The U.S. Treasury is seeking input on embedding identity checks directly into DeFi smart contracts to enhance KYC/AML but is controversial as it could alter the permissionless nature.
The proposal stems from the consultation process under the GENIUS Act, focusing on compliance tools against illicit finance. Proponents argue that this removes criminals from DeFi, while critics warn of monitoring risks, user exclusion, and privacy infringements.
KEY CONTENT
The Treasury is considering embedding identity verification into DeFi smart contracts to automate KYC/AML under the GENIUS Act.
Pro: reduces money laundering risk, increases real-time monitoring; Con: erodes pseudonymity, paves the way for censorship and exclusion of undocumented individuals.
Balanced solution: zero-knowledge proofs and decentralized identity allow for eligibility verification without full identity disclosure.
What is the new move from the U.S. Treasury?
The Treasury opens consultations under the GENIUS Act, considering integrating identity checks into DeFi smart contracts, according to Cointelegraph. The goal is to test new compliance tools to combat illicit finance in the cryptocurrency market.
This is an effort to shift KYC/AML steps from the application level to the blockchain infrastructure level, helping to screen users before transactions are executed. The question arises: can DeFi be both permissionless and deeply compliant right from the smart contract layer?
What does the GENIUS Act require?
The GENIUS Act, signed in July, directs the Treasury to evaluate compliance tools to counter illicit behavior in the cryptocurrency market, especially in the stablecoin sector.
The scope of consultation includes identity verification techniques, real-time monitoring, and audit capabilities for investigations. This approach aligns with the DeFi risk assessment trend the U.S. Treasury has highlighted since 2023 in its thematic report on illicit finance.
How does embedded ID verification in smart contracts work?
The idea is to embed identification information directly within the contract logic, so the protocol automatically verifies government IDs, biometric data, or digital wallet certificates before allowing transactions.
Instead of wallets and dApps performing KYC themselves, the eligibility criteria are encoded on-chain, and transactions will be blocked if not met. This model can incorporate oracles, wallet certificates, or verification standards to reduce compliance friction at the application layer.
What are the benefits of KYC/AML compliance in blockchain infrastructure?
Proponents argue that embedding KYC/AML into infrastructure will streamline processes and reduce crime. Fraser Mitchell, CPO of SmartSearch, told Cointelegraph: “Such tools can expose anonymous transactions that are attractive to criminals.”
He emphasized the capacity for real-time monitoring: “Real-time monitoring helps the platform reduce risk, detect, and ultimately prevent money launderers from using the network to launder profits from the worst crimes,” according to Cointelegraph. The automated audit trail also supports investigations, tracing, and applying remedies faster.
Does ID verification in DeFi protect data?
Potentially, if designed under data minimization principles. Mitchell acknowledges the trade-off of privacy but believes solutions exist: only retain necessary data for monitoring or auditing, delete the rest, and apply row-level encryption to reduce leak risks, according to Cointelegraph.
Good security practices typically include data segregation, role-based access restrictions, and off-chain storage of sensitive parts. Combining independent audits, strong encryption standards, and data deletion processes can alleviate concerns, although systemic risks cannot be entirely eliminated.
What are the monitoring risks when embedding ID into DeFi?
Critics warn of eroding the permissionless and pseudonymous foundations. Mamadou Kwidjim Toure, CEO of Ubuntu Tribe, likens the proposal to 'putting cameras in every living room,' according to Cointelegraph.
He said: “On paper, it's a neat compliance shortcut. But you turn neutral, permissionless infrastructure into a place where access is blocked by state-approved paperwork. That fundamentally changes the meaning of DeFi,” according to Cointelegraph. He warns of the risk of censoring transactions, blacklisting wallets, or automatically taxing through smart contracts.
Who could be left behind?
The community of undocumented individuals, migrants, refugees, and those without bank accounts could be excluded if protocols require government-issued ID.
Toure argues: “This could limit access for users who prefer anonymity or cannot meet ID requirements, undermining DeFi's democratic nature,” according to Cointelegraph. According to the World Bank ID4D (2021), approximately 850 million people globally lack official ID, emphasizing the risk of digital inequality if identification barriers increase.
What are the data security and biometric risks?
Linking blockchain wallets with biometric data or government IDs creates an attractive focal point for cyberattacks. If breached, the damage could be twofold: loss of funds and identity exposure.
Biometric data is immutable like passwords; when compromised, the consequences are long-lasting. Therefore, principles of data minimization, off-chain storage, strong encryption, and independent audits are crucial. Risks increase if identity is permanently linked to immutable transaction history on the blockchain.
Is there a balanced solution for privacy and compliance?
Yes. Privacy-preserving tools like zero-knowledge proofs (ZKP) and decentralized identifier standards (DID) allow for condition verification without revealing full identity.
ZKPs can prove you are not on a sanctions list or over 18 years old, without disclosing personal information. DIDs and Verifiable Credentials allow users to hold verifiable credentials and disclose selectively. The FATF's Digital ID guidance (2020) acknowledges the role of a trustworthy digital identification system in the risk-based AML/KYC process.
How do ZKP and DID operate in the context of DeFi?
ZKPs implemented at the application or contract layer allow for 'pass/fail' according to compliance policies without disclosing raw data. DIDs use open standards, enabling multiple parties to verify access based on cryptographic proof.
W3C has standardized DID Core, creating an interaction foundation between wallets, issuers, and verifiers across multiple chains. This reduces reliance on centralized databases and mitigates the risk of sensitive data leaks.
“Decentralized identifiers (DIDs) are a new type of identifier that enables verifiable, decentralized digital identity.”
– W3C DID Core 1.0, W3C Recommendation, 19/07/2022, W3C
Comparing approaches: on-chain KYC, zkKYC, and DID
Each model has its own benefits and limitations. The appropriate choice depends on compliance goals, privacy, compatibility, and user experience.
Traditional on-chain KYC criteria zkKYC (ZKP) DID + Verifiable Credentials Low Privacy, linkable ID data High, only disclose necessary attributes High, selective disclosure Strong Compliance, easily auditable Strong if policies are clear Strong if VC issuer is trustworthy Reduced Decentralization, dependent on lists/control points Better Preservation Good Preservation, open standard-based High Friction Experience Average, needs ZK integration Good if wallet supports standards Higher data leak risk Lower Lower if off-chain storage
What impact will this have on innovation and the market?
If rigid ID requirements are enforced at the protocol level, entry barriers may increase, impacting innovation and the openness of DeFi. Conversely, a lack of compliance may lead to increased legal risks and abuse.
A risk-based approach prioritizing open standards like ZKP/DID can maintain balance: protecting users, enabling businesses to comply, while preserving the core permissionless nature of DeFi.
What should the practical implementation roadmap look like?
Apply in phases, focusing on high-risk scenarios (e.g., high-value transactions, fiat inflows-outflows), using a 'privacy by design' model.
Prioritize open standards and interoperability (W3C DID, VC), sandbox testing with oversight, and transparent reporting. Compliance with FATF's risk-based principles helps reduce the burden on low-risk users and avoids a 'one-size-fits-all' mentality.
Frequently Asked Questions
Does embedding KYC into smart contracts compromise DeFi's permissionless nature?
There is a risk. According to Toure (Cointelegraph), requiring state-approved ID at the protocol layer could turn neutral infrastructure into an access control system, affecting the permissionless nature.
How do ZKPs help meet KYC/AML requirements while maintaining security?
ZKPs allow proving conditions (like not being sanctioned) without disclosing full identity. Compliance policies are encoded, with pass/fail results returned to the contract, limiting data exposure.
Is DID an accepted standard?
Yes. W3C DID Core 1.0 is an official recommendation (19/07/2022). Combining Verifiable Credentials helps verify user attributes across platforms while maintaining disclosure control.
Who is at risk of being excluded if ID is mandatory?
Undocumented individuals, migrants, refugees, and those without bank accounts. The World Bank's ID4D (2021) estimates approximately 850 million people lack official ID.
What is the proposed balanced approach?
Risk-based application, prioritizing ZKP/DID, minimizing data, off-chain storage, and independent audits. This approach ensures compliance while reducing monitoring risks and data leaks.
Source: https://tintucbitcoin.com/my-muon-id-defi-nhu-camera-nha/
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