A decentralized exchange (DEX) is a cryptocurrency exchange that operates without a central authority. Some DEXes do not have KYC processes, which are formulated and enforced as a process to track, monitor, and prevent money laundering and financial terrorism. Without a centralized authority, a DEX can’t turn back a transaction, thus users are baffled in the unfortunate event that their passwords or private keys are hacked.
Decentralized exchanges allow peer-to-peer trading of cryptocurrencies done through a “trustless transaction,” meaning participants involved do not need to know or trust each other or a third party for the system to function. In a trustless environment, there is no single entity that has authority over the system, and consensus is achieved without participants having to know or trust anything but the system itself.
If an exchange asks for personal information of user store it, it’s already centralized, in a sense. Hence, there is a heated debate regarding DEXes and KYC: Can an exchange that requires KYC classify itself as DEX?
So, here are different definitions of a DEX:
Custodial exchanges are in possession of your crypto information, meaning they are the custodians of your private keys. Trading is done off-chain as the trading is tracked on their balance sheet instead of being verified by the blockchain. This allows transactions to be done quickly and cheaply but leads to a lack of transparency.
Non-custodial exchanges are exchnages that take no account or records of users’ information. This model is perfect for people who just want to complete a quick trade, don’t want to commit to an exchange, or are hesitant to entrust an exchange with personal information. The environment allows for a higher degree of anonymity and security.
The goal of a DEX decentralized is to create an open-source, permissionless on-chain platform for trades to take place. There is no need to trust a third party with your private keys. Although speed bumps, such as scalability and fees, contributes to a slowing process and experience. Yet, the demand for this type of exchange is strong and growing rapidly.
If they require KYC, what happens with that?
KYC mostly incorporates four key elements: acceptance policy, identification procedures, transaction monitoring, and risk management. We will focus more on transaction monitoring and risk management here.
KYC is used mostly for security reasons. According to Crypto Briefing, malicious agents have managed to hack into various centralized exchanges, extract critical user information, and steal funds. As a result, losses from these attacks have often surpassed multi-million dollar figures. More importantly, this lack of security has tarnished the image of the crypto space as a potential competitor to conventional exchanges all over the world.
As a result, people have begun to turn their heads towards DEXes as a replacement to centralized exchanges. The question here is: How can a DEX monitor transactions and balance associated risks without asking KYC?
The two well-known examples of DEXes are Etherdelta and IDEX. EtherDelta was fined $388,000 for unauthorized crypto trading services by the U.S. Securities and Exchange Commission (SEC) in November 2018. IDEX, an Ethereum decentralized exchange, has replaced Etherdelta and obligated its users to pass the KYC verification process in August 2019. They implemented stricter KYC under a policy of “pragmatic decentralization,” which drew criticism from users and the media. Traders tend to use DEXes because they secure custody, privacy while giving access to desirable tokens before they make it into a major exchange. With IDEX requiring KYC, its competitive advantage of mainting a user’s privacy disappears.
Future trends in KYC and DEX: Two Different Approaches
Of course, different countries have different security scopes when it comes to KYC. The U.S. regulators are driving the enforcement with The Financial Crimes Enforcement Network, or FinCEN. FinCEN is the governing body that enforces the rules to prevent terrorist financing, money laundering, etc. Founded in 1990, FinCEN addressed Bitcoin and a virtual currency guidance that detailed regulations regarding the creating, obtaining, distributing, exchanging, accepting, or transmitting of virtual currencies in 2013. Under its ruling, the companies that provide cryptocurrency-related services must report all data to the government to prevent money laundering. Under FinCEN, cryptocurrencies belong to the category of Convertible Virtual Currencies (CVC), which are to be regulated and monitored by governing bodies.
In May 2019, FinCEN combined almost a decades worth of previous virtual currency claims (2011–2019), creating a guidance document called the Regulations to Certain Business Models Involving Convertible Virtual Currencies. This document warns crypto businesses that since they transact with CVCs, they are considered Money Service Businesses (MSBs). Therefore, they are in breach of the Bank Secrecy Act if they fail to register and comply to FinCEN policies. In light of the issuance of FinCEN’s CVC guidance, the cryptocurrency industry around this time had over 11,000 Suspicious Activity Reports (SARs)filed by virtual asset service providers (VASPs). In late December 2019, a new bill, dubbed the Cryptocurrency Act of 2020, was proposed to U.S. Congress. The proposed Act divides “digital assets” into 3 categories: crypto-securities, crypto-currencies, and crypto-commodities. The act categorizes FinCEN, the SEC and CFTC as “Federal Crypto Regulators” and assigns a crypto category to each agency . Focused on crypto-securities, FinCEN requires financial institutions in the U.S. to provide KYC information. That being said, while there are still controversial opinions as to whether KYC implementations heighten security, it is clear that the U.S. regulators are taking necessary steps to ensure safety as they recognise the relevance of cryptocurrency trade.
The bill to regulate cryptocurrencies in South Korea passed the National Assembly on March 5 this year. The bill, to be implemented in March next year, calls for existing crypto exchanges to meet requirements for a real-name account and ISMS. The Korean government’s announcement about cryptocurrency came in March this year as there have been no regulations in the industry since January 2018.
The government’s announcement came quite late in the game and killed many players in the industry by preventing a lot of opportunities, such as Korean companies’ ICOs, establishment of corporations, and achievement of a virtuous cycle. Other than that, there are still a lot of gray areas, and more clarity is expected to come in March 2021.
South Korean authorities aren’t very friendly towards DEXes as the government believes that DEXes are out of their control. From the government’s point of view, the want to know who earned how much and how big the market is so they can tax appropriately. The government believes that the trading information should be centralized to confirm that the amount the traders traded on an exchange match the bank’s records. But generally speaking, South Korea’s government is taking steps to regulate crypto assets and is responding more positively to the overall adoption of blockchain.
Once Korea’s new act is implemented, institutions and retail traders will be impacted. Currently, whale traders, the people who have done a lot of bitcoin mining, also are heavy traders. South Korean retail traders tend to do more leverage trading than spot trading, as spot trading has less liquidity. One of the main reasons this occurs is because South Korea currently has one of the best stock markets in history, with more than 800,000 active stock accounts in March. When the US stock market declined this year, the Korean market performed oppositely. Traders are taking money from the exchange and investing in stocks. However, once regulation comes and liquidity increases, spot trading can make a comeback.
There is no institutional trading in Korea at the moment. Korean exchanges allowed corporate accounts to participate in cryptocurrency trading until January 2018 when these were shut down due to government regulations. Once the bill is implemented in March next year, institutions are expected to open their corporate accounts once again. If the government decides to impose taxes on traders, then it will be easier for institutions to enter the space. We could very possibly see more B2B than B2C trading in Korea after 2020.
The debate about whether or not a DEX is truly decentralized if KYC measures are in space has yet to be settled. However, it is interesting how the international community as a whole is responding to the need for some form of KYC regulation and standardized processes as the adoption and creation DEXes occurs. The world of DeFi is jam packed with exciting developments that seem to emerge at an extremely fast pace. We can’t wait to see the how this topic evolves!
Stay tuned to our updates as we cover more topics on the different intricacies of decentralized finance!
About Injective Protocol
Injective Protocol is the first layer-2 decentralized exchange protocol that unlocks the full potential of decentralized derivatives and borderless DeFi. Injective Protocol enables fully decentralized trading without any restrictions, allowing individuals to trade on any derivative market of their choosing. Injective Protocol is backed by a prominent group of stakeholders including Pantera Capital, one of the most renowned venture capital firms in the world, and the leading cryptocurrency exchange, Binance.
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