Decentralised finance (DeFi) is often touted as the ‘future of finance’.
As opposed to centralised cryptocurrency exchanges, Decentralised exchanges (DEX) offer self-executing smart contracts without the need for intermediaries. However, there are some downsides to DeFi; the major of which is crypto-based money laundering.
Crypto-based money laundering has found a new channel through DeFi protocols since its surge during the pandemic. What has been lost so far, and how can reoccurrences be prevented?
Crypto-based money laundering has been around for a while and is a common theme in the cryptocurrency space. Blockchain technology thrives off on anonymity as its competitive edge and source of appeal to millions of users. However, the anonymity that users enjoy might as well be their bane.
According to a crypto crime report, 2021 witnessed a surge in crypto-based crime as illicit addresses received about $14 billion; almost double the amount lost to crimes of the same nature in 2020.
Threat actors in the crypto space are exploiting the anonymous feature of the blockchain to move funds from illegal activities off-chain and on-chain; to obscure the source of the funds. This way, the laundered funds cannot be traced to illegal activities. There are different ways by which these threat actors launder funds on the blockchain. They include nested services, mining pools, high-risk exchanges, and mixing. Over the past two years, DeFi protocols have increasingly opened a new pathway for criminals to launder crypto-based funds.
What are DeFi protocols?
They are communication standards generally utilised between DeFi platforms in a distributed network. These protocols are designed to address certain limitations in the conventional finance sector. Almost half of the world’s population lacks access to a bank account and other financial services, and DeFi protocols are designed to change that by decentralising financial services, thereby eradicating the need for intermediaries or third-party agents in peer-to-peer exchanges.
Of course, this is commendable as these protocols are sparking a revolution in the finance sector. At the same time, they are of high risk as they are prone to hacks and are now being used by criminal actors for money laundering. Many including governments have blamed this on the anonymity, interoperability of the blockchain technology, and lack of regulation on DeFi platforms.
The use of DeFi protocols in money laundering became popular during the pandemic – a period when cryptocurrency exchanges became more mainstream. The crypto market witnessed an influx of customers, and with great opportunities come great risks. Criminals who found it hard to syphon funds through centralised cryptocurrency exchanges due to regulation scrutiny sought respite through DeFi platforms that have escaped regulations.
DeFi platforms are also more vulnerable because they are under development. In 2021, DeFi platforms accounted for about 72% ($2.2 billion) of the $3.2 billion worth of stolen cryptocurrency. 2021 also had DeFi protocols see their highest growth by far in being utilised for money laundering at the rate of 1,964%.
The hype around the DeFi space has also made the increased interest of honest and criminal users alike. With the right technical skills, anyone can easily create new decentralised tokens like Shiba Inu, and get them listed on DeFi exchanges without a verification process also known as a code audit.
A code audit allows third-party firms or listing exchanges to analyse smart contract codes behind new tokens and other DeFi projects. It also enables the verification of the rules that govern the smart contracts to ensure that there are no devices that can allow blockchain developers to make away with investors’ funds. Errors in smart contract codes allow threat actors to exploit DeFi protocols.
However, the DeFi space is growing regardless of these threats but the use of DeFi protocols in crypto-based crimes can impede the growth and wider adoption of the technology in the long run. As mentioned earlier, the space is still under-developed and may be unable to reach its full potential and become the future of finance if its unique feature continues to encourage theft, scams, and money laundering.
On the bright side, the fight against crypto-based crimes is active, and the jurisdiction of law enforcement in certain countries continues to grow. The United States Internal Revenue Services (IRS), in its 2021 annual report, announced that it had seized over $3 billion worth of cryptocurrency from non-tax investigations. There are other instances where law enforcement agencies have been able to seize crypto funds from criminals. Beyond the involvement of law enforcement, DeFi users need enlightenment on how to avoid shady projects on the platforms. Also, major stakeholders in the DeFi space as well as in the entire crypto space, need to be more proactive in preventing the listing of dubious projects and tokens on major exchanges.
Yes, DeFi protocols take pride in their operation outside the regulatory confines, but this might increase and sustain their popularity with threat actors not only involved in money laundering but other crypto-related crimes. However, this state of free operations might not last for long as regulators seem to be gradually closing in.
Hopefully, DeFi protocols can be enhanced with extra security measures and maybe, an extent of regulation to ease the rate of illicit activities and protect its users; if it is to truly become the future of finance.