QuickTake:

• Wall Street’s entry into DeFi will necessitate identity checks.
• DeFi protocols will increasingly implement identification procedures.
• A new hybrid model of partially centralized and decentralized protocols may emerge.

Wall Street’s venture into the decentralized finance (DeFi) space marks a significant turning point, signaling the end of the anonymous transactions that have characterized DeFi. As traditional financial institutions explore the possibilities of blockchain technology, the decentralized finance landscape is poised for a transformation that balances regulatory compliance with the innovative potential of DeFi.

The Appeal of DeFi

DeFi protocols allow users to engage in complex financial activities such as lending, borrowing, and trading without intermediaries. For instance, MakerDAO, a prominent DeFi lending platform, enables users to take out loans on Ethereum without submitting personal identification. These protocols operate as lines of code rather than traditional companies, making them accessible to anyone with an internet connection.

However, this openness poses a significant challenge for institutions like Wall Street, which are legally obligated to assess counterparty risk by knowing the identities of those they transact with. This requirement stands in stark contrast to the anonymity central to many DeFi protocols.

Institutional Challenges and Solutions

Vertex co-founder Darius Tabai, a former global head of metals trading at Merrill Lynch and Credit Suisse, highlighted the difficulties institutions face in engaging with DeFi. “A lot of institutions are actually fascinated by DeFi,” Tabai told DL News. “The problem is that DeFi is still in Wild West mode.”

For these institutions, the lack of identification and counterparty verification is a dealbreaker. To address this, the next generation of DeFi platforms will likely incorporate some form of permissioned access or identity verification, merging the benefits of decentralization with the security and compliance of traditional finance.

The Emergence of Hybrid Models

The crypto industry traditionally categorizes projects as either centralized or decentralized. Centralized platforms, like Binance and Circle, operate with traditional business structures and require identity checks. Conversely, decentralized protocols like Uniswap and Tornado Cash are open-source and community-driven, allowing anonymous participation.

Tabai predicts these distinct categories will converge into hybrid models that leverage blockchain’s security while maintaining the efficiency and compliance of centralized systems. For example, Vertex, a perpetuals exchange co-founded by Tabai, executes trades off-chain like a centralized firm but records all transactions on-chain like a decentralized protocol. While Vertex currently lacks formal know-your-customer (KYC) checks, it uses third-party services like Chainalysis to monitor and flag high-risk wallet addresses.

Another example is Cube.exchange, a trading platform launched in December that has already implemented KYC checks. Users can still track their funds in real-time, similar to decentralized platforms. This hybrid approach mitigates risks associated with fund misappropriation and hacking, issues that have plagued the crypto space since the collapse of Mt. Gox in 2014 and the more recent downfall of FTX in 2022.

Industry Evolution

The integration of traditional financial standards into DeFi is inevitable. “Some of the standards from TradFi will start to move into crypto,” Tabai said, noting the increasing ubiquity of KYC checks across centralized exchanges over the past five years. “It makes sense that at some level, DeFi will probably do the same.”

Cube’s co-founder and CEO Bartosz Lipiński supports this view, arguing that hybrid models address many criticisms of both centralized and decentralized exchanges and offer a superior user experience. He also pointed out that many decentralized exchanges already perform identification checks to comply with anti-money-laundering regulations.

Regulatory Impact

The shift towards hybrid models in DeFi could pave the way for broader institutional adoption, provided regulatory uncertainties are resolved. As Wall Street firms seek to participate in the DeFi space, the demand for protocols that balance anonymity with regulatory compliance will grow.

This evolution will not only reshape DeFi but also ensure its integration into the broader financial ecosystem. By adopting hybrid models that incorporate identity verification and compliance measures, DeFi platforms can attract institutional investors while maintaining the innovative spirit of decentralization.

In conclusion, Wall Street’s entry into DeFi is set to transform the landscape, bringing about the end of complete anonymity and ushering in an era of hybrid models that blend the best of centralized and decentralized finance. As these changes take hold, DeFi will become more accessible and compliant, paving the way for greater institutional participation and the continued evolution of the financial sector.