DEX and KYC: Are they incompatible, or can they have both?

Israeli serial entrepreneur Ariel Shapira reports on emerging technologies in the fields of cryptocurrencies, decentralized finance, and blockchain, and their role in shaping the 21st century economy, in his monthly crypto column.

The White House recently issued an executive order on regulating cryptocurrencies. Across the ocean, European lawmakers have thwarted legislation that could spell major trouble for proof-of-work networks. These developments remind us of what most crypto enthusiasts have long been accustomed to: regulation is still largely on the agenda, and while the blockchain community is now more compliant than it was before, it will cause at least some dissatisfaction.

One thing that will inevitably be on the target list of regulators is KYC (know your customer) protocols. As far as today's ecosystem is concerned, these protocols are nearly ubiquitous. Some platforms (often more centralized ones) handle KYC more or less the same as traditional financial institutions, including at least identity checks. However, its platform is basically based on plug-and-play, which means that as long as you have a crypto wallet, you can start your business.

Decentralized exchanges (DEXs) are the poster child for the latter approach. For example, using Binance Smart Chain on PancakeSwap, or using Cardano on WingRider, you can interact with the smart contracts that drive the liquidity pool. In most cases, anyone can stake their tokens into the pool, earning a share of the transaction fees they accrue, and anyone can utilize the pool to exchange their tokens without much KYC. It is a convenient, fast and reliable way to transfer value between different token ecosystems, and also allows liquidity providers to profit by keeping their services running.

Compliance needs will increase

When delving deeper into the blockchain space, regulators may find this approach a bit too laissez-faire. They might ask for more KYC from such protocols, and such requests might get a conventional response: how on earth do you expect KYC to be performed on chaincode pieces?

At the most basic level, this is indeed a tricky question. "Code is law," is a popular crypto saying, so the capabilities of any decentralized application are inherently limited by its underlying code. Bringing KYC into these capabilities is a daunting challenge, both from a technical and ideological standpoint. In terms of the former, this means having to build an all-encompassing digital KYC platform capable of handling this task on its own without human involvement. From the latter perspective, this means moving away from some of the core values and beliefs of the crypto world, which love and cherish anonymity and privacy.

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Some companies in the crypto space, such as Everest, have achieved eKYC through traditional means. The company can also anonymously confirm the uniqueness and humanity of each user, which is very important in our robot-infested age. In the future, anonymity is likely to be the battle cry of KYC against blockchain. A system where a trusted third party can verify the compliance of a customer's identity and issue a cryptographically secure confirmation of a successful check without revealing the customer's data itself could become common ground for crypto purists and regulators alike. This token will enable both central and decentralized exchanges to verify the identity of users without knowing them.

Importantly, such a solution would also eliminate the need for exchanges to actually store users’ private data. A centralized database of users’ personal information doesn’t even have to include their banking information or private keys to be valuable to hackers, but if an exchange wants its proper KYC, it has to create such a database. This creates a vicious cycle that exposes users to tangible threats while creating additional headaches for the exchanges themselves of having to manage and maintain these records.

Decentralized KYC compliance?

Another way to deal with the decentralized KYC conundrum is to have AI try to solve it. This may require a multi-layered solution where the first model will process the scanning of the document and pass the output to one or more other models to complete the task. While this is complicated, it's not entirely unthinkable - at least as long as we don't envision such things being deployed into smart contracts. However, off-chain implementations can still act as trusted third-party KYC providers, enabling exchanges to operate with all the right rules.

Essentially, KYC, like many other processes, always follows a protocol. It includes inputs (documents, financial statements, and other information the counterparty may need to process) and outputs (approval or rejection). Many of these processes are easily digitized because they follow the same logic that most computer algorithms follow. Of course, building a system flexible enough to accommodate different KYC rules in different jurisdictions will be a challenge, but it is also very possible. It is not difficult to imagine that the value of this system can also be seen in the traditional financial field where KYC is the main responsibility, thereby creating a potential market worth billions of dollars.

Improved KYC procedures could also spark a renaissance in user interfaces, making DEXs more accessible to ordinary investors. One of the biggest pain points across the crypto space, especially on decentralized platforms geared towards crypto enthusiasts rather than newcomers, is complexity of use. For example, before Kirobo's undo button appeared, crypto users couldn't even confirm that they were sending their crypto to the correct address. With strict compliance with regulations, more mainstream users come in, and they often demand a smoother mechanism for buying and selling cryptocurrencies.

Those DEX development teams that are more innovative, building their projects with KYC compliance in mind, while still staying true to the value of decentralization, will definitely stand out - so they better start innovating now and prepare for the coming wave Be ready for change.

Cointelegraph Chinese is a blockchain news information platform, and the information provided only represents the author's personal opinion, has nothing to do with the position of the Cointelegraph Chinese platform, and does not constitute any investment and financial advice. Readers are requested to establish correct currency concepts and investment concepts, and earnestly raise risk awareness.