Traditional finance has a simple rule for fighting financial crime: follow the intermediaries. Banks, payment processors, and exchanges are considered 'obliged entities' under regulations like those from the FCA. They are required to know their customers (KYC) and report suspicious activity. But what happens when there's no intermediary to oblige?

Decentralised Finance (DeFi) operates on this very principle. Transactions occur directly between users, mediated by code rather than a company. The primary tool for this is the non-custodial wallet, which gives users sole control over their private keys and, therefore, their assets. While this empowers the user, it creates a major headache for regulators. Without a central custodian, there is no single point to enforce KYC checks or freeze illicit funds. The 'customer' is just a string of characters on a blockchain, offering a high degree of pseudonymity.

In a decentralised ecosystem, value flows through new channels that can obscure the origin and destination of funds far more effectively than traditional shell corporations. Two key mechanisms are liquidity pools and flash loans.

Liquidity pools are the lifeblood of decentralised exchanges. Users deposit pairs of assets into a shared pool, which others can then trade against. While essential for the market, they also act as massive mixing pots. An individual can deposit illicit funds into a large, active pool and withdraw an equivalent value later, effectively co-mingling their assets with thousands of others. This breaks the clear on-chain link between their old and new funds.

Then there are flash loans, a DeFi-native innovation. These are uncollateralised loans that must be borrowed and repaid within the same blockchain transaction. They allow a user to command huge amounts of capital for a few seconds. Attackers can use flash loans to manipulate asset prices on an exchange, exploit vulnerabilities in other protocols, and then launder the proceeds through a complex series of swaps, all in a single, near-instantaneous event. From a monitoring perspective, it’s a blur of activity that is incredibly difficult to unpick.

The very code that runs these protocols presents its own set of risks. A smart contract is just a program running on a blockchain. Flaws or bugs in that code can be exploited by criminals to drain funds. What might look like a simple hack could be a deliberate, pre-planned money laundering event, where the 'exploit' is actually an intentional backdoor.

Beyond the code itself is the issue of control. Many DeFi protocols are governed by governance tokens which grant holders voting rights on proposals to change the system's rules. A malicious actor, or a group of them, could acquire enough tokens to seize control of a protocol. They could then vote to change the rules in their favour, for instance, by disabling security features or whitelisting their own wallets to drain the treasury. It's a hostile takeover, executed on-chain.

This decentralised nature makes monitoring a massive challenge. On a peer-to-peer network, there's no central server to subpoena for records. All data is public, but it's a firehose of pseudonymous transactions. Sifting through this data to identify coordinated illicit activity requires sophisticated analytical tools that are always a step behind the criminals they are trying to track.

Time to check your understanding of these new risk vectors.

The shift from centralised intermediaries to decentralised code fundamentally changes the landscape for financial regulation. Understanding these new vectors is the first step in adapting AML frameworks for the on-chain world.