Oracle Can Be a Go-To Solution for AML in DeFi – This Is How
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Six steps on how an AML oracle for DeFi can work as a part of an atomic transaction
It’s no secret that DeFi (decentralized finance) and AML (anti-money laundering) policies are difficult to align.
Regulators and industry players advocate for the importance of regulation, but we face the stark reality t’s nearly impossible to implement effective oversight in this space.
Meanwhile, stolen funds continue to be laundered through DeFi tools.
How do we balance decentralization with legal obligations? Using oracles becomes an effective solution.
Why traditional AML fails in DeFi security and limitations of smart contracts
Traditional AML policies struggle to adapt to the DeFi ecosystem because of a significant limitation.
Smart contracts can’t make decisions that require external information, such as passing AML checks.
These contracts are limited to the data available on the blockchain they run on. They cannot directly access data from other blockchains or external sources, such as websites or APIs.
This is because smart contracts are executed by blockchain nodes, which do not have built-in internet connectivity and can only connect to their own blockchain.
This design is intentional to preserve the security and decentralization of the blockchain.
Blockchain consensus requires that all data used in a transaction must be recorded on the blockchain before the transaction can be executed.
This ensures that the network operates in a trustless and secure manner, with all nodes agreeing on the same information.
If smart contracts could connect to the internet, they would introduce security and operational risks.
External data like from websites or APIs oesn’t follow blockchain rules, making it possible for manipulated or false data to be fed into the system.
Oracles bring additional information to DeFi apps
This is where DeFi oracles play a key role. Oracles allow DeFi applications to bring in external data to the blockchain, enabling blockchain transactions to achieve consensus with this off-chain information.
This information can include data from an AML platform, such as KYC (know your customer)/KYB (know your business) information, watchlists, blacklists, sanctions lists, transaction monitoring and transaction screening/filtering.
The diagram below depicts how the AML oracle for DeFi works.
How the DeFi compliance oracle works
1. User interacts with DeFi service
Users engage with the DeFi service to perform common financial actions such as depositing, withdrawing, swapping, lending or staking assets.
Before processing the transaction, the DeFi service must ensure the transaction complies with AML regulations.
2. DeFi service request to the AML oracle
When a user initiates a transaction, the DeFi service requests an AML check for the user’s address and the associated data.
The DeFi service communicates with the AML oracle smart contract, asking for the KYC/KYB assessment result and a transaction risk rating or address risk rating.
3. External AML provider monitors the AML oracle requests
The external AML provider continuously monitors the AML oracle smart contract for incoming requests from DeFi services.
Once the external AML provider detects a request, it begins the AML check based on the specific details provided in the request.
4. External AML provider screens blockchain and off-chain data
The external AML provider conducts the AML check by analyzing both on-chain and off-chain data.
- On-chain data such as transaction history, wallet addresses and other relevant blockchain activities
- Off-chain data, including sanction lists, watchlists and internet or deep web sources that contain information about suspicious addresses
- KYC/KYB data provided by users and linked to their corresponding blockchain addresses
5. AML provider responds
After completing the check, the external AML provider writes the result to the blockchain and provides a reference to this data for the AML oracle smart contract.
The result typically includes a pass/fail status and a link to more detailed data stored by the AML provider for audit purposes (to save on costly blockchain space).
6. DeFi service acts based on the AML check result
Once the AML check result is available on the blockchain, the DeFi service automatically takes action based on its smart contract rules.
- If the user passes the AML check, the DeFi service proceeds with the transaction (deposit, withdrawal, swap, lending, staking, etc.).
- If the AML check fails or raises concerns, the DeFi service may halt the transaction or freeze the user’s funds.
All of these steps occur as part of an atomic transaction
In blockchain, an atomic transaction means that either all the steps in the process succeed or none of them do.
This guarantees that no partial or inconsistent state is left, ensuring the integrity and security of the transaction.
For example, if a user’s address appears on a sanctions list, the swap transaction would be automatically canceled by the blockchain’s rules without any need for human intervention.
This eliminates the risk of system failure or human error from a compliance officer.
To sum up
DeFi systems have the potential to integrate effective AML solutions. Achieving this goal will likely require time and effort.
So far, oracles can be considered a universal technical solution for AML embodiment in DeFi.
Lex Fisun is a CEO and co-founder at Global Ledger, a Swiss company providing cryptocurrency AML risk analysis, blockchain forensics and cybercrime investigation tools. Since 2015, Lex has worked in fintech, AI and anti-fraud tech companies, leading him to founding Global Ledger in 2019 in response to increased scrutiny of crypto regulations.
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Author: Lex Fisun
