Decentralized Finance, or DeFi, is one of the most exciting and fastest-growing areas of crypto.
But it is also a major headache for compliance teams. DeFi operates on a blockchain. Transactions are visible, but the people behind them are often not. This is why a new area of compliance has emerged: DeFi AML and Onchain Risk Monitoring.
What is DeFi?
First, let's make sure we are on the same page. DeFi is a catch-all term for financial services that are run using smart contracts on a blockchain.
Instead of a bank, you use a computer program to:
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Lend crypto and earn interest.
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Borrow crypto.
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Trade cryptocurrencies without a central exchange.
Popular platforms include Aave, Uniswap, and Compound.
Why DeFi is a Compliance Challenge
DeFi presents several unique challenges for AML professionals.
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Anonymity: A user can create a wallet address and start using a DeFi protocol without ever providing their name or ID. This is the "unhosted wallet" problem on a larger scale.
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Speed: Transactions happen instantly. There is no 24-hour bank processing window for criminals to be caught.
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Complexity: The transactions can be complex, involving multiple steps, different coins, and different protocols. It can be hard to follow the money.
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Jurisdiction: There is often no physical location for a DeFi protocol, making it hard to know which country's regulations apply.
What is Onchain Risk Monitoring?
Onchain risk monitoring is the process of using blockchain data to assess the risk of a transaction or a wallet.
It involves looking at the public blockchain ledger. You are not just looking at the transaction in isolation; you are looking at the history of the wallet.
What you look for:
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Source of Funds: Where did the crypto come from? Is it from a legitimate exchange, or did it come from a wallet associated with a scam?
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Wallet Reputation: Does the wallet have a history of interacting with known criminal addresses?
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Transaction Patterns: Is the wallet using "mixers" or other obfuscation tools?
How DeFi AML Works in Practice
For a centralised exchange, AML is about KYC and transaction monitoring. For DeFi, AML is often "KYT" - Know Your Transaction.
Step 1: Integrate with Blockchain Analytics
You need to use a blockchain analytics tool. Companies like Chainalysis, Elliptic, and TRM Labs provide these services.
What they do:
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Tag Wallet Addresses: They identify and label wallet addresses. For example, they know that "0x123..." is the official Uniswap wallet or a known ransomware wallet.
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Track Funds: They follow the flow of funds across the blockchain.
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Assess Risk: They provide a "risk score" for a wallet or a transaction.
Step 2: Set Risk Parameters
Your compliance team will decide what is acceptable and what is not.
Examples of risk parameters:
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High-Risk Jurisdiction: Flag any transaction that touches a wallet in a high-risk country.
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Known Scam Address: Block any transaction that interacts with a wallet known to be associated with a scam.
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Thresholds: Flag any transaction over a certain size.
Step 3: Monitor and Investigate
You will receive alerts based on your parameters.
The Process:
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An alert is generated.
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An analyst reviews the transaction.
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They check the source and destination of the funds.
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They decide if the risk is acceptable or if action is needed.
Key Tools for DeFi AML
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Blockchain Explorers: These are free tools (like Etherscan) that let you see every transaction on a blockchain. They are a starting point for any investigation.
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Analytics Platforms: These are paid, professional-grade tools. They provide the "tagging" and "tracking" capabilities that are essential for scaling DeFi AML.
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Risk Scoring Systems: These platforms provide automated risk scores for wallets, helping you focus your attention on the highest-risk activity.
Real-World Scenario: The High-Risk Borrower
You are a compliance analyst at a centralised exchange. A customer wants to borrow 50,000 USDC from your platform using their crypto as collateral.
Onchain Analysis:
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You check the customer's wallet address using your analytics tool.
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The tool tells you that the customer's wallet has interacted with a known mixer service in the past three months.
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It also shows that a portion of the crypto they are using as collateral originated from a wallet in a high-risk jurisdiction.
Your Decision:
This is a high-risk scenario. The "mixer" and the high-risk jurisdiction are red flags. You decide to reject the loan application and potentially file a SAR for suspicious activity.
Conclusion
DeFi AML is a new and complex field. It requires a different approach than traditional AML. You have to move from checking identities (KYC) to checking transactions (KYT). With the right tools and the right training, you can manage these risks effectively.
For a deep dive into this topic, explore our DeFi AML And Onchain Risk Monitoring course at Crypto Compliance Academy.
FAQs
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Q1: What is DeFi AML?
A1: It's the process of monitoring and managing money laundering risks on Decentralized Finance (DeFi) platforms. It often relies on blockchain data. -
Q2: What is onchain risk monitoring?
A2: It's the process of using blockchain data to assess the risk of a wallet or a transaction. -
Q3: Why is DeFi so risky for AML?
A3: Because it often allows users to transact without identity verification (KYC), and it operates at high speed. -
Q4: What are blockchain analytics tools?
A4: They are software platforms (like Chainalysis) that use blockchain data to identify suspicious activity and track funds.
This is a fast-moving field. Get the training you need to stay ahead. The DeFi AML And Onchain Risk Monitoring course covers the latest tools and techniques.
