Source: Cointelegraph
Original: “Know Your Peer: The Pros and Cons of KYC”

Perspective from: Josef Je, Co-founder of PWN DAO

This is not another article insisting that “Know Your Customer” (KYC) practices are the only way to legitimize cryptocurrency, nor is it an article claiming that KYC is destined to disappear. Instead, we will look at how we got to where we are today, why we still have to deal with these burdens, in what situations KYC is beneficial or harmful, and how we can utilize the option of “Know Your Peer” to effectively comply in relevant contexts without compromising privacy and freedom of choice.

How did we get to where we are today?

KYC regulations stem from decades of efforts to combat financial crime. The Bank Secrecy Act (BSA) in the United States, enacted in 1970, required financial institutions to record and report large cash transactions. This laid the groundwork for modern customer due diligence, even before the term “KYC” was coined. As the global financial system expanded, the G7 established the Financial Action Task Force (FATF) in 1989 and issued recommendations for countries to adopt anti-money laundering (AML) measures, including customer identification.

The 21st century brought stricter controls. After the 9/11 attacks, the USA PATRIOT Act (2001) mandated the comprehensive implementation of customer identification programs. Europe passed successive AML directives, gradually bringing more industries, including cryptocurrency exchanges, under KYC requirements. Over time, “KYC” became a universal norm—a checklist for any institution considered part of the regulated financial system.

Our current situation

These rules are aimed at combating our potentially anonymous cryptocurrency ecosystem. Today, centralized exchanges require the submission of identification documents, selfies, and proof of address, similar to traditional financial systems. The KYC framework now shapes the user experience of many cryptocurrency trading platforms and is slowly extending into the decentralized finance (DeFi) space.

Different perspectives on KYC

From a regulator's perspective, KYC makes sense: if you want to enjoy the protections of a regulated market, you must monitor suspicious activities. If cryptocurrency wishes to achieve integration with the real world—tokenizing tangible assets, connecting to traditional banks, and meeting institutional investors—it must adhere to certain standards.

However, the libertarian or cypherpunk viewpoint sees KYC as an invasive overreach. Criminals can still exploit loopholes, while honest users are treated as suspects. Ordinary users find the identity verification process burdensome. Meanwhile, the personal data collected during KYC processes often leaks or is hacked, exposing users to the risk of identity theft.

The benefits of KYC in cryptocurrency

Let’s face it: cryptocurrency is still rife with scams and “pump and dump” schemes. KYC can help legitimize cryptocurrency. KYC controls assure newcomers of the existence of some basic accountability standards. Furthermore, as more real-world assets (RWAs)—such as property ownership certificates or tokenized securities—are introduced to the blockchain, regulators will require certain forms of identification to reduce fraud and ensure the enforceability of laws, thus preventing ownership gaps in the physical realm.

The harms of KYC in cryptocurrency

KYC is also an outdated solution that is now imposed on cutting-edge technology. DeFi protocols are decentralized code, not intermediary trading parties. True DeFi protocols cannot run away with funds. The “KYC or die” model is at best awkward and at worst lacks regulatory rigor. They also undermine the effectiveness of other regulations, such as privacy protections, which have little impact on curbing serious crime but often burden honest users and create the risk of data honeypots.

Know Your Peer: A New Path

Rather than always emphasizing “Know Your Customer,” we might shift to “Know Your Peer.” In true DeFi, peer-to-peer interactions dominate. If a business needs to ensure compliance, it can selectively verify the attributes of the other party without disclosing or storing identity information.

Zero-knowledge proofs and privacy-preserving tools can play a role. ZK-based verification services can allow individuals to verify specific facts without exposing all data, similar to Privado.ID or zkPassports, which can help prove someone's qualifications without complex documentation.

Reputation systems and self-regulation

On-chain transparency allows for the establishment of reputation systems. You can assess the credibility of the other party based on past transactions rather than looking at a passport photo. Tools like Chainalysis can flag suspicious addresses, while credit scoring protocols rely on verifiable histories. Combined with ZK proofs, we can create a self-regulating ecosystem where malicious actors are naturally filtered out. This won’t magically resolve the acceptance issues of regulation, but it may demonstrate that decentralized, privacy-respecting approaches can achieve similar goals. Over time, if regulators see effective results, they may accept these new methods.

Currently implemented KYC may continue to exist in centralized exchanges and custodial solutions, especially in places where traditional regulatory bodies have clear jurisdiction. However, in the DeFi space, we can explore other models. We can rely on cryptographic proofs, selective disclosures, and reputation systems instead of mandating complete identity verification, allowing us to comply with laws and ethics without penalizing everyone else.

The optimistic hope is that through self-regulation, we can filter out bad actors and persuade policymakers that cryptocurrency does not need to be forcibly integrated into traditional frameworks. But it can still achieve the same or even better results.

Perspective from: Josef Je, Co-founder of PWN DAO

Related: The Evolution of Crypto Payments and Future Outlook

This article is for general informational purposes only and does not constitute legal or investment advice. The views, thoughts, and opinions expressed in the article are solely those of the author and do not necessarily reflect or represent the views and opinions of Cointelegraph.

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