• Permissioned DeFi is designed to meet the compliance requirements of institutional investors, facilitating the development of on-chain finance.

• Its key features are geographical differentiation, counterparty selection, whitelisting & KYC.

• KYC processes are vital to regulating DeFi, while compliance is an essential component of financial services regulation.

• Zero-knowledge proofs could help to preserve privacy in a regulated DeFi ecosystem.

Institutional investors, such as US banking giant J.P. Morgan, have been dipping their toes into decentralized finance (DeFi) for some time. However, financial institutions have always been cautious of the scams, rug-pulls and fraud risk in the crypto space, and even more so after the events of 2022. Permissioned DeFi can solve these challenges, facilitating the development of institutional on-chain finance and potentially attracting trillions of dollars in capital to the Web3 space.

In a previous blog, we outlined the rise of institutional interest in DeFi and on-chain finance and the compliance challenges posed by existing financial regulation. This article explores the potential for permissioned DeFi to bridge compliance, security and privacy by providing an accessible yet secure platform for institutional participants and individual users alike.

What is permissioned DeFi?

Permissioned DeFi is a development that enables regulated financial institutions and professional investors to access the world of on-chain finance in a secure and compliant manner.

A permissioned DeFi protocol requires participants to undergo an identity and background check process known as Know-Your-Customer (KYC), which ensures that all trading counterparties have been properly vetted and are not blacklisted.

As a concept, KYC goes against the principles of decentralized finance: most DeFi protocols are completely permissionless and accessible to anyone with a Web3 wallet.

However, the extra layer of security would enable compliance-conscious institutions to actively participate in the evolving DeFi ecosystem, taking advantage of decentralized applications such as lending protocols and decentralized exchanges.

Key features of permissioned DeFi protocols

Open access to finance and the absence of KYC might have facilitated the explosive growth of DeFi in 2020-21. However, the absence of institutional-grade security and compliant solutions prevents institutional capital from entering the ecosystem.

Permissioned DeFi addresses these shortcomings through several key features.

Geographical differentiation

Certain financial products and services may be sensitive to geographical limitations. Permissioned protocols could enable institutions to enforce geographical limitations as part of their permission preferences, allowing them to offer differentiated products tailored to different regions.

Counterparty selection

Counterparty selection allows institutional participants to create different product buckets for different sets of users. This helps to streamline the onboarding process and enables institutions to offer specialized products with tailored risk assessment processes.

Whitelisting & KYC

Permissioned DeFi protocols require identity verification and background checks to whitelist users. This helps to mitigate the risks associated with anonymous blockchain transactions by ensuring that all counterparties are legitimate and not blacklisted.

Attracting institutional investors

The trustless and permissionless nature of DeFi makes it unsuitable for regulated institutions in its original form. Despite this, some 50% of all DeFi transaction volume globally comes from institutions, according to a June 2022 report from Chainalysis.

However, the decentralized finance sector currently represents a small fraction (around 0.1%) of the multi-trillion-dollar traditional finance industry. As such, there is a huge opportunity for DeFi transaction volumes to catch up with traditional financial transactions.

Permissioned DeFi could play an important role in facilitating this. It presents a unique opportunity for institutions to tap into the benefits of blockchain technology while still adhering to stringent compliance and regulatory requirements.

Permissioned DeFi encompasses all the services found in traditional finance, such as lending, borrowing and trading. This creates growth opportunities in the B2C, B2B and B2B2C segments.

KYC, compliance and regulatory scrutiny

Following the collapse of crypto exchange FTX and its sister trading company, Alameda Research, regulatory scrutiny of the crypto and DeFi space can be expected to increase exponentially. Already, we are seeing global regulators focusing more attention on the crypto industry.

As this trend gathers speed, KYC-compliant permissioned DeFi could play an important role in 2023 and beyond. By introducing identity verification to existing products, on-chain protocols can remain compliant with the latest regulatory requirements in specific jurisdictions, allowing them to offer tailored products to their local user bases.

The future of KYC in DeFi: Zero-knowledge proofs

However, offering products tailored to different jurisdictions creates a risk of market segmentation. In addition, most DeFi users today oppose KYC standards on privacy grounds, which could make KYC difficult to enforce, resulting in the loss of market share to platforms without such requirements.

The technology behind zero-knowledge proofs, primarily used in blockchain scaling, could come to the rescue here. Zk-proofs can be used to help DeFi protocols comply with the latest regulations while respecting the privacy rights of their users.

With zero-knowledge KYC (zkKYC), users can prove their identity and eligibility to use a financial service, without giving away their personal details, enabling full compliance with KYC regulations while respecting user privacy rights.

Recent developments in on-chain finance

Aave Arc

Aave, one of the leading DeFi protocols, has been making forays into the institutional market. In 2022, the blue-chip protocol launched its institutional DeFi platform: Aave Arc.

Launched in January 2022, Aave Arc is a permissioned decentralized liquidity protocol focusing on Bitcoin, Ethereum, USDC and the Aave token. This pool is segregated from Aave's other DeFi products.

Aave works with digital asset specialists Fireblocks to guarantee that institutional users have been whitelisted prior to using these liquidity pools.

This involves a strict due diligence process that ensures adherence to relevant regulations and the absence of counterparty risks.

Coinbase

Meanwhile, Coinbase provides a different solution that allows its users to access crypto assets and the on-chain financial system through its platform after completing the KYC process.

Once a Coinbase user has passed KYC, they are able to link their brokerage account to their Coinbase Web3 wallet. This can then be used to access a wide range of DeFi protocols, without the need for additional identity verification.

This self-custody solution allows users to maintain full control of their crypto assets. However, it removes the pseudonymous nature of wallets, as all wallet activity is transparently captured on a public ledger. As such, privacy advocates are likely to favor zkKYC over such a solution.

Conclusion

In its original form, DeFi does not meet the requirements of institutional and professional investors, since participation in the unregulated DeFi world comes with compliance risk. However, it is clear that institutional investors are increasingly becoming interested in the opportunities presented by on-chain finance.

This demand is driving the development of exciting new solutions that could finally bring trillions of dollars in institutional capital to the Web3 ecosystem. In 2023 and beyond, we can expect developments in the permissioned DeFi arena that facilitate institutional adoption.

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DISCLAIMER: The content of this article does not constitute financial advice and is for informational purposes only. The price of digital assets can go down as well as up, and you may lose all of your capital. Investors should consult a professional advisor before making any investment decisions.