Decentralized Finance (DeFi) is becoming one of the most debated and revolutionary concepts in the field of cryptocurrency. Built on blockchain technology, DeFi allows for the transfer, issuance, and exchange of assets through decentralized platforms— without the involvement or oversight of traditional financial institutions.
One of the primary goals of DeFi is to eliminate intermediaries, increase security, and reduce the costs of transactions while simultaneously making financial services more accessible. However, just like any other ecosystem, DeFi also has its share of bad actors who seek to exploit the system through illicit activities such as fraud, theft, and money laundering.
As the DeFi ecosystem evolves and gains more traction, it’s inevitable that various attempts will be made by these malicious players to manipulate and sabotage the system. In addition, the lack of centralized authorities within DeFi brings new challenges for identifying and stopping these bad actors.
So, how can DeFi eject these bad actors while upholding its crypto ideals? Here are some potential solutions.
1. Regulations and Standards
The lack of regulations has long been a primary concern for the traditional financial world, and the same applies to DeFi. While the absence of regulatory hurdles has its advantages, it has also made DeFi platforms susceptible to corruption.
The value of self-regulation has become apparent in recent years with the emergence of various industry-standard protocols and practices. For instance, the DeFi Alliance, a group that fosters collaboration and innovation in the industry, has established guidelines for specific use cases in DeFi products and services.
Implementing a regulatory framework and establishing industry standards can be a significant step in deterring bad actors. Regulations such as Anti-Money Laundering and Know Your Customer (KYC) policies should be encouraged in DeFi platforms without infringing upon their decentralized nature.
2. Decentralized Reputation Systems
Reputation is critical within any financial ecosystem, and DeFi is no exception. To maintain a credible and trustworthy ecosystem, the use of decentralized reputation systems can be a game-changer.
These reputation systems allow users to rate applications and smart contracts in terms of reliability, security, and performance. The users’ ratings are recorded on a decentralized blockchain, making them immutable.
Incorporating reputation systems in DeFi can be a deterrent to bad actors because their activities would result in negative ratings and tarnish their reputation.
3. Whitelisting and Blacklisting
Another option for DeFi to eject bad actors is through whitelisting and blacklisting. With this method, users who have passed the stringent KYC and Anti-Money Laundering policies set up by DeFi platforms would be whitelisted and granted access to the platform.
On the other hand, blacklisting can be used to prevent bad actors from gaining access by keeping track of their activities and behavior during their interaction with the platform.
4. Smart Contract Detectors
Smart contracts are the backbone of DeFi. They provide automation, secure and transparent transactions, and code formalization. However, they’re also prone to errors and vulnerabilities.
Malicious actors can exploit these errors and access users’ assets and information on the DeFi platform. Thus, detecting and addressing smart contract errors and vulnerabilities can improve DeFi’s security and prevent bad actors from exploiting the platform.
Smart contract detectors like Slither, Mythril, and Echidna are examples of tools that help identify security vulnerabilities in smart contracts.
5. Asset Tracking
DeFi platforms deal with different digital assets, including cryptocurrencies, tokens, and stable coins. The interoperability of these assets can make it challenging to detect asset movements.
However, asset tracking can play a critical role in detecting illicit activities. This technology can help track suspicious trading patterns, identify and flag fraudulent accounts, and monitor transaction trails.
Conclusion
As DeFi becomes more prevalent, the threat from bad actors continues to grow. It’s essential to have a multifaceted approach to identify and neutralize malicious actors to ensure the sustainability and success of the DeFi ecosystem.
This approach should include implementing regulations and industry standards, deploying decentralized reputation systems, deploying whitelisting and blacklisting protocols, using smart contract detectors, and deploying asset tracking. In doing so, bad actors would lose the ability to exploit the DeFi platform for illicit activities, making it a safer and more secure financial ecosystem for all stakeholders.
The recent release of the U.S. Treasury’s 2023 DeFi Illicit Finance Risk Assessment highlights the need for decentralized finance (DeFi) to comply with anti-money laundering (AML) requirements. The report stresses the potential for bad actors to use DeFi to launder funds. While the traditional financial system is more prone to illicit finance, it is still important to prevent illicit activities in DeFi. Zero-knowledge (ZK) technology can enable DeFi applications to comply with AML while retaining user data privacy.
The collapse of centralized finance lending platforms like Celsius in 2022 followed by FTX have negatively impacted the public perception of crypto. The U.S. government’s Operation Chokepoint 2.0 aims to quash crypto innovation through harsh regulations, which may drive talent, money, and tech innovation outside of the U.S. Although only 1% of all crypto activity last year was illicit, a total of US$20.1 billion in illicit transaction volume occurred, which is not a small number.
The Bank Secrecy Act (BSA) requires banks and other registered money service businesses to share details on transactors when the value being transferred exceeds US$10,000 cumulatively for a given day. At the global level, the Financial Action Task Force (FATF) suggests that for digital asset businesses, any amount exceeding US$3,000 must be reported to the appropriate regulatory agency. The international guidelines are increasingly being implemented by various jurisdictions worldwide. The U.S. BSA has proposed reducing the threshold from US$3,000 to US$250 for international transfers, but this has not been implemented yet.
Zero-knowledge (ZK) technology is a mathematical concept that can be encoded to demonstrate the validity of information without revealing the information itself. With ZK, users can prove they are not on international sanctions lists without sharing their personal details. This technology can also be applied to proving a user is KYC or AML compliant, making it a key element enabling institutional adoption of crypto and blockchain technology.
The European Union’s Research and Energy Committee will incorporate ZK into its framework for digital identity. This would enable users to have control of their data and decide what information to share and with whom. Identity is important within the traditional financial system, as a verified ID gives permission to open a bank account, take out a loan, or make investments. ZK can make a significant difference in DeFi compliance, allowing decentralized apps to be compliant while remaining true to crypto ideals and collecting personal information about users.
Regulators and crypto insiders want the crypto industry to be a safe place for users and businesses. ZK technology can be leveraged to make this shared goal a reality. The DeFi industry should take advantage of ZK technology to satisfy regulatory policy goals while preserving privacy for its users. Both parties should communicate about implementations that satisfy each party’s objectives, which are not far apart as they seem.
