Understand Your Peers: The Pros and Cons of KYC

Source: Cointelegraph Original text: “Understanding Your Peers: The Pros and Cons of KYC”

The viewpoint comes from: Josef Je, co-founder of PWN DAO

This isn’t another article that insists that Know Your Customer (KYC) practices are the only ones that legalize cryptocurrency, or that KYC is doomed to disappear. Instead, let’s take a look at how we got to where we are today, why we still have to deal with these burdens, where KYC can be beneficial or harmful, and how we can use the Know Your Peers option to be effectively compliant in relevant contexts without compromising on privacy and free choice.

How did we get to today?

KYC regulations stem from decades of efforts to combat financial crime. The Bank Secrecy Act (BSA) of 1970 in the United States required financial institutions to record and report large cash transactions. This laid the groundwork for modern customer due diligence, even before the term “KYC” was invented. As the global financial system expanded, the G7 established the Financial Action Task Force (FATF) in 1989 and issued recommendations for countries to adopt anti-money laundering (AML) measures, including customer identification.

The 21st century has brought about stricter regulations. After the 9/11 attacks, the U.S. Patriot Act (2001) mandated the comprehensive implementation of customer identification programs. Europe, on the other hand, has passed a series of AML directives, gradually including more industries, including cryptocurrency exchanges, under KYC requirements. Over time, “KYC” has become a common standard - a checklist for any entity considered part of the regulated financial system.

Our current situation

These rules are aimed at fully combating our potentially anonymous cryptocurrency ecosystem. Nowadays, centralized exchanges require submission of identification documents, selfies, and proof of address, similar to traditional financial systems. The KYC framework is now shaping the user experience of many cryptocurrency trading platforms and is gradually expanding into the decentralized finance (DeFi) space.

Different Perspectives on KYC

From the regulator’s perspective, KYC makes sense: if you want to enjoy the protection of a regulated market, you must monitor suspicious activities. If cryptocurrencies hope to achieve integration with the real world—tokenizing tangible assets, connecting with traditional banks, and meeting the needs of institutional investors—they must adhere to certain regulations.

However, libertarians or cypherpunks view KYC as an invasive overreach. Criminals can still exploit loopholes, while honest users are treated as suspects. Ordinary users feel troubled by the identity verification process each time. Meanwhile, the personal data collected during the KYC process is often leaked or hacked, exposing users to the risk of identity theft.

The role of KYC in cryptocurrencies

Let’s face it: cryptocurrencies are still rife with scams and “pump and dump” activities. KYC can help give legitimacy to cryptocurrencies. KYC controls assure newcomers of the existence of certain basic accountability standards. Furthermore, as more real-world assets (RWAs) — such as property ownership certificates or tokenized securities — are introduced to the blockchain, regulators will require certain forms of identification to reduce fraud and ensure the enforceability of laws, thus preventing ownership gaps on a physical level.

The harm of KYC to cryptocurrencies

KYC is also an outdated solution that is now imposed on cutting-edge technology. DeFi protocols are decentralized code, not intermediary trading parties. True DeFi protocols cannot run away with funds. The “KYC or die” model is at best awkward and at worst lacks regulatory rigor. They also undermine the effectiveness of other regulations, such as privacy protections, which have little impact on curbing serious crimes but often burden honest users and create the risk of data honeypots.

Understand Your Peers: A New Path

Instead of constantly emphasizing “Know Your Customer,” we might shift towards “Know Your Peers.” In true DeFi, peer-to-peer interactions dominate. If a business needs to ensure compliance, it can selectively verify the attributes of the other party without disclosing or storing identity information.

Zero-knowledge proofs and privacy protection tools can play a role. ZK-based authentication services, for example, allow individuals to verify specific facts without exposing all data, similar to Privado.ID or zkPassports, which can help prove someone’s qualifications without complex documentation.

Reputation system and self-regulation

On-chain transparency allows for the establishment of a reputation system. You can judge the credibility of the other party based on past transactions, rather than looking at a passport photo. Tools like Chainalysis can flag suspicious addresses, while credit scoring protocols rely on verifiable histories. By combining ZK proofs, we can create a self-regulating ecosystem where malicious actors are naturally filtered out. This won’t magically resolve the issue of regulatory acceptance, but it may prove that decentralized, privacy-respecting approaches can achieve similar goals. Over time, if regulators see effective results, they may accept these new methods.

The currently implemented KYC may continue to exist in centralized exchanges and custodial solutions, especially in places where traditional regulatory authorities have clear oversight. However, in the DeFi space, we can try other models. We can rely on cryptographic proofs, selective disclosures, and reputation systems, instead of mandating complete identity verification, thus allowing us to comply with legal and ethical standards without penalizing everyone else.

The optimistic hope is that through self-regulation, we can filter out bad actors and persuade policymakers that cryptocurrency does not need to be forcibly integrated into traditional frameworks. But it can still achieve the same or even better results.

The opinion comes from: Josef Je, co-founder of PWN DAO

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This article is for general informational purposes only and does not constitute legal or investment advice. The views, thoughts, and opinions expressed in the text are solely those of the author and do not necessarily reflect or represent the views and opinions of Cointelegraph.