DeFi is no longer decentralized — compliance is undermining decentralization

Opinion by: Artem Tolkachev, Web3 investor

When decentralized finance (DeFi) first emerged, the core idea was simple: financial freedom, transparency and the absence of centralized control. Smart contracts were meant to replace banks, liquidity was to be distributed globally, and users were supposed to have complete control over their funds. 

It sounded like a dream. People embraced that dream, adopting DeFi despite technical issues, poor UX and low liquidity. In the last two years, DeFi has evolved significantly, addressing most of its significant problems. 

The core concepts of decentralization and freedom have, however, begun to crack. Compliance, which once seemed entirely unnatural to this ecosystem, is now being integrated into DeFi.

Previously, the primary risks in DeFi were related to smart contract hacks and low liquidity. Today, the biggest threat comes from over-compliance. We now see cases where users lose access to their funds without warning, without recourse, and without transparent criteria.

There is no clear regulatory body to protect users. DeFi projects are introducing compliance mechanisms, but users remain completely defenseless against potential abuse. This is especially ironic, as DeFi was created as a space free from regulation, yet users are now subject to Anti-Money Laundering (AML) mechanisms without legal recourse.

How does compliance work in crypto?

In traditional finance, compliance mechanisms aim to prevent money laundering, tax evasion and terrorist financing. In crypto, compliance is enforced through transaction monitoring and wallet labeling.

Private analytics firms play a central role, building complex risk assessment models and assigning wallet risk scores based on criteria they deem relevant. These services operate closed and unregulated, yet regulators have been actively pushing licensed exchanges and services to adopt their tools over the past decade.

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One major issue that any user can face is “wallet contamination” through transactions. If one wallet is flagged as suspicious, all wallets that have interacted with it may also be sanctioned. In many cases, this happens retroactively. A counterparty that was initially considered safe may later be deemed high-risk. As a result, users cannot predict or control whether their counterparties are risky at the time of interaction. Innocent addresses get blocked, and regaining access is nearly impossible.

This affects not just DeFi but also licensed virtual asset service providers (VASPs), who may find themselves in trouble as a result of retroactively reassessing their clients’ risk levels. Banks and payment providers may close accounts based on similar triggers, even if an address was clean during the original transaction. That raises questions about the reliability of such assessments and the need for transparent dispute resolution mechanisms.

A fundamental flaw in wallet monitoring systems is that they do not analyze the actual nature of transactions. If a “red flag” is assigned to any wallet in the transaction chain, it can be enough to block a user. This approach has little to do with AML compliance or sanctions in their traditional sense. Even strict banking compliance involves an investigation in cases of suspicious activity rather than an automatic ban without customer dialogue. 

DeFi not only lacks clear rules and protections against over-compliance, but it also enforces these rules more harshly than traditional banking.

To minimize risks, users can preemptively check their wallets for potential sanctions. Several tools enable you to get a risk score for your wallet and counterparties. Of course, this is not a foolproof solution and does not prevent suspicious post-factum wallet designations, but at least it provides some visibility before engaging with DeFi platforms.

Why are DeFi projects adopting compliance?

At first glance, the reason is apparent: Regulators are tightening their grip, and projects want to avoid enforcement actions from the Securities and Exchange Commission, Financial Action Task Force, or Office of Foreign Assets Control. This is especially true for platforms registered in the US, EU and other highly regulated jurisdictions.

Numerous lawsuits and administrative actions have instilled fear and uncertainty in the industry. Compliance and sanctions monitoring have become top priorities following the Binance case and enforcement actions against other exchanges. Lawyers and compliance officers, fearing potential sanctions and legal risks, prefer to over-comply, even when restrictions seem excessive. 

Faced with a series of high-profile cases, many founders find it difficult to resist these demands, ultimately eroding DeFi’s core principle of eliminating intermediaries between users and their funds.

Regulatory uncertainty is only part of the picture. Many projects seek funding from prominent venture capital firms, requiring teams to comply with AML/KYC standards. Additionally, as more developers operate as identifiable legal entities rather than anonymous contributors, they proactively implement compliance mechanisms to mitigate risks for themselves and their investors. 

Another reason is pseudo-decentralization. Some projects use the term “DeFi” but are, in reality, centralized entities. They seek to avoid licensing as exchanges while reducing AML and sanctions risks by implementing wallet blocks and verification processes. As a result, DeFi is turning into CeFi, but without the guarantees of a centralized system.

Can DeFi coexist with regulation?

Compliance will not disappear, but it can be made more transparent. One potential approach is opt-in compliance, where users decide whether to undergo Know Your Customer (KYC) to interact with specific protocols. This could create segmented ecosystems within DeFi, where some platforms comply with regulatory requirements while others remain as autonomous as possible.

From a technical perspective, transparent blocking mechanisms could be implemented. Instead of simply “cutting off” wallets based on decisions from opaque analytics firms, projects could use onchain mechanisms governed by decentralized autonomous organizations. This would allow users to see why a wallet is blocked and participate in dispute resolution rather than being hit with sudden sanctions they cannot contest.

Another option is the development of “clean” liquidity pools, where assets are vetted against clear, predefined criteria rather than hidden Chainalysis algorithms. This could reduce the risk of arbitrary blocks while maintaining a certain level of regulatory compliance.

All these mechanisms require a balanced approach. If DeFi protocols continue introducing centralized compliance mechanisms, they risk following the fate of centralized exchanges, where control is concentrated in the hands of a few. Implementing transparent decision-making models and ensuring user control over protocol governance could help maintain a balance between regulatory compliance and user freedom.

There is also an alternative perspective: If DeFi remains truly decentralized — without front ends controlled by centralized teams and without a single entry point that can be pressured — then regulation and compliance may not be necessary. The question is whether this is realistic in today’s environment. Most users still prefer a convenient UI rather than interacting with smart contracts directly.

The future of DeFi

If DeFi continues down the path of hidden compliance, it will lose its key advantage — decentralization. In a few years, we may see not a free financial market but a new form of centralized platforms with worse UX and increased risks of wallet blocks.

There is still a chance to change this trajectory. Developing new regulatory models, transparent onchain mechanisms, and a clear separation between DeFi and CeFi could help the industry maintain its independence.

Compliance should not become a mechanism for hidden censorship. It can serve as a tool for protecting users and projects — if implemented consciously rather than through closed decisions and mass wallet bans.

For now, users should regularly check their wallets for potential sanctions and, when possible, spread funds across multiple addresses to mitigate risks in case of a sudden block.

Opinion by: Artem Tolkachev, Web3 investor.

This article is for general information purposes and is not intended to be and should not be taken as legal or investment advice. The views, thoughts, and opinions expressed here are the author’s alone and do not necessarily reflect or represent the views and opinions of Cointelegraph.