US Treasury’s DeFi Identification Initiative Faces Privacy Concerns

The US Treasury is considering integrating identity verification directly into decentralized finance (DeFi) smart contracts, a shift that critics warn could undermine the core principles of permissionless finance.

Recently, the agency initiated a consultation under the Guiding and Establishing National Innovation for US Stablecoins Act (GENIUS Act), enacted in July. This Act requires the Treasury to assess new compliance mechanisms to combat illicit activities in crypto markets.

One proposal involves embedding identity credentials straight into smart contracts. This would allow a DeFi protocol to automatically check a user’s government ID, biometric data, or digital wallet certificate prior to approving a transaction.

Proponents claim that incorporating Know Your Customer (KYC) and Anti-Money Laundering (AML) checks into blockchain infrastructure could enhance compliance and prevent criminals from exploiting DeFi.

Fraser Mitchell, Chief Product Officer at AML provider SmartSearch, informed Cointelegraph that such tools could “unmask the anonymous transactions that attract criminals to these networks.”

“Real-time monitoring for suspicious activities can aid platforms in mitigating risks, detecting, and ultimately preventing money laundering using their systems to process proceeds from serious crimes,” Mitchell added.

Related: GENIUS Act to lead to a surge of ‘killer apps’ and new payment services: Sygnum

DeFi ID checks: balance data protection and surveillance?

Mitchell acknowledged the possible privacy compromises but argued that solutions are available. “Only essential data for monitoring or regulatory audits should be preserved, with all unnecessary data eliminated. Any retained data should be encrypted at the row level, minimizing the risk of a significant breach.”

Nonetheless, critics contend that the proposal could undermine the essence of DeFi. Mamadou Kwidjim Toure, CEO of Ubuntu Tribe, likened the initiative to “installing cameras in every household.”

“On paper, it appears to be a clever compliance shortcut. But it transforms a neutral, permissionless infrastructure into one gated by government-approved identity credentials, fundamentally altering the nature of DeFi,” Toure said to Cointelegraph.

He warned that if biometric or government IDs are linked to blockchain wallets, “every transaction risks being permanently linked to a real individual. This leads to a loss of pseudonymity and the accompanying ability to transact without surveillance.”

For Toure, the implications extend beyond compliance. “Financial freedom hinges on the right to a private economic existence. Implementing ID at the protocol level diminishes that right and sets worrying precedents. Governments could restrict transactions, blacklist wallets, or even automate tax collection directly through smart contracts.”

Related: GENIUS Act yield ban could shift trillions into tokenized assets — former bank executive

Who gets marginalized?

Another concern is the exclusion potential. Billions worldwide still lack formal identification. If DeFi protocols mandate government-issued IDs, entire groups, including migrants, refugees, and the unbanked, may be effectively excluded.

“This could restrict access for users who want to remain anonymous or cannot fulfill ID stipulations, undermining DeFi’s democratic ethos,” Toure noted.

Data security remains a critical issue. Associating biometric databases with financial activities could result in catastrophic hacks, compromising both funds and personal identities in a single incident.

Critics argue that the choice isn’t limited to crime havens versus mass surveillance. Privacy-preserving mechanisms like zero-knowledge proofs (ZKPs) and decentralized identity (DID) standards offer methods to verify eligibility without compromising full identity.