The essence of decentralized exchange is getting great attention in crypto-currency domains because exchanges are being hacked, launched as exit scams, or subject to regulation. Some crypto-currency projects are aiming to replace typical, centralized and purely virtual crypto-exchanges with tokens and blockchain. Today we’ll look at the importance of setting up AML-policies for such exchanges and analyze the main aspects of their successful implementation.
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Introduction to customizing DEX for AML compliance and licensing success
Many traders and investors have begun to transfer their assets to decentralized platforms. Their main advantage is that you can carry out trading operations through a personal wallet, the keys to which are held only by you. As long as you keep key data, your assets are safe.
However, despite the theoretical attractiveness of DEX platforms, they have one big drawback; it’s the risk of acquiring dirty cryptocurrency (obtained illegally). Large centralized exchanges employ large teams that monitor asset input/output flows to identify and prevent use of these tokens on the site. On a decentralized platform, this responsibility falls on the user.
It is possible to receive “dirty currency” with every trade on a DEX, since trading transactions are carried out directly between the seller and the buyer. If you further attempt to use such assets on large CEXs, they will be blocked along with your account. Unfreezing them will be almost impossible, since you will have to confirm their legal origin. In addition, your crypto wallet may be blacklisted and blocked until the end of the proceedings. Therefore, effective AML DEX strategies that comply with modern legislative and tech standards are so essential for DEXs.
More currency coming from trusted sources, the safer the transaction. Suspicious categories that are challenges for DEX include the next-mentioned:
- sites that do not use KYC/AML checks or have requirements only for some countries;
- cryptocurrency ATMs;
- exchanges from which you can withdraw more than $2000 in crypto daily without KYC/AML.
Such sources negatively affect the level of trust.
Challenges faced by DEX platforms in AML compliance and licensing
The governments of many countries can no longer remain aloof from such a significant market as the cryptocurrency sector. They recognize the importance of determining the legal status of cryptocurrencies, addressing taxation issues, creating a favorable climate for attracting blockchain talent, stimulating progress of companies in the industry, and ultimately ensuring the digital sovereignty of their country.
AML verification is an analysis of the sources of funds received by a crypto address and an assessment of the risk-score indicator. Risk score is a percentage risk score ranging from 0 to 100. It takes into account the history of receipts to a crypto-address, likelihood of it being associated with illegal activity, user behavioral patterns, as well as available information about address itself, its associated clusters and owner.
DEXs by their nature allow users to conduct transfers without intermediaries and without centralized control. However, due to growing concerns about money laundering and terrorist financing, a number of countries have begun to consider applying AML rules to DEXs.
By default, DEXs do not require KYC (know your customer) and do not have centralized monitor over who uses their platform. This makes direct implementation of traditional AML procedures difficult or impossible.
Some countries are considering introducing regulatory requirements for DEXs to comply with AML regulation standards. However, implementation of this regulation is complicated by the decentralized nature of these platforms. AML in DEXs is the subject of debate and consideration in the context of global cryptocurrency regulation.
Principles of customizing DEX to meet AML regulations and obtain licenses
There is an intergovernmental organization called FATF in the world that fights money laundering. It released a document Travel Rule for crypto companies. There are other international and local directives such as 6AMLD, AML/CFT, etc. that market professionals must follow. Essentially, these AML regulation basis boil down to two principles:
- KYC – know your client. The essence of the principle is that before providing certain services, the exchange or crypto exchanger must establish the identity of the person who interacts with them through the platform.
- KYT – know your transaction, or “know your transaction”. Companies need to know how money appears in a particular wallet. This is the only way to be sure that the crypto is not associated with illegal activities.
To keep a DEX decentralized, you ideally want to make setting up a server and adding a client as simple as possible. Unlike DEX platforms, setup in alternative versions is labor-intensive: this concerns, for example, creating and maintaining a blockchain or setting up a service taking into account KYC/AML restrictions. Although unlikely in practice, the possibility of blocking access to a specific blockchain within national borders exists, and this can happen with any exchange service. The easy-to-configure client-service architecture not only simplifies the process of setting up new servers and clients, but also improves censorship resistance.
Benefits of AML compliance and licensing for DEX platforms
So, the purpose of decentralized exchanges is to enable the exchange of digital assets without forcing users to sacrifice privacy or trust the exchange to hold their funds. DEXs offer access to exchanges without going through AML procedures, meaning they do not ask users for ID, address or phone number.
AML procedures are services for automated scoring of the legality of the origin of crypto-assets with the assignment of an appropriate risk assessment for working with them. The integration of AML procedures is not something completely new in the crypto industry. On the contrary, many large cryptocurrency trading platforms have already implemented AML as an additional layer of protection for the interests of their users.
The anonymity of unregulated exchanges and the potential security vulnerabilities of cryptocurrencies make it possible to commit various criminal activities. The exponential growth of sectors such as decentralized finance and non-fungible tokens has prompted regulators and professional investors to work to make these systems more secure. Some regulators have begun to develop frameworks for the widespread use of cryptocurrency. The overall goal of AML cryptocurrency regulation is to link any such transaction to a real person, making money laundering more difficult. These are the exact AML compliance benefits for DEXs.
User identification and verification options for cryptocurrency transactions are often quite limited. They also leave gaps in oversight, enforcement and compliance with AML standards, especially in relation to cross-border transactions. Additionally, cryptocurrencies currently lack a centralized authority to oversee these transactions. However, analytics tools can use the cryptocurrency address to check the transaction for AML compliance.
The article’s author is Denys Chernyshov – founder and CEO of globally-famous organization Eternity Law International.