ZKs & The Regulatory Tinderbox
Crypto has proved a foreign and complex challenge for regulators. Without the experience or instruments to intervene in an on-chain financial system, governments are concerned about the proliferation of illicit activity they cannot identify or curtail.
Regulatory bodies such as the SEC, CFTC, FinCEN, and OFAC are incipient crypto watchdogs. Among other legislation, the Bank Secrecy Act, a landmark framework governing financial activity, has significantly impacted the on-chain behavior of U.S.-based users and developers. Existing compliance solutions are often haphazardly achieved at the expense of both privacy and developer efficiency, and missteps can yield draconian consequences—blunt tools, like sanctions on open-source software, have been employed to dissuade (even innocuous) crypto usage.
And if crypto is already a regulatory tinderbox, then the privacy promised by ZK technology is a flame. Ironically, to wholly reject on-chain privacy is to overlook the (ostensibly conflicting) visibility ZKs offer. Access keys, a protocol-layer feature of certain ZKs, contain decryption codes that unlock specific, predetermined information. This selective disclosure can be customized (at the protocol or application layer) to address regulatory requirements, thereby automating compliance. For example, third-party reviewers can use a temporary access key to reveal wallet addresses and confirm their absence from sanctions lists.
If successfully executed, legally-sound privacy will allow for the development and growth of products currently excluded from the crypto ecosystem. ZK attestation can support undercollateralized loans by certifying borrower creditworthiness, dark pools by validating the existence of funds and bids, and permissioned liquidity pools by ensuring users meet participation prerequisites. Additionally, on-chain, embedded compliance infrastructure will be a meaningful step towards onboarding important, traditional (read: conservative and highly regulated) liquidity providers.
Crypto’s maturation depends not only on regulators remaining open-minded, but also on crypto enthusiasts’ continued efforts to collaborate; those attempting to circumvent legislation will find themselves on an increasingly anemic and self-referential testing ground. Hopefully, the emergence of ZKs, and the compliance opportunity they represent, will spur a productive dialogue between governing bodies and crypto ecosystem participants that will ultimately result in a safer digital financial system.
About Slow Burn
Weekly explorations into emerging crypto trends and how to navigate 2023 from the Slow Crypto Team, Sam Lessin, Clay Robbins, and Caroline Cline