In recent times, there has been a growing trend of institutional investors entering the decentralized finance (DeFi) space. However, these investors require robust compliance layers to mitigate risks associated with DeFi protocols. To address this need, protocol builders are incorporating modular on-chain controls that can be audited and upgraded.
The incorporation of compliance layers is essential for DeFi protocols to gain traction among institutional investors. These layers include identity checks, transaction screening, transfer restrictions, and audit trails, which are similar to those found in traditional finance. To implement these controls, protocol builders are using on-chain credentials, allowlists/denylists, transfer-restriction token standards, and policy engines embedded in smart contracts.
Permissioned lending pools, RWA tokens, tokenized funds, and geofenced front ends are increasingly being used to implement compliance layers. These protocols operate at the protocol layer, rather than just the user interface (UI), allowing for more secure and compliant interactions with institutional players. Additionally, the use of zero-knowledge credentials, standardized compliance registries, and evolving guidance from regulatory bodies such as FATF, OFAC, EU MiCA/TFR, and UK FCA is becoming increasingly popular.