Challenges of Money Laundering and Illicit Activities in Ether Liquid Staking Protocols

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Challenges of Money Laundering and Illicit Activities in Ether Liquid Staking Protocols

A recent report from digital asset infrastructure provider Northstake reveals that various decentralized finance (DeFi) protocols that aggregate users' Ether for staking purposes are vulnerable to funds associated with money laundering, scams, sanctioned addresses, and malicious actors. While the proportion of illicit funds remains relatively small, this poses potential obstacles for institutional investors who must adhere to rigorous regulations.

The report examined three of the leading Ether liquid staking protocols and discovered instances where these platforms had been exposed to funds directly linked with illegal activities, as well as those originating from high-risk cryptocurrency exchanges and unregulated gambling sites that do not require users to undergo know-your-customer checks.

Sebastian Heine, Chief of Risk and Compliance at Northstake, suggests that the extent of the exposure is likely underestimated. In reference to the amount of questionable or illicit crypto discovered in the staking protocols analyzed by Northstake, Heine acknowledged that there may be additional risks involved.

The report does not disclose the specific liquid staking protocols reviewed. Notably, Lido and Rocket Pool, the two largest liquid staking protocols, have not provided immediate comments on the findings.

These protocols stake users' deposited Ether on their behalf and issue liquid staking tokens, also known as placeholder tokens or derivatives, in exchange. These tokens not only accumulate rewards from Ether staking but can also be utilized as collateral for DeFi loans.

This year has witnessed a significant surge in the Ether liquid staking market. The largest provider, Lido, saw its deposits increase from $5.8 billion to $14.5 billion, reflecting a remarkable 150% growth over the span of several months.

James Butterfill, Head of Research at digital asset manager CoinShares, emphasizes that institutional stakeholders must carefully consider the potential risks and counterparty exposure associated with liquid staking protocols.

However, it is important to contextualize Northstake's figures. Unlike traditional finance, it is easier to assess one's exposure to illicit or questionable funds in the crypto space. Ether liquid staking protocols typically do not enforce know-your-customer or anti-money laundering checks, as DeFi operates under a permissionless framework.

While institutional investors may remain cautious due to the risks involved in using these protocols, retail investors, who are not affected by exposure to illicit funds, have shown great interest in them.

Please contact Tim Craig, DL News' DeFi Correspondent based in Edinburgh, at tim@dlnews.com, or Aleks Gilbert, DL News' DeFi Correspondent based in New York, at aleks@dlnews.com, with any tips or inquiries related to this topic.