Uniswap, the leading decentralized exchange, is introducing so-called hooks. One such hook allows for the verification of cryptocurrency merchants' identities. There's growing concern within the community that this might signal the end of a permissionless DeFi ecosystem, and that "decentralized finance" might soon become an empty phrase.
Uniswap, the largest decentralized exchange boasting a daily volume of around half a billion dollars even during the most lethargic bear markets, has become a cornerstone in the world of Decentralized Finance (DeFi).
Note: Decentralized finance apps (DeFi) like Uniswap aren't companies but rather a network of smart contracts on Ethereum and other blockchains. These smart contracts emulate exchanges by structuring the interaction of decentralized parties. The website isn't central but merely an interface; it doesn't control anything but aids users in interacting with the smart contracts. All operations occur decentralized via users' wallets.
With its fourth protocol version, Uniswap introduced "hooks" in the summer of 2023. These are plugins that allow liquidity pools to be enriched with custom features. Liquidity pools are essentially Uniswap's pillars: they contain reserves of two cryptocurrencies, such as WBTC and ETH, enabling users to swap their coins. Hooks allow for the customization of these pools. As Uniswap developers explain on Twitter, they "introduce code at key points in a pool's chronology, like before or after a swap."
Uniswap Labs leads by example, unveiling their self-developed hook, "Time-Weighted Average Market Maker" (TWAMM). This is designed to reduce the impact of large cryptocurrency exchanges on price by spreading them out over time. Other hooks introduce new oracles, allow limit orders instead of the usual market price purchases, introduce dynamic fees, or offer a hedge against "impermanent losses" – losses liquidity providers face when the assets they contribute lose their balance.
In short, hooks decentralize the mechanics of swapping on Uniswap. They allow for experimentation without jeopardizing the core functionality of the exchange.
KYC for Uniswap Hooks are wonderful in principle. However, they also have the potential to change Uniswap in undesirable ways. This is evident in the directory of "From the Community" hooks.
Here, one can find hooks that limit participation in pools. "Whitelists" allow only specific addresses, "NFT Owners Only" restricts to certain NFT owners, and most notably, "KYC" requires some form of identity verification before a user can exchange cryptocurrency. Hooks make it possible to create pools where only verified, professional, adult, European, Russian investors, party members, men, women, princes, Brahmins, Catholics, etc., can proceed cryptocurrency exchanges.
This naturally raises concerns that hooks might be the gateway to regulating DeFi. "It starts as an 'option,' but we all know how it ends... Uniswap is fake DeFi," laments a crypto influencer on Twitter. More options might also mean more restrictions, and greater freedom can also mean the freedom to introduce new constraints.
Bitcoinik, a Bitcoin-focused online magazine, even anticipates that due to hooks, "all DeFi protocols will introduce KYC barriers in the near future. The definition of DeFi protocols will likely change in the coming years." DeFi will align with TradFi, the traditional financial system, adopting its restrictions and inefficiencies, ultimately becoming just a technical upgrade stripped of its revolutionary potential.
KYC as an Opportunity While it's essential to remain vigilant, there's no immediate cause for alarm. Optional KYC might even be seen as an opportunity. Without user verification, decentralized exchanges might never be able to cryptocurrency exchange stocks or government bonds – traditional securities that yield interest or dividends.
The model leaning towards KYC verification through NFTs is promising rather than dystopian. Identity service providers can issue (Soulbound) NFTs confirming a wallet owner's verification without revealing their identity. In case of issues, it's enough to know that the identity can be unveiled. Such a model would be a significant advancement over today's primitive KYC. Currently, one has to submit private data, including ID photos, to every bank and exchange, and even when activating a SIM card. This inevitably means private data awaits the next hack on numerous servers. An NFT would be both more discreet and secure.
If a Uniswap hook establishes identity NFTs, say for cryptocurrency exchanges government bonds or stocks, it would be a win that extends beyond Uniswap. It would bridge the blockchain and the real world, potentially laying the groundwork to finally place traditional digital identity on a solid foundation.
No Cause for Alarm Despite these advantages, there's no need for overreaction. A hook is, first and foremost, an option that pools can choose. Some hooks can make pools more user-friendly, like the aforementioned TWAMM or insurance against Impermanent Loss, but KYC isn't one of them. Identity verification is initially a burden, avoided if possible.
More restrictions mean fewer merchants, leading to less revenue for liquidity providers, resulting in reduced liquidity and worse prices, further reducing the number of cryptocurrency merchants, and so on. For popular pools, like major currency pairs with Ether, Bitcoin, and Dollar, there's little chance a KYC pool will dominate. Nor will it for the multitude of pools that integrate new altcoins and tokens faster than any exchange can manage. To survive, KYC pools must offer something other pools don't, like government bonds, real stocks, or a special backup. They'll likely remain a niche.
Even if all Uniswap pools adopt the KYC hook, there are plenty of other decentralized exchanges whose developers operate beyond the reach of regulators and law enforcement.