US Treasury’s DeFi Identification Proposal Faces Privacy Concerns

The US Treasury is considering the incorporation of identity verification directly within decentralized finance (DeFi) smart contracts, a proposition critics argue could undermine the essence of permissionless finance.

Recently, the agency initiated a consultation following the enactment of the Guiding and Establishing National Innovation for US Stablecoins Act (GENIUS Act), signed into law last July. This Act mandates the Treasury to assess new compliance tools aimed at combating illicit activities in crypto markets.

One proposed idea involves embedding identity verification credentials directly into smart contracts. This would allow a DeFi protocol to automatically authenticate a user’s government-issued ID, biometric identifier, or digital wallet certificate prior to processing a transaction.

Proponents argue that integrating Know Your Customer (KYC) and Anti-Money Laundering (AML) measures into blockchain infrastructure could enhance compliance and deter criminal activity in DeFi.

Fraser Mitchell, Chief Product Officer at AML provider SmartSearch, expressed to Cointelegraph that such implementations could “unmask the anonymous transactions that render these networks appealing to criminals.”

“Real-time monitoring for suspicious activities can empower platforms to mitigate risks, detect, and ultimately prevent money laundering within their networks,” Mitchell stated.

Related: GENIUS Act to trigger a wave of innovative applications and payment solutions: Sygnum

DeFi ID verification: safeguard data or risk surveillance?

Mitchell recognized the privacy trade-offs but asserted that viable solutions exist. “Only the essential data required for monitoring or regulatory audits should be retained, with all other data being deleted. Any stored data should be encrypted at the row level, decreasing the likelihood of a significant breach.”

Nonetheless, critics argue that the proposal threatens to erode the core values of DeFi. Mamadou Kwidjim Toure, CEO of Ubuntu Tribe, likened the initiative to “installing cameras in every living room.”

“While it appears to be a convenient compliance measure on paper, it transforms a neutral, permissionless framework into one where access is contingent upon government-sanctioned identity credentials. This fundamentally alters the core purpose of DeFi,” Toure told Cointelegraph.

He cautioned that tying biometric or government ID to blockchain wallets could render “every transaction permanently traceable to a real-world individual, resulting in a loss of pseudonymity and, consequently, the ability to transact without oversight.”

For Toure, the implications extend beyond compliance. “Financial freedom hinges on the right to maintain a private economic life. Integrating ID at the protocol level undermines that principle and sets precarious precedents. Governments could censor transactions, blacklist wallets, or even automate tax collection via smart contracts.”

Related: GENIUS Act yield ban may drive trillions toward tokenized assets — former bank executive

Who gets marginalized?

Another issue is potential exclusion. Billions around the world still lack formal identification. Should DeFi protocols mandate government-issued credentials, entire communities, including migrants, refugees, and the unbanked, risk being shut out.

“This could limit access for users preferring anonymity or unable to fulfill ID requirements, thus undermining the democratic essence of DeFi,” Toure remarked.

Data security is another critical concern. Linking biometric databases to financial activities could amplify the impact of hacks, risking both funds and personal identities in a single breach.

Critics emphasize that the solution isn’t a choice between facilitating crime or endorsing mass surveillance. Privacy-enhancing tools like zero-knowledge proofs (ZKPs) and decentralized identity (DID) standards provide methods to verify eligibility without exposing full identities.