The compliant future of privacy in decentralized finance

In this article, I discuss the most existential threat to decentralized currencies, and how we tackle them in perhaps one of the most difficult segments: privacy-respecting networks.

In January, the American Securities and Exchange Commission approved the listing of 11 Bitcoin ETFs. After traditional finance industry titans like Blackrock and Fidelity started filing for these ETFs many correctly assumed it was only a matter of time before they would eventually be approved. For some, these monolithic finance institutions getting involved in cryptocurrency at all is seen as a subversion of the anarchic roots that has been the prevailing sentiment in cryptocurrency for many years, for others, it was a welcome change towards a more compliant future, with large capital inflow and a piqued interest from “the establishment”.

That’s what we’ll be discussing in this blog post: a shift to conforming with global standards in the world of finance, and the trade-offs that will come with such a change. I’ll address my view on why it’s important, why it was inevitable, and how privacy can fit within the framework of compliance, and finally, why privacy has to be able to fit within a compliant framework, or cryptocurrency will never be utilized in the ways we imagined or hoped for.

It has now been 15 years since Bitcoin officially launched (January 9th, 2009) and 8 years ago since the Ethereum network came online (July 30th, 2015), and yet, I see a large amount of people ponder if we’re right on the cusp of a great boom of a huge breadth of applications taking advantage of decentralized ledger technology, analogous to 1995, the beginning of the dot-com boom, or if we’re stuck in a perpetual speculative state, where cryptocurrencies get to see a few more cycles of boom and bust followed by a whimper to eternal irrelevance.

My personal conviction is as follows; it’s neither! There’s a third path, an option I’m gonna refer to as “transient purgatory”, as in, a bit of action is needed for cryptocurrency to flourish, and until we get there, we will have these cyclical speculative seasons, where people speculate on real-world use cases, and trying to justify the combined market cap of crypto, by ascribing some potential future value of real-world integrations that can be made.

I’ll just briefly list some of the most notorious, recurring themes of ‘potential real world integrations’ where cryptocurrencies might serve a useful purpose that I’ve observed over the years: supply chain management, health care, real estate, tokenization of literally all assets, and my personal favorite, but perhaps not so common, money remittance.

Now if you think carefully about what each of these respective themes deal with, you might arrive at ‘sensitive data’, and that would be correct.  These ‘holy grails’ of decentralized global management haven't been seriously tested for several reasons, but key among them are that this information is highly sensitive, and by nature, and in some places, by legislation, requires very strict encryption to satisfy data handling law.

Fortunately, at a high level, there’s a fairly simple way to get out of transient purgatory and begin to have some of these more practical applications be a viable option to build on decentralized ledgers, in fact, it might have great benefits for global standardization, and the answer is: on-chain privacy in all aspects, both in identity (at the IP layer), at the transaction level, and at the contract level.

We’re now at a point where, thanks to both privately funded, and open-source research, we have a good understanding of cryptographic primitives that can aid in keeping your on-chain activity completely confidential to prying eyes, data collection agencies (Chainalysis, Ciphertrace, etc.) and other parties, but still allow for certain actors, i.e. regulatory bodies, centralized exchanges, trusted parties, to be fully confident in the compliant nature of a transaction that was made on a privacy chain.

Recently, Binance announced that it would be delisting certain assets, key among them was Monero (XMR). It is becoming increasingly difficult for virtual asset service providers (VASPs) such as Binance to operate legally, especially when it comes to privacy-promoting coins such as Monero, so it did not come as much of a surprise to many – in fact the most surprising aspect of this was how long Binance had been able to support Monero on their platform. Likewise, ZCash (ZEC) has been completely delisted from OKX, and has been delisted in four European countries from Binance.

The issue is that, though these coins have extraordinary researchers in their community, they make little effort to tackle the regulatory requirements that are beginning to be set out for coins that aim to preserve user-level privacy. However, this perfectly highlights the necessity for increased focus on these aspects in a privacy protocol.

Now that traditional finance is starting to pay more serious attention to cryptocurrency, with Blackrock’s CEO, Larry Fink, even pushing for an ETF for Ethereum, the industry is met with a choice: do the necessary research and protocol upgrades to support the requirements set out for AML compliance, or be outlawed, only being tradeable in fewer and fewer regions, and offramps being increasingly hard to find. This dilemma is why Discreet heavily chose to invest in new research and development to strike a very reasonable balance on compliance, and full, uncompromising privacy, in what we have coined “regulatory-grade privacy”.

Specifically, the recommendation set out by the FATF that could make crypto meet its demise is the so-called “Travel Rule”. A rule that stipulates, in broad strokes, that transactions must provide verifiable identity documentation for each transaction, so that a source of funds can always be accounted for, whether on or off-chain. While this might seem to be completely backwards to the idea of private transfers, there has been a lot of research, both from the team at Discreet, and many other great papers, that means that we now have the cryptographic means to do this in both a trustless, and fully private manner, by attaching DIDs (decentralized identities) to transactions through so-called “compliant wallets”.

In the last few months, Discreet has finalized our consensus algorithm Aurem, and written our own proof framework, as well as proprietary bytecode to support the types of proofs that allows Discreet transactions to prove certain aspects about a transaction, these could be things such as whether the sender is under sanctions, their age, nationality, and so on, but in manner whereby only the parties it is meant for (VASPs, regulatory bodies) has access to this encrypted data. Furthermore, no data is stored on-chain in eternity, merely the proof that the data exists.

We believe this new framework for proving identities is absolutely necessary to carry us into the next era of decentralized finance, and means that Discreet, by many metrics, is actually more compliant than pseudonymous networks like Bitcoin, since we can attach identity proof objects directly to a transaction.

The framework we’ve developed, called Clarity, offers a multi-faceted set of tools for relevant bodies to have a full account of proofs that the coins on their books were done in compliance with financial anti-money laundering laws, without infringing on the rights of the user of the network. It should also be mentioned that if you do not wish to off-ramp to fiat, these DIDs are not a requirement for transacting on the Discreet Network, and are fully optional, developed a longevity hedge against future laws to ensure that Discreet stays compliant in the next decade and onwards.

Again, we are extremely proud of the progress we’ve made and the solution we’ve arrived at will make Discreet de-facto compliant, while staying true to our core values of complete, uncompromising privacy at every level.

Currently, no functional implementation of this exists in any other network, and we are excited for you to test the DID functionality out when it is eventually rolled out network-wide on our alpha testnet set to release this month.

This roughly outlines why, from a regulatory perspective, which is perhaps the most existential threat to our ecosystem, I am the most “bullish” on Discreet compared to any other network.

Thank you for reading along. See you on-chain!

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