G7’s Proposed Crypto Regulations Could Stifle DeFi Innovation
Recently, the Group of Seven nations met to discuss global issues, including regulation of the crypto industry. While topics such as stablecoin issuer requirements and cookbooks for central bank digital currencies were covered, the G7's joint statement regarding the growth of illicit activities in the crypto market and the Financial Action Task Force’s (FATF) work on accelerating global implementation of FATF Standards on virtual assets grabbed attention.
The G7 nations expressed support for initiatives by the FATF on emerging risks, including DeFi arrangements and peer-to-peer transactions. The travel rule, including its enforcement on DeFi/permissionless blockchain networks, has been looming over the crypto industry as a major existential threat that requires all virtual asset service providers to obtain, verify, hold and transmit sender and receiver information, including “know your customer” and “anti-money laundering” screening. These compliance practices have yet to be willfully adopted by any DeFi ecosystem actor.
However, the potential enforcement of the travel rule across every virtual asset service provider could create a firewall between centralized finance exchanges and DeFi protocols, restricting crypto liquidity and functionality across the entire ecosystem. In addition, self-custody wallet providers may need to prompt users to provide personally identifiable information about them, which would jeopardize the censorship-resistant and permissionless nature of DeFi.
While decentralized identity is being worked on as a technical solution to such regulatory enforcement, it would take a paradigm shift for Web3-native users to accept this new reality if implemented at scale. The worst-case scenario is if ill-informed regulation creates a firewall on permissionless transactions being non-compliant, rendering the crypto-native sector obsolete.