DeFi and KYC: A Hate-Hate Relationship

• Why DeFi and KYC Will Never Be Friends: A Comprehensive Dive
• The Origins of the the DeFi and KYC Feud
• The IRS KYC Rule: What’s Happening Now?
• A History of Resistance: DeFi and KYC
• Final Thoughts: What Happens Next for DeFi and KYC?

Decentralized Finance (DeFi) was born to sidestep the middlemen of traditional finance. 

No banks, no gatekeepers, no prying eyes—just you, your crypto wallet, and a world of possibilities. 

So when the IRS rolled out new rules mandating KYC (Know Your Customer) for DeFi front ends, it felt like throwing a toga party in a corporate boardroom. Or vice versa. You get the idea.

Forced transparency clashes with the very DNA of DeFi. 

Let’s unpack why KYC and DeFi have always been—and likely will always be—a hate-hate relationship.

Why DeFi and KYC Will Never Be Friends: A Comprehensive Dive

First, let’s get our definitions straight. 

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 the DeFi and KYC Feud

The clash between KYC and DeFi has been brewing since2018. 

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:

1. Collect user IDs and transaction details.
2. Report these details to the IRS.
3. Deny access to users who don’t comply.

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. 

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.

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.

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, defeating their core purpose.

Innovation could move offshore. Like many crypto exchanges fled to friendlier jurisdictions after the U.S. tightened its regulatory grip, DeFi protocols might do the same. 

Developers could relocate to countries with less stringent rules, limiting U.S. users’ access to cutting-edge projects.

Legal challenges are almost certain. Leading figures in the crypto industry, like Hayden Adams of Uniswap, have already criticized the IRS rule, framing it as an attack on innovation. 

Crypto advocacy groups like the Blockchain Association are expected to challenge the rule in court, arguing that it oversteps regulatory authority and could stifle innovation in the U.S.

Privacy-focused alternatives will rise. Users might turn to privacy-focused projects because KYC requirements make traditional DeFi less appealing. A handful of protocols offer complete anonymity (albeit controversial), and new projects emphasizing zero-knowledge proof technology could gain traction. 

These technologies allow users to verify their identity or funds without revealing sensitive details, offering a potential middle ground.

A History of Resistance: DeFi and KYC

This isn’t the first time crypto has faced off against regulation, and history suggests the community won’t back down without a fight. 

When New York introduced its controversial BitLicense in 2015, many crypto companies simply left the state, which was a significant component of the New York City talent drain to pro-crypto and pro-business cities like Miami. 

Similarly, after China banned Bitcoin mining in 2021, miners didn’t stop—they just moved to Kazakhstan, the U.S., and other countries with looser mining restrictions.

DeFi could follow a similar path. The protocols themselves—being decentralized—can’t be shut down. 

At most, regulators can target the front ends (the user-friendly websites). 

But for savvy users, interacting with DeFi directly via smart contracts or decentralized app (dApp) browsers isn’t that difficult. It’s not ideal for mainstream adoption, but it’s a workaround that hardcore users will embrace.

Final Thoughts: What Happens Next for DeFi and KYC?

The fight between KYC and DeFi is far from over. 

While regulators like the IRS are doubling down on compliance, DeFi developers are innovating at breakneck speed. Whether through legal battles, technological advancements, or sheer stubbornness, the crypto community will find ways to adapt.

Still, the IRS’s rule is a watershed moment. It signals a future where governments won’t sit idly by while decentralized systems thrive outside their control. The question isn’t just whether KYC and DeFi can coexist—it’s whether the vision of decentralized finance can survive the growing pains of regulatory oversight.

For now, the best thing the average DeFi user can do is stay informed. 

The battle over financial privacy is heating up, and the decisions made in the next few years could shape the future of finance for decades to come.

Here’s how we see it playing out.

Some DeFi front ends—Uniswap, Aave, and others—may quietly explore options to comply with the IRS’s KYC requirements, even if publicly they dig in their heels. 

Expect a mix of strategies: some may implement geofencing (banning U.S. users outright), others may begin exploring partnerships with compliance providers, and some may double down on decentralizing further to escape the regulatory crosshairs.

Crypto advocacy groups, like the Blockchain Association or Coin Center, will likely file lawsuits challenging the IRS’s authority to enforce these rules. 

The crux of the argument is that DeFi protocols aren’t “brokers” and therefore fall outside the scope of the law. Makes perfect sense to us, but these cases could drag on for years but expect at least a few fiery court battles to kick off within months.

Now, assuming nothing changes and we’re headed for KYC enforcement… 

DeFi platforms targeting U.S. users could see a sharp decline in liquidity as privacy-conscious users pull out. 

This will be most apparent on big-name protocols with centralized front ends, as users migrate to decentralized alternatives or non-U.S. platforms. 

However, DeFi is global, and regions like Europe and Asia (especially Singapore and Hong Kong) may absorb some of the liquidity that leaves the U.S. ecosystem.

DeFi enthusiasts in the U.S. will begin (if they don’t already) using VPNs and other means to access those platforms. 

On that same note, we’ll see the rise of peer-to-peer and underground DeFi. Just as centralized exchanges gave rise to decentralized ones, KYC-enforced DeFi platforms will likely give rise to P2P protocols and underground alternatives. 

Some platforms already offer non-custodial, peer-to-peer trading without intermediaries. 

We could see a new generation of DeFi tools that bypass regulated front ends altogether, relying instead on wallet-to-wallet transactions and direct, smart contract interactions.

The push for KYC compliance will supercharge development in two key areas: privacy-preserving technologies (zero-knowledge proofs and decentralized identity solutions) and RegTech (Regulatory Technology) companies specializing in crypto compliance will explode in relevance, offering plug-and-play KYC solutions for DeFi protocols. 

Finally, while the U.S. tightens its grip on DeFi, other countries could go the other way. Regulators in jurisdictions like Switzerland, Estonia, and Liechtenstein have shown a greater willingness to work with the crypto industry than against it. 

If Europe adopts a softer, innovation-friendly approach, it could attract developers, users, and liquidity from the U.S., creating opportunities for global regulatory arbitrage.

As a reminder of what’s at stake, as of December 2024, DeFi’s total value locked (TVL)—a measure of all assets deposited in DeFi protocols—stands at $45.5 billion globally, down from its 2021 peak.

Platforms like Uniswap ($3.86 billion TVL), Aave ($4.6 billion TVL), and Curve ($3.5 billion TVL) dominate the space, processing billions in transactions monthly.

Transaction fees are also a meaningful source of revenue. Uniswap alone collects $3 million in fees daily, making it one of the most lucrative protocols in the ecosystem. That money doesn’t just number on a screen—it funds development, pays contributors, and fuels an entire industry of jobs. 

If the U.S. enforces overly harsh regulations, much of this activity could migrate offshore. The jobs, the innovation, the revenue—it’ll all follow. Globally, 1.4 billion adults remain unbanked, and DeFi allows anyone with a smartphone and an internet connection to access savings accounts, loans, and investment opportunities without needing a bank account or credit history.

The need for DeFi won’t disappear, but the opportunity in the U.S. might if we’re not careful.