Undoubtedly, 2020 will go down in history as the year decentralized finance has sprung into the collective consciousness of the crypto community. From lending and borrowing over decentralized exchanges to smart contract insurance, DeFi paradigms such as liquity mining, yield farming, and automated market makers have been the main driver for new ways to earn a passive income on crypto holdings. 

However, while crypto enthusiasts have greatly benefited from the DeFi boom of 2020, there is still a long way to go until DeFi will have a transformative impact on the financial world at large. One of the problems the sector is currently facing is the lack of accountability, which is a result of crypto's pseudonomous nature. Let us take a look at what DeFi projects can do to improve their compliance and the various benefits of doing so. 

DeFi risks and benefits for retail investors

Since the beginning of the year, the total value locked in DeFi has risen by over 2000 %, with most money coming from retail investors. At the time of writing, the TVL is closing in at 15 billion US-dollars. 

The period with the largest increase was in summer when many DeFi protocols started to introduce their own tokens for liquidity mining. At this time, it wasn't uncommon for protocols to indicate annualized returns in the two-figure, sometimes even three-figure percentage range. 

Even after APRs have returned to sustainable levels by now, DeFi investments can still offer significantly higher returns than bank deposits. Besides stablecoin deposits, DeFi users can also earn an additional, albeit smaller APR on their crypto holdings. However, DeFi investments also come with some risks attached. 

With the rise of DeFi protocols, which were often unaudited, or audited only poorly, became subject to cyberattacks, often costing the millions of dollars at the sole expense of Investors. Secondly, DeFi protocols may facilitate money laundering, if they accept deposits from illicit funds. This might get investors in trouble when they decide to convert their gains to fiat and the transaction gets flagged as suspicious. 

Both problems can be remedied by adding KYC checks to DeFi protocols. Without these compliance measures, it is not possible to determine whether the deposits come from a hacked smart contract, a drug deal on the dark web, or legitimate source. Furthermore, requiring users to identify themselves before being whitelisted to use a DeFi smart contract can effectively deter malicious actors from attempting to hack the protocol's smart contracts. 

Institutional investors in DeFi

The DeFi sector could greatly benefit from institutional investors, but for them, corporate reporting comes into play. The requirements to give a detailed report about their business activities is much higher than for retail investors. Investing in a DeFi protocol without knowing who their counterparties are is therefore usually out of the question. 

At the current time, institutional investors typically only have a chance to profit from the DeFi boom through capital investments, rather than by providing liquidity to the protocols. Compliant DeFi protocols can give them the regulatory security they need to safely invest in DeFi. 

On top of that, the money flowing into DeFi from institutional investors requires the liquidity to be allocated as efficiently as possible. This will make it necessary for lending platforms to make first ventures in undercollateralized, or even uncollateralized loans. However, this is not possible without an identity layer on top of the protocols that makes it possible to calculate a risk score for loan applicants and to prevent them from defaulting on their debt. 

DeFi Compliance vs. DeFi Privacy

One might ask whether it is desirable to give up privacy in the DeFi sector for improved compliance. After all, privacy has been touted as one of the upsides of crypto payments. However, it soon became clear that crypto transactions could be tracked and traced back to an identity. 

Compliance requirements for crypto exchanges, such as KYC/AML checks ultimately buried the dream of anonymous crypto payments, unless a privacy coin is used. As a result, DeFi currently neither excels at privacy, nor compliance. With decentralized identity solutions like Shyft Network, it is possible to conduct basic KYC identification, while at the same time taking into account the basic needs for automation and data security within the DeFi sector. 

In the Shyft Network, encrypted Personal Identifiable Information, such as the information needed for KYC verification, can be stored off-chain  by trust anchor nodes, which can then open a secure communication channel with other service to pass the data, or pass an on-chain attestation of the data. 

Rather than having to undergo KYC verification each time they want to use a new crypto exchange or DeFi protocol, the user can simply request a trust anchor where he already is verified (which could be a centralized exchange, a bank, or a government agency) to attest his identity. Since this attestation happens instantly, the user can then immediately use the service he shared his identity information with. 

Moreover, this prevents the redundant storage of sensitive information in data silos, which has multiple benefits. Firstly, it reduces the overhead cost of data storage. At the same time, this also reduces the risk of data breaches, as the personal information isn’t scattered around in multiple silos. Lastly, the user stays in control of his personal data, rather than having to share it to each service without knowing what the services may be doing with their personal information. 

All in all, DeFi protocols can greatly benefit from connecting with an identity management solution that takes both privacy and compliance into account. Becoming compliant will be a necessary step for the whole DeFi sector, which brings many advantages for both retail and institutional investors.