Decentralized Finance vs U.S. Regulations: Would KYC Destroy DeFi?

The IRS's move raises existential questions for DeFi. Here are a few key ways KYC could shake things up.

The U.S. Internal Revenue Service (IRS) has announced new rules that will require cryptocurrency exchanges and decentralized finance (DeFi) front ends to report customer transactions above $10,000 to the agency.

The move is part of a broader effort to close the tax gap and generate an additional $124 billion in tax revenue over the next decade.

While centralized exchanges are already subject to KYC (Know Your Customer) regulations, DeFi platforms have largely operated in a gray area due to their decentralized nature.

However, the IRS's new rule effectively extends KYC to DeFi, a move that has sparked widespread debate within the crypto community.

In this article, we will delve into the clash between KYC and DeFi, exploring its origins, potential consequences, and the strategies that crypto enthusiasts and regulators may adopt in the face of these new regulations.

What is KYC and Why is it Important in Traditional Finance?

KYC laws were created as part of a global effort to fight money laundering and terrorism financing, and they’ve been around in traditional finance for decades.

In practice, KYC means financial institutions are legally required to verify the identities of their customers.

When you sign up for a bank account, provide a copy of your driver’s license, or submit a utility bill to prove your address, that’s KYC in action. Makes sense, can’t really argue its necessity in most use cases. That’s why it’s a contentious topic.

For centralized crypto exchanges like Coinbase and Gemini, KYC rules have long been a fact of life.

Platforms like these are registered businesses with identifiable owners, so they comply with KYC regulations to stay in the good graces of governments.

But DeFi? It operates in the gray space between finance and tech, built on permissionless, decentralized protocols.

The idea of slapping KYC on a DeFi app isn’t just a logistical headache—it’s an existential threat.

The Origins of the DeFi and KYC Feud

The clash between KYC and DeFi has been brewing since 2018.

Protocols like Uniswap, Compound, and Aave changed crypto trading, lending, and borrowing by eliminating the need for a central authority.

Instead, users interacted with smart contracts— self-executing code that runs on the blockchain.

No forms, no IDs, no approvals.

To regulators, this anonymity was an obvious red flag. Without KYC, bad actors could use DeFi platforms to launder money or evade taxes.

For DeFi enthusiasts, though, anonymity was the whole point. The system was designed to be trustless and borderless—a financial system for everyone, no matter who or where they were.

The real fireworks began in 2021 when the U.S. Treasury flagged DeFi as a potential hub for illicit activity in its “Anti-Money Laundering and Countering the Financing of Terrorism” (AML/CFT) priorities.

While regulators didn’t move immediately, the writing was on the wall: DeFi was in their crosshairs.

The IRS KYC Rule: What’s Happening Now?

Fast forward to 2024, and the IRS has officially dropped the hammer. The new rule, set to take full effect by 2027, requires DeFi front-end platforms to:

- Collect and verify the name, address, Social Security number, and other identifying information of any U.S. customer whose transactions exceed $10,000 in a calendar year. This includes transactions made on behalf of another person, such as a nominee or agent.

- Report these transactions to the IRS annually, using a standardized format.

- Maintain the collected customer information for at least five years and make it available to the IRS upon request.

If it sounds familiar, it’s because centralized exchanges were hit with a similar mandate earlier this year.

But while Coinbase and its ilk have the infrastructure to handle compliance, DeFi platforms don’t. Most don’t even have employees, customer service desks, or compliance officers.

Many DeFi front ends may simply shut down rather than comply. Others might try to adapt but risk alienating users, who could seamlessly switch over to another DeFi platform that doesn’t comply.

Here are a few key ways KYC could shake things up in the world of DeFi.

1. Liquidity could dry up

DeFi runs on liquidity. When users provide funds to protocols in exchange for rewards, those funds create the pools that power lending, borrowing, and trading.

But if KYC requirements spook users, or just don’t want their details shared with the IRS, they might withdraw their liquidity, shrinking the ecosystem.

2. DeFi could lose its decentralized soul

Sounds dramatic; the beauty of DeFi lies in its decentralization. Enforcing KYC would likely push DeFi platforms toward centralization.

Platforms might have to partner with intermediaries or centralize their operations to comply,