Decentralized Finance (DeFi) and AML implications in UAE

Decentralized Finance (DeFi) and AML implications in UAE

The scope of Decentralised Finance is growing rapidly as the concept of virtual assets is being widely accepted across the globe. Decentralized finance, popularly known as DeFi, is an emerging finance domain that operates very distinctly from the traditional centralized financial system regulated and controlled by a country’s government.

With anonymity and lack of centralized governing authority, the money laundering risk around the same is also very grave. In this context, let us understand what DeFi is and what AML implications are around DeFi.

What is DeFi? 

DeFi is a blockchain technology-based borderless and independent financial network. 

Unlike a centralized financial system, there is no central authority governing DeFi, but it is owned by the users who operate and build it. DeFi is an independent system that works autonomously. People trade on the virtual platform, using technology to borrow, lend, invest, or trade without any central authority/intermediary regulating their finances. 

DeFi works on blockchain technology in which the financial services are distributed in a series over the blockchain structure. It is monitored using smart contract programs without the involvement of any intermediary. Protocols are created using open-source software managed by a community of developers of DeFi.  

With DeFi, financial transactions such as lending or borrowing can be done from any place with internet connectivity. A distributed financial database collates and aggregates data from all users and verifies the same using a consensus mechanism (a mechanism used to obtain agreement, trust, and security over a single value or parameter across a decentralized network). 

DeFi is all about peer-to-peer transactions, where two parties come together to exchange cryptocurrency against any supply of goods or services without the involvement of any third parties like banks. Let’s take an example of a loan, where generally you would go to a bank or lending institution and get the money on interest. In the case of DeFi, once you input your loan requirement into the DeFi systems, an algorithm will run to find you a match. Of all the potential peer matches shown, you would agree to the lending terms of one of the peers and get the money on loan. This lending transaction is then recorded in the blockchain. Everything happens at a click of a mouse, and that too in a few seconds. 

Decentralized Finance (DeFi) and AML implications in UAE

What are the benefits of DeFi? 

  • It reduces the cost of financial services, which generally the banks and other financial institutions levy for obtaining their services. 
  • Eliminates the intermediaries and establishes direct connections between the parties. 
  • The money is kept in a digital wallet rather than placing it in a bank account. 
  • Transferring funds becomes easy and quick. 

What is Virtual Asset Service Provider? 

Here, reference should be made to the definition of VASP as given by FATF, which is as under: 

"A business which conducts one or more of the following activities or operations for or on behalf of another natural or legal person:  

  • an exchange between virtual assets and fiat currencies, 
  • exchange between one or more forms of virtual assets, 
  • transfer of virtual assets; (transfer means to conduct a transaction on behalf of another natural or legal person that moves a virtual asset from one virtual asset address or account to another), 
  • safekeeping and administration of virtual assets or instruments, enabling control over virtual assets, 
  • participating in and provision of financial services related to an issuer’s offer or sale of a virtual asset. 

Can DeFi be construed as VASP or the person controlling it? 

As apparent from the definition above and in the context of DeFi, the DeFi arrangement may fit in the definition of VASP as this technology-based network enables the users to enter if smart contract related to financial services using virtual assets. Thus, DeFi provides a platform to transfer virtual assets between parties by way of a transaction executed between the involved parties. 

As mentioned above, though DeFi qualifies for VASP per se, it cannot be subjected to AML regulations as it is a technology solution or an application. It is essential to understand that even though the name suggests that such software operates on a decentralized ledger, these applications have an authoritative structure where any person or group of a few individuals influence or control DeFi. This control or influence may be related to enhancing the functionalities of the application, aspects related to user interfaces, say, over the governing protocols, or even earning profits out of this network.  

In line with the FATF’s intent to apply the AML regulations to a natural or legal person, the person who is exercising control or has sufficient influence over the DeFi shall be construed as VASP for the purpose of implementing the AML provisions. Accordingly, the owners, developers, or the application operators have to ensure that they undertake due ML/FT risk assessment prior to operating the application as DeFi. This shall also include the implementation of adequate routine AML/CFT procedures and ongoing monitoring measures. 

For details on AML/CFT obligation on owners, developers, and operators controlling the DeFi, please refer to our article on Virtual Assets and VASP. 

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About the Author

Jyoti Maheshwari

Chartered Accountant

Jyoti has over 5 years of hands-on experience in regulatory compliance, policymaking, risk management, technology consultancy, and implementation. She holds vast experience with Anti-Money Laundering rules and regulations and helps companies deploy adequate mitigation measures and comply with legal requirements. Jyoti has been instrumental in optimizing business processes, documenting business requirements, preparing FRD, BRD, and SRS, and implementing IT solutions.