Despite its potentially huge returns, institutional investors have steered clear of decentralized finance.
In part, this is because DeFi is a risky business, but another big part of the equation is the lack of know-your-customer (KYC) checks required for anti-money laundering (AML) compliance that makes it a no-go for institutional investors who do not desire and cannot afford to upset regulators.
However, this is beginning to change, as a number of companies have begun offering AML/KYC solutions designed for DeFi.
One of the first projects to embrace AML is Aave, a lending/borrowing protocol that is the No. 3 DeFi project, with $5.6 billion total value locked (TVL). Investors “lock” in funds that borrowers can access via overcollateralized loans — generally requiring them to put up crypto with 125% to 150% of the amount borrowed.
See also: Crypto Basics Series: How Does Decentralized Crypto Lending Work?
These funds do not come from a single source but from liquidity pools — groups of investors who get together to form a single lender operating on the platform, generally competing by accepting and lending different cryptocurrencies and stablecoins at varying terms.
In January, the protocol introduced Aave Arc, targeting these institutional investors.
Its differentiator? Aave Arc allows liquidity pools to add permissioning, meaning both lenders and borrowers must be approved by a central body of “whitelisters” who can do something unique on the platform: refuse access.
“We’re bringing the world of DeFi to the institutions because they can’t come to it in its decentralized form,” Jason Allegrante, chief legal and compliance officer at Fireblocks, told Blockworks when Aave Arc launched.
Calling it a “hybrid solution,” Allegrante explained that while it’s part of Aave and governed by the smart-contract controlled DAO like any other liquidity pool, it adds a centralized component to the decentralized protocol.
“The technology is still what it is, but building a permissioned environment around it,” he said. “I do hope we can trend toward a fully decentralized future, but we have to realize the opportunity we have before us by bringing DeFi to institutions. If you look at DeFi and what it could do, we may be looking at the next wave of institutional adoption.”
The Next Wave
This is a big enough market that several companies have formed specific AML tools aimed at DeFi projects — which can, by a governance vote, add features including an AML provider, which would presumably be paid by fees leveled on users.
These include ShuftiPro, PureFi, Comply Advantage and Coinfirm. The latter announced the launch of an AML oracle for DeFi platforms in May, allowing them to plug in an outside information service that will list blacklisted addresses that can be added to a blocked list.
Others, like Shufti Pro, offer a KYC verification service, while Comply Advantage is an artificial intelligence (AI)-driven service that helps customers identify potential risks.
A Growing Need
Aave is hardly alone in pursuing this market — and adding AML compliance more broadly. In March, another top DeFi project, the decentralized exchange (DEX) SushiSwap, passed a governance proposal to start a Swiss-incorporated foundation that would give it some centralized control and a regulating entity that would, among other things, make it possible to add AML controls.
Read more: Top DeFi Exchange SushiSwap Builds in Controls as AML Measures Loom
The goal, it said, was “to mitigate future risks.”
This became a bit clearer on Aug. 2, when authorities in the Netherlands announced the arrest of a developer of Tornado Cash, a decentralized mixing service that obscures the origin of cryptocurrencies. It was added to the U.S. Treasury Department’s list of sanctioned “persons” the same day, which alleged it had been used extensively by North Korean hackers robbing crypto platforms to fund nuclear weapons research.
See also: Tornado Cash Arrest Signals Gathering AML Storm for DeFi Developers
Dutch authorities on Aug. 17 reportedly told the DeFi Education Fund that tools that “have been created for the sole purpose of committing criminal acts, for example to conceal criminal flows of money, then putting online/ making available a developed tool may be punishable.”
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