US Treasury mulls digital ID verification in DeFi to curb illicit finance

The United States Department of the Treasury is looking into the possibility of deploying a digital identity to curb illicit financial activities in the decentralized finance (DeFi) sector. The US Treasury is seeking public feedback on how digital identity tools and other emerging technologies could be used in its fight against crime.

According to its document, the Treasury noted that one of its options will be to embed identity checks into DeFi smart contracts.

The recently published consultation comes from the newly passed Guiding and Establishing National Innovation for US Stablecoins Act (GENIUS Act), which was signed into law in July. The Act, which spells out a regulatory framework for payment stablecoin issuers, directs the Treasury to look into new compliance technologies, including programming interface (APIs), artificial intelligence, digital identity verification, and blockchain monitoring.

US Treasury to fight illicit financial activities with digital IDs 

One of the ideas that the Treasury is requesting public comment on is the potential for DeFi protocols to embed digital identity credentials directly into their code. Under this model, a smart contract would be able to verify the credentials of a user before they execute any transactions. This way, they would have effectively built Know Your Customer (KYC) and Anti-Money Laundering (AML) safeguards into blockchain infrastructure.

In its statement, the US Treasury mentioned that the digital identity solutions, which will likely include government IDs, biometrics, or portable credentials, could reduce compliance costs while making sure that users still have the same level or even more privacy when carrying out their transactions.

In addition, it could also make it easier for financial institutions and DeFi services to detect money laundering, terrorism financing, or sanctions evasion even before transactions happen.

The Treasury also discussed the potential challenges, including concerns about data privacy and the need to balance innovation with regulatory oversight. “Treasury welcomes input on any matter that commenters believe is relevant to Treasury’s efforts,” the agency wrote.

Meanwhile, the agency has opened comments until October 17 and will submit a report to Congress. It is expected that the body will also issue guidance or propose new rules based on the findings.

United States banks warn against loopholes in stablecoin yield

Several banking groups, led by the Bank Policy Institute (BPI), urged Congress to tighten rules under the GENIUS Act, warning that a loophole could let stablecoin issuers bypass restrictions on paying interest. The BPI warned that a failure to close the loophole would result in the disruption of credit flow to American businesses and families, triggering about $6.6 trillion in deposit outflows from traditional banks.

The group mentioned that the GENIUS Act prohibits stablecoin issuers from offering interest or yield to token holders. However, the ban does not extend to crypto exchanges or affiliate businesses, potentially allowing issuers to sidestep the law by offering yield through those partners. Offering yields is one of the features that stablecoin issuers have used to attract users, with some offering yield natively while others reward users for holding stablecoins on exchanges.

The BPI added that such a shift could pose a serious risk to the American credit system. The result will be greater deposit flight risk, especially in times of stress, which will undermine credit creation throughout the economy. The corresponding reduction in credit supply means higher interest rates, fewer loans, and increased costs for Main Street businesses and households.