- The US Treasury cites centralization, money laundering, drug trafficking, and terrorism as risks in DeFi.
- The report comes after the regulatory climate in the US turned against crypto.
- It is unclear whether authorities can effectively ban decentralized protocols.
Decentralized Finance (DeFi) has been touted as a game-changer for the financial industry. Supporters call it an accessible, transparent, and decentralized alternative to traditional finance. However, a recent report by the US Treasury sheds a different light on the industry.
In a first-of-its-kind move, the US Department of the Treasury published the 2023 DeFi Illicit Finance Risk Assessment on Friday. The report highlighted the risks associated with DeFi services and urged the industry to take steps to mitigate them.
The report highlighted the potential for DeFi to serve individuals engaging in illicit activity, such as drug trafficking and avoidance of international sanctions. Moreover, the report also claims that many of the supposedly decentralized DeFi protocols are firmly under the control of a few wealthy founders.
Treasury Highlights Fake Decentralization of DeFi
Decentralized Finance (DeFi) services are virtual asset protocols and services that enable automated peer-to-peer transactions. They use “smart contracts,” or code that executes autonomously based on blockchain technology.
This enables developers to create services that enable users to transact without the need for intermediaries or trusted third parties.
However, many DeFi services are not fully decentralized and are operated by a small group of developers or validators.
“There is a wide range of activity that exists on the spectrum between fully ‘centralized’ and fully ‘decentralized’ services,” the Treasury wrote.
“In line with previous U.S. government reports, this risk assessment finds that DeFi services are in many cases decentralized more in name than in fact.”
These false decentralized services leave users vulnerable to attacks and manipulation, including hacks and scams. But that’s only the start of the DeFi rabbit hole.
Scams, Ransomware, Money Laundering in DeFi: US Treasury
The Treasury report also discusses DeFi’s risk of serving illicit actors. These include cybercriminals, ransomware attackers, and scammers who use DeFi to launder their illegal proceeds.
These actors exploit the fact that DeFi services don’t implement anti-money laundering and countering the financing of terrorism (AML/CFT) mechanisms. As a result, DeFi services have become an attractive target for those looking to engage in illicit activities.
“Other vulnerabilities include the potential for some DeFi services to be out of scope for existing AML/CFT obligations,” the report writes. There is also a risk of poor cybersecurity controls by DeFi services, which enables the theft of funds.
The Treasury recommends that the US government strengthen AML/CFT regulatory supervision to mitigate these risks. Moreover, the government should consider giving more guidance on DeFi services.
The Treasury has called for the private sector to implement effective AML/CFT controls to prevent DeFi’s use by bad actors.
On the Flipside
- The report shows that US government agencies are not oblivious to the realties of DeFi space. Instead of a one-sided view, the Treasury demonstrated a nuanced approach to the subject, including an understanding of the value of decentralization.
- Regardless of the Treasury’s recommendations, it is unclear whether authorities can effectively ban decentralized protocols. In 2022, US authorities banned Tornado Cash, a protocol that obscures the flow of tokens on the blockchain, citing money laundering. Despite the ban, the protocol remains operational.
Why You Should Care
US regulators seem intent on cracking down on the excesses in the crypto and DeFi space. While crypto supporters point out the risks of stifling innovation, there are also risks of leaving the space completely unregulated.
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