platforms, and wallet providers. However, DeFi platforms could also fall under its scope unless covered by other regulations, such as the Payment Services Directive. Under MiCA, crypto-asset service providers must be authorized and maintain a physical presence within the EU. The regulation also mandates robust security measures, including capital requirements, segregation of client assets, complaint-handling processes, investor protection provisions, and oversight of crypto-asset issuers and service providers.
Globally, regulatory bodies are intensifying efforts to curb illegal activities on DeFi platforms and services. Updates to international guidelines now require VASPs, including many DeFi platforms, to be treated similarly to traditional financial institutions. These updates, aligned with FATF standards and adopted by regulators worldwide since June 2019, impose the same reporting and „Know Your Customer“ (KYC) obligations on VASPs as those applied to traditional financial institutions.This regulatory shift reflects a broader push to align innovation with financial integrity while addressing the unique challenges posed by decentralized technologies.
However, fulfilling regulatory obligations presents significant challenges in the context of DeFi (Decentralized Finance) smart contracts. These contracts operate without intermediaries, are not backed by identifiable legal entities, and execute agreements automatically. In 2023, the U.S. Senate proposed that the group of individuals responsible for maintaining a DeFi protocol should also bear the responsibility for complying with AML and CFT obligations. If no group controls the protocol, the proposal suggested that any investor contributing more than $25 million to the development of a DeFi protocol should assume these regulatory responsibilities. However, it is unlikely that development teams or investors would willingly take on the responsibility for fulfilling AML requirements or subject themselves to the scrutiny associated with AML and CFT compliance, as is common in the traditional financial industry.
