Artificial Intelligence Could Make DeFi Compliance Less Messy

July 18, 2024

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The crypto industry has rebounded after a brutal period defined by scams, scandals, massive price declines and continuing gaps in real-world utility.

As the industry stabilizes and innovation once again flourishes, decentralized finance’s (DeFi’s) progress has come to symbolize the growth and maturation of an industry some predicted would evaporate as it sunk deeper into a bear market.

However, as the crypto industry seeks greater legitimacy amid increased ties with the traditional financial world, DeFi’s messy compliance issues will eventually be spotlighted.

Centralized Web 3.0 organizations operating in major markets like the US, UK and EU have a general understanding of what is expected of them to comply with security laws, anti-money laundering and other consumer safeguards.

Due to its unclear status, DeFi doesn’t have the same luxury, which could undermine its acceptance among institutions and the public, effectively halting its growth.

Therefore, the expanding DeFi ecosystem should enact some measures and standards in anticipation and preparation for future regulatory actions.

DeFi can’t maintain its progress without compliance

From KuCoin to Binance and now Uniswap, many of the industry’s largest exchanges have come under – just or unjust – scrutiny from regulators and the public over fraud and money laundering concerns.

Recent SEC involvement alongside a developing EU manifesto (MiCA) focusing on digital assets has built the basis for an evolving regulatory landscape that aims to shake up the industry.

US efforts to wrangle the industry into compliance have focused on stronger risk mitigation, while the EU has prioritized transparent governance.

We have yet to see how this will impact DeFi, and to a lesser extent, Bitcoin – but major changes that affect user anonymity and more are expected.

While DeFi is naturally harder to regulate due to the absence of a centralized body, internal debates over whether DeFi should do more to ensure criminals and terror organizations aren’t exploiting its protocols and applications continue.

Traditional financial regulatory approaches aren’t fully compatible with today’s automated, smart contract-dependent protocols, and imposing old frameworks on a new and innovative asset class would likely derail its development.

Regulating decentralized systems will always come with its fair share of challenges – not to mention opposition from some within the crypto community.

Although regulations could potentially undermine innovation, a complete lack of compliance and safeguards leaves DeFi users at the mercy of hackers and protocols at risk of being used to wash dirty cash.

With bad actors loitering around DeFi protocols, we’ve already seen SEC movement to empower its enforcement efforts.

In February 2024, the SEC proposed an amendment to the definition of a securities dealer to address these very issues, suggesting it may subject AMMs (automated market makers) and other ‘DeFi participants’ to register.

As recently reported by Forbes, an impending showdown between the two sides is on its way. The SEC’s increased role in crypto’s affairs implies DeFi’s progress is at risk of stalling unless it self-regulates.

This is where an overlooked potential intersection between crypto and artificial intelligence (AI) can meaningfully enhance DeFi and crypto.

The case for AI in blockchain compliance and security

In an under-the-radar and somewhat surprising development from November 2023, the Federal Reserve established a generative AI incubator program to explore ways of using AI to analyze payment system data and data related to supervision and regulation activities.

A similar approach could be used within Web 3.0 environments to take preemptive measures to secure DeFi protocols and their users.

While cybercriminals and bad actors will always look for – and usually find – a method or vector to exploit, DeFi provides them cover via anonymity.

Fair or unfair, this hijacks DeFi’s image to the outside world, overshadowing its innovative nature and unique approach to digital assets and blockchain technology.

AI can make proper Web 3.0 compliance and risk mitigation more efficient, making the space more approachable for financial institutions and non-crypto retail investors.

Applying advanced AI algorithms within a blockchain environment will enable decentralized protocols, apps and platforms to predict and identify security breaches by analyzing transaction patterns and flagging anomalies.

AI capabilities offer DeFi the best and most responsible way to remain decentralized, adhere to any regulatory action and safeguard users’ assets.

Furthermore, AI can enable DeFi systems to simplify compliance processes by automating and facilitating audits while maintaining and respecting transparency.

As KYC and AML regulations become more relevant within DeFi, businesses and customers can feel comfortable using AI-powered compliance solutions to protect user assets while staying out of the SEC’s crosshairs.

Navigating DeFi’s decentralized, community-run governance systems could provide an obstacle.

Therefore, the industry’s loudest voices have an onus to communicate the need to establish compliance standards and that AI offers the space the perfect solution to maintain its momentum.

Marrying blockchain’s secure and trusted environment with AI’s advanced analytical capabilities will dramatically cut down on fraud attempts, enable compliance and empower both users and DeFi protocols to interact in a more secure ecosystem.

It’s only a matter of time before blockchain and AI advances disrupt DeFi and the broader Web 3.0 sector.

But without a plan to address current and future regulatory frameworks and provide users with safe interactions, institutional interest will start to diminish – and with it, the hope of mainstream adoption.

Ilan Rakhmanov is the CEO and founder of ChainGPT, the AI-powered Web 3.0 infrastructure providing a diverse suite of tools and services. Under his leadership, ChainGPT experienced significant growth in the Web 3.0 sector in 2023, supported by a community of over 500,000 members. Ilan’s successful experience serving in executive roles for multiple seven and eight-figure companies across various industries is largely due to a diverse skillset ranging from coding and compliance to business, law, design and marketing.

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