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Why DeFi needs better KYC to curb money laundering

Despite anti-money laundering (AML) laws, many DeFi sites have weak know-your-customer practices. Experts point to BitMEX as a cautionary tale.

With more than half of all crypto exchanges having weak know-your-customer (KYC) protocols, the illicit use of cryptocurrencies — including for money laundering — remains a glaring flaw in the crypto world.

"I truly believe that money laundering is an insidious side of humanity that we need to eradicate," said Charles Day, a senior account executive at multi-factor identity verification service Onfido.

A recent report by blockchain analysis firm CipherTrace examined more than 800 virtual asset service providers (VASPs) in 80 countries and discovered that 56% of them have weak or porous KYC processes. As a result, money launderers can use those services with very minimal or no KYC checks despite anti-money laundering (AML) regulations in those countries.

Charles Day Onfido

Regulators around the world are starting to catch up with the need for stricter rules for VASPs such as crypto exchanges and how they onboard clients to prevent money laundering and terrorism financing. The U.S. Financial Action Task Force’s (FATF’s) “travel rule” and Europe's 5th Anti-money laundering Directive are some examples of regulators around the world coming to grips with the need for better KYC standards in fintech and cryptocurrency.

See related article: How tokenization via blockchain can digitize assets and open up investment opportunities

"There's great work being done at the moment to identify addresses, identify the people that own these addresses, and I think that if you continue along that path and that happens across the board — it's made a requirement by regulators and companies have to abide by it," Day aid. "I think you [could] see this space as a more legitimate area than even the traditional banking system."

Decentralized finance (DeFi) is a relatively new application of cryptocurrencies where users can lend and borrow cryptos directly without going through a bank as an intermediary. DeFi's popularity has exploded in 2020, with the total value locked into a variety of DeFi protocols — most of them running on the Ethereum network — reaching an excess of US$13 billion at the time of writing. But DeFi has also seen a number of scams and Ponzi schemes erupt over time as crypto investors chase yields.

See related article: Congested Ethereum hosts 96% of DeFi transactions. Who are its up-and-coming competitors?

"All the DeFi platforms, they pretty much do very little KYC, or if any at all," said Gunnar Jaerv, COO of First Digital Trust, a Hong Kong-based technology-driven financial institution. "If the platforms cannot provide trust to their clients, whether it's on making sure that they don't have bad actors on their platforms, those platforms will fall into the blacklist and people will tend to gravitate towards good platforms."

Gunnar Jaerv First Digital Trust

A prominent example is the U.S. Commodity Futures Trading Commission charging cryptocurrency exchange BitMEX executives in October with violating KYC/AML requirements under the Bank Secrecy Act.

"Recently we saw the BitMEX story, right?" Jaerv said. "It doesn't matter how big you are, if you don't do things properly, there are issues that you have to face in the future."

"All DeFi platforms should be at least thinking about this, should be thinking about KYC and should be thinking about transaction monitoring and all of that, how to make it easier while still maintaining that balance and keeping sort of the ethos of the whole blockchain and the anonymity and all of that, not compromising it," Jaerv added.

Watch Day and Jaerv's full interview with Forkast.News Editor-in-Chief Angie Lau to find out more about the crypto world's need for better KYC, the future of blockchain in ID systems and more.

Highlights

  • Blockchain could assist national ID systems: "A lot of governments actually keep track of their people and they KYC their people. In pretty much every country, when you have an ID card, you're in some sort of a government database. I think this is where in the future there could be an overlap with blockchain."
  • Financial systems could improve with technology: "Technology improves upon what a human can do by a factor of 14. Better than identifying two faces. This is a comparison between passport control people, so it's not perfect, but it's certainly the best solution possible."
  • Lack of KYC is unsustainable in DeFi: "All the DeFi platforms, they pretty much do very little KYC, or if any at all. In the long term, this is not sustainable. There are reputation risks — essentially right now we see a lot of hype around DeFi platforms, but I foresee that we will see some bad news coming in the next months or years."
  • Crypto and DeFi could be more lucrative than traditional finance: "If you were to consider the potential revenue that you could earn from the legitimate use, it outweighs the non legitimate money… by a huge order of magnitude."
https://open.spotify.com/episode/6PWdeYYU5jnjovv1jPbDbB

Full Transcript

Angie Lau: A FinCEN leak motivates digital assets to secure KYC and identity verification solutions as regulators begin cracking down on those that don't play by the rules. Welcome to Word on the Block, the series that takes a deeper dive into blockchain and the emerging technologies that shape our world at the end of business, politics and economy. We cover it right here on Forkast.News. I'm Forkast.News editor-in-chief, Angie Lau, and your host.

All right, so we're talking about one of the most critical issues in crypto and blockchain today, and it is, as it ever is, KYC, or know your customer. Now, recent revelations from FinCEN files exposed over 200,000 suspicious financial transactions valued at over 2 trillion dollars by some of the biggest banks in the world, and the cryptocurrency community says they are finally being vindicated by these leaks, pointing to the faults in the existing banking system. It's just not crypto. And so the narrative has shifted.

Even so, the digital assets industry is far from perfect. In a recent report by CipherTrace, it notes that over 50% of existing virtual assistant service providers, or VASPs, have weak KYC protocols in place. And as we recently heard from the troubles surrounding BitMEX, it could be a good time to secure KYC and identity verification solutions. So how is this all going to be achieved?

Well, we've invited two guests who are at the forefront of this discussion. Charles Day is from multi-factor identity verification service Onfido, and Gunnar Jaerv is the CEO of First Digital Trust. Gentlemen, welcome to the show. It's great to have you on.

Charles Day: Thank you. Thanks for having us back.

Gunnar Jaerv: Thanks for having me. Very good to be here.

Lau: Charles, Gunnar, tell us briefly about your firms' efforts and activities in KYC, in identification, in verification, authentication, all that good stuff. Gunnar, I'll start with you.

Jaerv: So I think from our side, we come from a very traditional background, but we operate in an industry that's borderless, yet it's defined by borders. And what happens is we have to, on a daily basis, import clients from around the world.

So the biggest question for us is, how do we assure the identity of our clients if they don't walk into your office or branch and you cannot look at their ID and match it with their face? How do we assure the identity and make sure that the person behind the computer is the person that they claim to be? That's the biggest question for us. And that's where we sort of crossed paths with Onfido quite a few years ago.

Lau: That's a great point. Charles, how about you, what are you guys doing over there?

Day: So Onfido is essentially a multi-factor ID verification service. So that service uses a combination of both government-issued ID documents, over 4,500 across 195 countries. And then we combine that government-issued document with a biometric with an individual's face. We do that so we can essentially determine whether the document's genuine, then determine whether the face and the individual is genuine, and then more importantly, make sure that the individual who is submitting that document is one and the same, that same person.

We do that for companies — mostly at the point of registration, they onboard the KYC piece, but more and more, we're starting to see companies reuse our suite of services to re-verify those customers on an ongoing basis on various different other touch points.

Lau: So Gunnar, you are at First Digital Trust, and Charles, you're with Onfido. For the both of you, you're kind of in the same space. What is the critical issue that you think faces all of us across the industry right now, and what are the unique ways that you're approaching the same problem? Gunnar?

Jaerv: Well, I think the common denominator is that we're both in new industries. I think both companies are very committed to not letting any sort of rogue or criminal elements interact with us or use our services. We are sort of fighting the same fight. I think this is sort of the right thing to do. And that's the main common denominator. On our side we are more of a consumer in a way that we are putting what Onfido is building into action. But the ultimate goal is really actually the same.

Lau: The recent FinCEN leaks really taught us a lot about the existing banking system, and I think for a lot of us it wasn't surprising, but the scope of it was incredible. 2 trillion dollars. How can we improve on all of this? And where can blockchain in identity identity verification that we are seeing in this specific space be more broadly applied? Charles?

Day: So I guess it can be improved by making it essentially more accurate, more reliable. Onfido's service is essentially an AI machine learning model combined with human specialists. The traditional method of doing KYCs is typically a manual process, and that process is fraught with errors and inconsistencies and things that essentially just don't make it reliable. Humans can have bad days; they can have incentives not to do KYC properly.

So this is where outsourcing it to a third party like Onfido, where we use a combination of both humans and AI, we can essentially provide a much better result, much more reliable way of identifying someone and making sure that these bad actors, this money laundering and so forth doesn't happen, essentially.

Jaerv: And this is actually quite interesting. I remember reading a few months ago, they've actually done studies out there where they compare people identifying faces and machines identifying faces, and apparently AI and computers are better at recognizing and matching faces than humans these days. So that's just a glimpse of what's to come in terms of implementing AI technologies and all of that.

On our side, we're very excited about that. It goes back to the same fundamental issue: how do you make sure that the face on the document is the same, that's, let's say, on a selfie? That's quite amazing.

Lau: [We're] really talking about the future application as well. As we talk about blockchain and cryptocurrency, we also talk about the unbanked. How do you KYC people on the other side of the digital divide [think of this]? We recently talked with Tim Draper and we recently talked to Unocoin that he had just invested in. This is a huge Indian crypto exchange and really the earliest in that country.

But that is a beautiful example of how frustrating — sorry to use those two words together, but it is an example of how frustrating it can be for an entire nation to KYC its own people. And so how do we ensure that this can be done easily and how critical it truly is for people to be able to assert that this is who they are so that they could participate in the financial system?

Jaerv: Yeah, I think this is sort of a very fundamental issue. A lot of governments actually keep track of their people and they KYC their people. In pretty much every country, when you have an ID card, you're in some sort of a government database. I think this is where in the future there could be an overlap with blockchain. I know companies that are already sort of doing something like this, where you take that identity and put it on a blockchain, and then you don't have to KYC yourself every time you open an account or do anything.

That can drastically increase accessibility of banking services if we end up in the future like that. There's obviously issues with privacy and all of that, but I think that's sort of a thing. I think that innovation will come from the private sector, because people distrust governments these days, and I think companies and the private sector needs to step up to build something. And blockchain could well be the tool for that, to make it borderless in a way.

Day: Absolutely, and that's a problem that you're talking about that I don't think Onfido's going to solve, to be honest. That problem of how to verify someone is who they say they are in a reliable way, without getting it back to the government-issued ID document. So Onfido pins it back to that, because that's the best form of identifying someone at the moment and then using that face to compare it and making sure they are one and the same.

But if you're talking about the unbanked, the large part of the world where they don't have ID documents, this is a challenge. But there are, as I mentioned, that's probably quite a small area of the world, the majority of people have some form of identity, and our coverage specifically is wide, and our mission statement is to make this accessible for everyone. So we do make sure that software is able to verify almost every identity document type. And as a result then that does include those people, those unbanked that you are talking about.

Lau: I mean, it's an age-old problem. You know, modernity has allowed us to KYC, with much more efficiency and much more accuracy. But, you know, in Asia, it used to be the chop. You would carry around your chop and that would be your identity, or it was your fingerprint, or then it evolved to your signature. And now it's evolved into, what, your face — AI-identity as it's tied to everything else.

So does the system need to be completely redefined, or is there another layer where technology can be a rule that allows us to participate in the way that we need to and also prevent the kind of 2 trillion dollars worth of questionable transactions that the leaked FinCEN files showed was possible by even the oldest legacy, traditional banks in the world?

Day: Yeah, I'm not sure about redefined, I mean, it certainly needs to be changed and improved upon. I think the problem is that everyone is looking for one simple solution, one silver bullet that would solve this problem. As you mentioned, it was used in various different ways in the past to identify someone — his signature, proof of address, these, as we see them now, are typically very poor ways of identifying someone because things have improved. And I hope that in the future, what we're doing now is maybe there's a better way of identifying someone.

As it stands, with the technology we have in front of us, we are doing the best we can to identify someone. But even that, we're using, as I mentioned, a multi-factor approach to this because there is no simple, single way to identify someone. So I think that certainly it needs to be improved upon, and I think that companies like Onfido are certainly at the edge of getting as good as it can possibly be. And I think the important thing is it doesn't need to be perfect. It doesn't need to be absolutely without error, although that's the aim of Onfido.

It just needs to be better than the manual process that it was replacing, that as Gunnar mentioned, technology improves upon what a human can do by a factor of — he didn't mention the figure, but the actual factor is a factor of 14. Better than identifying two faces. This is a comparison between passport control people, so it's not perfect, but it's certainly the best solution possible.

Jaerv: And I think also on our side, we come from, as I mentioned, very regulated space, and we always have to follow the guidelines of regulators and we have to follow the laws. Where we would like to see more innovation is regulators being more open-minded when it comes to identification and how that relates to KYC.

In Hong Kong we were quite fortunate; the regulators in Hong Kong are already quite open minded, but in some different countries, you know, they still take two forms of ID and the proof of address copies and all of that. And statistically it doesn't do anything.

The fact that you're collecting a lot of data doesn't mean that you actually verified it. So it's more about the substance of it rather than the function of doing it. And I think regulators worldwide need to sort of critically look at what technology is out there. You know, iPhones are using face scans; there are fingerprint readers; there's a million ways of identifying people. But we sort of need to bring that into the traditional financial world. And in any case, where national identity is required, essentially.

Lau: One of the big criticisms of the rising trend of DeFi in cryptocurrency and all these crypto exchanges is that factor of anonymity. You know, there's this perception that KYC is really poor, that people can remain anonymous and disappear without a trace. Where do you think KYC should be within the innovation space, within DeFi, within crypto, as this industry evolves? Do you think that it is important?

Jaerv: Yes, I think so, like no financial system can exist without a level of trust and DeFi is a huge experiment right now. All the DeFi platforms, they pretty much do very little KYC, or if any at all. In the long term, this is not sustainable. There are reputation risks — essentially right now we see a lot of hype around DeFi platforms, but I foresee that we will see some bad news coming in the next months or years.

If the platforms cannot provide trust to their clients, whether it's on making sure that they don't have bad actors on their platforms, those platforms will fall into the blacklist and people will tend to gravitate towards good platforms, think platforms. And I think defining itself has a huge potential. And I think the platforms, if we look into the future two years from now, three years from now, they will be very sort of ethical and very maybe even sort of self-regulatory in a way.

Jaerv: And it won't be like it is right now in a way. But a giant experiment. So we're sort of excited to see how it goes.

Day: So I think the important thing there is that anonymity is why crypto gained so much traction in the early days. But as more legitimate people come on board and want to invest and want to be part of this space, I think that if the companies that are supporting them, if they also want to evolve and be considered alongside some of the biggest legitimate players in the world, then they need to take the same sort of caution to make sure that that money laundering and bad actors are not not part of that pool of customers.

Lau: And that is a great point.

Jaerv: Recently we saw the BitMEX story, right? So it doesn't matter how big you are if you don't do things properly, there are issues that you have to face in the future. And this could be if you're running it as a business or if there is the ultimate goal, do make some gains. This can be very, very damaging.

So I think all of DeFi platforms should be at least thinking about this, should be thinking about KYC and should be thinking about transaction monitoring and all of that, how to make it easier while still maintaining that balance and keeping sort of the ethos of the whole blockchain and the anonymity and all of that, not compromising it, essentially.

Lau: Well, you know, excitement for some, as we observe innovation can be hard for others, especially if you are a regulator. And that's certainly what we saw with ICOs. We are seeing no doubt that sentiment is being repeated right now in DeFi. One of the the most recent reports that we saw from CypherTrace is that 56% of VASPs have very weak KYC, which obviously increases money laundering risks to both your points.

This has got to change. Do you think that, you know, obviously the both of you represent a part of the industry that recognizes that KYC identity authentication and verification is critical not only to the system, but to the people who are participating in the system. Do you think that the appetite internally in the innovation space needs to also rise for KYC and AML?

Day: Absolutely. So I think if you're talking about encouraging legitimate users to use these platforms, I think this is a great opportunity for the blockchain space to actually show an example of how well it can be done. I mean, if you were to consider the potential revenue that you could earn from the legitimate use, it outweighs the non legitimate money… by a huge order of magnitude.

So if you want to take it to the next level, you have to show to these legitimate users, how they will be protected throughout this process, and how the platform... is of the highest standards. And that starts with a thorough assessment process. I think that's only going to encourage people that are somewhat skeptical of this area at the moment.

Lau: One day, and that day is coming soon — Covid-19 has accelerated the digital transformation of that, that we have little doubt. And we are now living in a virtual and digital world. Increasingly, many of us are engaging in transactions online and that access is critical. KYC is part of that. God forbid that suddenly somebody doesn't believe that I exist and I can't get access to my funds or my assets.

But fast forward to the future a little bit for me. In five years from now, if the work that you're doing right now is applied more broadly, what could the average person see? [Will] our information be on blockchain so that we have our records? Does it necessarily need to be verified by utility bills before we get a library card or, you know, birth certificates that need to be authenticated by a government agency halfway around the world? In five years time, if we were to apply the work that you're doing right now, what could be our day-to-day experience in an ideal scenario?

Day: In an ideal scenario, from my standpoint, I truly believe that money laundering is an insidious side of humanity that we need to eradicate, and I think that there's great work being done at the moment to identify addresses, identify the people that own these addresses, and I think that if you continue along that path and that happens across the board — it's made a requirement by regulators and companies have to abide by it — I think you see this space as a more legitimate area than even the traditional banking system. You could see that absolutely no money laundering is taking place in this space. And I think that would be a really, really great opportunity.

Jaerv: And I think on our side, I'm a firm believer that, in say five years, we will have, or most of the people around the world will have, sort of a portable identity in a digital form where the trust doesn't come from your home government or your local authority. And that will make it much easier for anybody to open, let's say, bank accounts, to subscribe to financial services and all of that. It's about getting to that point, and also getting the traditional financial institutions and regulators to sort of accept that.

As I mentioned, there a few companies that are working on that right now; it's not quite there yet because there's not that level of trust yet, but once we solve the problems of a shared identity and how to transport that safely and securely, then it cannot be forged. I think blockchain could be underpinning that. I think that's really the future. I think we're all tired of submitting a stack of documents 2 centimeters thick every time we open an account somewhere, if that could be done once in your life. Or it could be fluid and changing as time goes by. You could just pass the token digitally. I mean, that would be an amazing future to live in.

Lau: It would be an amazing future, it would be an efficient future, it would be really critical for so many people who are still off the grid a little bit and might not have all those documents in place and/or you can't overcome the kind of bureaucratic obstacles that are often placed in our way simply to do a financial transaction.

So Gunnar, Charles, thank you for opening up our eyes a little bit more into the importance of KYC and all the innovations that you're both doing in this space. Separately, Charles Day from Onfido and Gunnar Jaerv from First Digital Trust, thank you both for joining us on Word on the Block today, and thank you all for joining us on this latest episode. I'm Forkast.News Editor-in-Chief Angie Lau. Until the next time.

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