Crypto and Know Your Customer guidelines (KYC), seem to be an unhappy union — pseudonymity within the digital currencies’ DNA isn’t compatible with the old-school central protocols of traditional finance but cohabitation seems inevitable for the industry’s maturing.
Tension never ends, and even though recent market failures in crypto have caused market turmoil, regulators have clearly been hogging the blanket, pushing established platforms towards more stringent authentication procedures, as well as cutting out the privacy-hardline participants from the market.
Charles Hoskinson, Cardano’s co-founder, expressed popular opinion among the industry side of the United States Congress when said that regulators were not doing a good enough job with KYC (Anti-Money Laundering) safeguards. Will the crypto community be able to achieve the technical and reputational milestones that would allow it to have a private, more decentralized KYC system?
From passport photos to third-party database
Although it is difficult to believe, KYC — which was once a standard in the financial system for many decades — has just recently been made a default feature by the biggest players in crypto.
Binance, for example, announced that users will be required to identify themselves only in 2021 following a number of legal disputes around the world. Needless to mention, there are still many smaller exchanges that manage to ignore the global call for stricter KYC and evade regulators’ attention.
However, it’s not as easy for those who want to exploit the grey area. It isn’t just the overreaching enforcers and officials who are threatening the existence of this section.
Individual and institutional newcomers are feeling the pressure. While they may not be familiar with crypto’s ideological history, the former are willing to trade sovereignty in exchange for ease on an established platform. They are not willing to put their money in an unregulated market, as it could expose them to financial risk. Cointelegraph spoke with Justin Newton, CEO and founder of Netki, a crypto-focused KYC firm.
“As crypto becomes a mass market, it is probable that the vast majority will choose to use services with at least some centralization. Most people are not ultra-libertarians, but they value privacy and civil liberties in the real world. If given the option between a moderately regulated platform or potentially opaque alternatives, most people will choose the former.
Cointelegraph spoke with Lisa Fridman, cofounder and president, Quadrata, a spin-off from Spring Labs that develops Web3 passports. She described KYC’s lack of development in crypto as a growth issue.
“There are many financial institutions that have trillions of assets, but they cannot participate in decentralized finance because it lacks the compliance-aware frameworks and ways to reduce the risk of commingling.
Despite all the acronymic mystery, KYC in Crypto works quite simply. It generally involves an ID confirmation that snaps a photo of your passport. Basic data is then compared with public and private records and cross-checked against other data such as email address or phone number. Common requests include a selfie with a handwritten note.
An advanced approach, which is unique to lending and loan platforms, involves tracking the customer’s credit history or decentralized assets. The potential customer’s name will be checked against the appropriate sanctions and politically exposed people (PEP) lists by financial institutions. Some types of financial transactions may require additional steps such as verification of accreditation investor status.
It is not possible to do as little KYC and still be a viable solution
High pressure from regulators and enforcers, combined with the lack of uniform international standards, contributes to the stress surrounding KYC in an industry that is rapidly maturing.
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Marshall Hayner, CEO of Metal Pay, told Cointelegraph that there is no universal standard for electronic data interchange among traditional financial institutions like ISO20022. Newton concurs, pointing out that market players often use misguided cost-cutting strategies due to a lack of clear standards.
“Regulators provide guidelines and guidance, and companies interpret them for their businesses.” This causes inconsistency within the industry. Companies want to minimize KYC to cut costs and onboarding friction.
This situation was not sustainable, as the industry aims to disrupt or merge with traditional financial systems and grow by attracting institutional investors.
The regulators are at the forefront of the game. They are slowly moving towards a more holistic framework or several large ones, such as the Markets in Crypto-Assets regulation in Europe or the Lummis-Gillibrand crypto bill in the United States.
Although the departure from the permissionless early crypto era is causing anxiety among crypto evangelists there is clear potential for both parties to win. Fridman said that the irony of this situation is that not disclosing data actually limits the potential use cases and gives you the chance to be rewarded for building a strong reputation. She believes that there is an important connection between transparent credit stories and the ability to use capital-efficient solutions. However, many people underestimate the risks.
“A number of crypto market participants might underestimate the risks involved, as the recent developments have shown,” These risks could be managed by a constructive regulatory framework.
Verifiable credentials (ZKP, on-chain KYC)
There are many innovative solutions that the industry can offer to bridge the gap between privacy and regulatory requirements. Verifiable credentials is one of these. It’s an open standard for digital credentials and uses a digital signature that can be easily verified. This signature matches the issuer, individual (holder), and verifier in a triangle. The former doesn’t need to provide sensitive data directly to any entity they interact with. This technology was already well-known by the medical sector, which faced new challenges in the COVID-19 epidemic.
Zero-knowledge proofs is another promising concept. This protocol allows for digital authentication without the need to use passwords or any other sensitive data. Examples of self-sovereign identities platforms allow third-party personnel (for example, law enforcement agencies), to verify whether an individual holds a valid driver’s license. This is done without the individual having to give any other information than their ID number. ZCash (ZEC) is a more well-known use case for crypto. It uses a special version of zero-knowledgeproofs to allow native transactions to remain fully encryption while being verified under the network’s consensus rules.
There are many on-chain KYC solutions. Quadrata’s goal is to preserve sensitive customer data, preserve the pseudonymity of on-chain identities while allowing for a more compliant crypto ecosystem to develop. Hayner believes that one can still maintain a pseudonymous identity, which won’t be disclosed to anyone without proper credentials, while linking the real identity to the places that are important. Hayner is currently working on decentralized identification (DeID), using Proton blockchain.
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“If I cannot see into my bank account, why should I be allowed to see into my crypto account?” Proton blockchain is working to ensure privacy compliance. We see this as the future of crypto. Secure, private, compliant.”
The KYC isn’t the only thing that should be changing the crypto industry, but vice versa. Consumers are becoming more concerned about privacy and data ownership, which drives the demand for options that enable end-users transact with confidence, knowing that their identifying information is safe. Newton observed with a smidge of optimism:
“The limitation is not technology. It is regulators’ willingness to accept and study these new technologies.”