Source: Cointelegraph
Original: “DeFi is no longer decentralized — Compliance is undermining decentralization”
Author: Artem Tolkachev, Web3 Investor
When decentralized finance (DeFi) first emerged, the core idea was simple: financial freedom, transparency, and no centralized control. Smart contracts were supposed to replace banks, liquidity would be distributed globally, and users should have complete control over their funds.
It sounded like a dream. Despite technical issues, poor user experience, and low liquidity, many embraced this dream and adopted DeFi. Over the past two years, DeFi has made significant progress, addressing most major issues.
However, the core ideals of decentralization and freedom have begun to show cracks. Compliance, a concept that once seemed completely unnatural to this ecosystem, is now being integrated into DeFi.
Previously, the main risks in DeFi were related to smart contract vulnerabilities and low liquidity. Today, the biggest threat comes from excessive compliance. We now see some users losing access to their funds without warning, without remedies, and without transparent standards.
Currently, there is no clear regulatory body to protect users. DeFi projects are introducing compliance mechanisms, but users remain completely defenseless against potential abuses. This is particularly ironic, as the original intention of DeFi was to create a space free from regulation, yet users are now subject to anti-money laundering (AML) mechanisms and cannot seek legal recourse.
How does compliance work in crypto?
In traditional finance, compliance mechanisms are designed to prevent money laundering, tax evasion, and terrorist financing. In crypto, compliance is enforced through transaction monitoring and wallet tagging.
Private analytics firms play a central role in this, building complex risk assessment models and assigning risk scores to wallets based on criteria they deem relevant. These services are closed and unregulated, but regulators have been pushing licensed exchanges and services to adopt these tools for over a decade.
One major issue any user may face is "wallet contamination" through the spread of transactions. If a wallet is flagged as suspicious, all wallets that have transacted with it may also be sanctioned. In many cases, these sanctions are retroactive. A counterparty initially deemed safe may later be considered high-risk. Therefore, users cannot predict or control whether their counterparties pose a risk during interactions. Innocent addresses can be blocked, and regaining access is nearly impossible.
This affects not only DeFi but also licensed virtual asset service providers (VASPs), which may run into trouble due to reassessing customer risk levels. Banks and payment providers may also close accounts based on similar triggers, even if an address was clean at the time of the initial transaction. This raises questions about the reliability of these assessments and the need for transparent dispute resolution mechanisms.
A fundamental flaw in wallet monitoring systems is that they do not analyze the actual nature of transactions. If any wallet in the transaction chain is flagged, that alone is enough to block a user. Unlike traditional AML compliance or sanctions, this practice has little to do with AML compliance. Even strict bank compliance involves investigating suspicious activity rather than automatically banning without customer dialogue.
DeFi not only lacks clear rules and protections against excessive compliance but also enforces these rules more harshly than traditional banks.
To minimize risk, users can check in advance whether their wallets might face sanctions. Some tools allow you to obtain risk scores for your wallet and counterparties. Of course, this is not a foolproof solution and cannot prevent the retroactive marking of suspicious wallets, but it at least provides some visibility before interacting with DeFi platforms.
Why are DeFi projects adopting compliance?
At first glance, the reasons are obvious: regulators are tightening oversight, and projects want to avoid enforcement actions from the Securities and Exchange Commission (SEC), the Financial Action Task Force (FATF), or the U.S. Department of the Treasury's Office of Foreign Assets Control (OFAC). This is especially true for platforms registered in the U.S., EU, and other highly regulated regions.
The Binance case and enforcement actions against other exchanges have filled the industry with fear and uncertainty. Compliance and sanctions monitoring have become top priorities. Lawyers and compliance officers prefer to over-comply due to concerns about potential sanctions and legal risks, even if these restrictions seem overly harsh.
In the face of a series of high-profile cases, many founders find it difficult to resist these demands, ultimately eroding the core principle of DeFi, which is to remove intermediaries between users and their funds.
Regulatory uncertainty is only part of the issue. Many projects seek funding from well-known venture capital firms, which require teams to comply with AML/KYC standards. Additionally, as more developers operate as identifiable legal entities rather than anonymous contributors, they proactively implement compliance mechanisms to reduce risks for themselves and investors.
Another reason is pseudo-decentralization. Some projects use the term "DeFi," but are actually centralized entities. They seek to avoid licensing as exchanges while reducing AML and sanctions risks through wallet blocking and verification processes. As a result, DeFi is turning into CeFi, but without the safeguards of a centralized system.
Can DeFi coexist with compliance?
Compliance will not disappear, but it can become more transparent. One possible approach is selective compliance, where users can decide whether to undergo KYC to interact with specific protocols. This could create a segmented ecosystem in DeFi, where some platforms comply with regulatory requirements while others maintain autonomy as much as possible.
From a technical perspective, transparent blocking mechanisms can be implemented. Instead of relying on opaque analytics firms to decide to "cut off" wallets, projects can use on-chain mechanisms governed by decentralized autonomous organizations (DAOs). This would allow users to see why a wallet was blocked and participate in dispute resolution, rather than facing unchallengeable sudden sanctions.
Another option is to develop "clean" liquidity pools, where assets are reviewed based on clear, predefined standards rather than obscure Chainalysis algorithms. This can reduce the risk of arbitrary blocking while maintaining a degree of compliance.
All these mechanisms need to be balanced. If DeFi protocols continue to introduce centralized compliance mechanisms, they may face the fate of centralized exchanges, with control concentrated in the hands of a few. Implementing transparent decision-making models and ensuring user control over protocol governance can help maintain a balance between compliance and user freedom.
There is another perspective: if DeFi remains truly decentralized — without a front end controlled by a centralized team and without a single entry point that can be pressured — then regulation and compliance may no longer be necessary. The question is whether this is realistic in today's environment. Most users still prefer to use convenient UIs rather than interact directly with smart contracts.
The future of DeFi
If DeFi continues down the path of hidden compliance, it will lose its core advantage — decentralization. Years from now, what we may see is not a free financial market, but a new form of centralized platform with a worse user experience and increased risks of wallet blocking.
There is still an opportunity to change this trajectory. Developing new regulatory models, transparent on-chain mechanisms, and clear separations between DeFi and CeFi can help the industry maintain its independence.
Compliance should not become a tool for covert censorship. If implemented consciously rather than through closed decision-making and mass wallet blocking, it can become a tool for protecting users and projects.
Currently, users should regularly check whether their wallets might face sanctions and, where possible, spread their funds across multiple addresses to reduce the risk of sudden blocking.
Author: Artem Tolkachev, Web3 Investor
Related: Decentralized Finance (DeFi) can help us filter the best bot service solutions
This article is for general informational purposes only and does not constitute legal or investment advice. The views, thoughts, and opinions expressed in this article are solely those of the author and do not necessarily reflect or represent the views and opinions of Cointelegraph.
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