The U.S. Treasury Department plans to promote DeFi digital identity verification! Targeting on-chain illegal finance, smart contracts may be mandated to embed KYC.

The U.S. Treasury is exploring the use of digital identity technology to combat illegal financial activities in the Decentralized Finance (DeFi) sector and is seeking public comments on this issue. One of the core proposals is to embed identification verification directly into DeFi smart contracts, mandating user credential verification before transaction execution to achieve on-chain KYC/AML Compliance. This initiative stems from the authorization of the GEN stablecoin bill that came into effect in July. Meanwhile, banking groups warn that the bill has a loophole regarding stablecoin yields, which could trigger a massive outflow of traditional deposits amounting to trillions of dollars.

Ministry of Finance Consultation: Digital Identity May Become a Regulatory Tool for Decentralized Finance

The U.S. Treasury Department is conducting an in-depth study on the deployment of digital identity systems to curb illegal financial activities in the DeFi space, and is publicly soliciting public opinions on this matter. Treasury documents indicate that one of its options is to embed identification checks directly into DeFi smart contracts. This move aims to leverage emerging compliance technologies (including APIs, artificial intelligence, digital identity verification, and blockchain monitoring) to strengthen regulation.

Smart contracts or mandatory on-chain KYC

The key proposal being solicited by the Ministry of Finance is to require DeFi protocols to directly integrate digital identity credentials into their underlying code. In this model, smart contracts will automatically verify the identity credentials of users before they execute transactions, thereby embedding Know Your Customer (KYC) and Anti-Money Laundering (AML) risk control measures directly into the blockchain infrastructure.

Digital Identity Solutions: Balancing Privacy and Compliance

The statement from the Ministry of Finance pointed out that digital identity solutions may include government IDs, biometrics, or portable credentials. Their advantages are:

1. Reduce compliance costs: Simplify the regulatory burden for financial institutions and DeFi service providers.
2. Enhance transaction privacy: Ensure that users enjoy equal or greater privacy protection during transactions.
3. Improve risk control efficiency: Money laundering, terrorist financing, or sanction evasion activities can be detected before a transaction occurs. At the same time, the Ministry of Finance acknowledges the need to address data privacy concerns and balance the challenges of innovation and regulation. The public consultation period ends on October 17, after which a report will be submitted to Congress and new regulations may be introduced.

Policy Background: The "GENIUS Act" Drives Regulatory Technology Exploration

This consultation stems from the "Guiding and Establishing the American Stablecoin Innovation Act" (GENIUS Act) that came into effect in July 2024. This act establishes a regulatory framework for payment stablecoin issuers and authorizes the Treasury to study new compliance technologies. Digital identity verification is one of the key exploration directions specified in the act.

Bank Warning: Stablecoin Yield Vulnerabilities Threaten Financial Stability

A bank group led by the Bank Policy Institute (BPI) is urging Congress to fix the loopholes in the GENIUS Act, warning that these loopholes may allow stablecoin issuers to circumvent interest payment restrictions.

• Vulnerability: Although the bill prohibits stablecoin issuers from directly paying interest or returns to holders, it does not restrict cryptocurrency exchanges or related companies from providing returns. Issuers may indirectly provide returns through such partners.
• Potential Risks: BPI estimates that if vulnerabilities are not addressed, approximately $6.6 trillion in deposits could flow out of traditional banks, leading to: a. Disrupt the credit flow of American businesses and households b. Increase systemic risk (especially during periods of stress) c. Leads to a decrease in credit supply, an increase in interest rates, and tightening of loans d. Push up the financing costs of the real economy and households

Conclusion

The U.S. Treasury is exploring DeFi digital identity verification, marking a move by regulators to deeply embed the KYC/AML framework of traditional finance into the underlying blockchain. If realized, this could fundamentally change the anonymous nature of DeFi, but it also raises concerns about on-chain privacy rights and the spirit of Decentralization. Meanwhile, warnings from the banking sector about stablecoin yield vulnerabilities highlight the deep concerns of the traditional financial system regarding the siphoning of deposits by crypto assets. Policymakers are facing a difficult trade-off: they need to leverage technological innovation to enhance regulatory effectiveness and prevent illegal activities, while avoiding excessive stifling of industry innovation or triggering unexpected turmoil in the financial system. Participants in the crypto industry should closely monitor the opportunity to submit comments before October 17, as well as the potential regulatory details that may follow.