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Privacy And Compliance Are Not Orthogonal

Privacy And Compliance Are Not Orthogonal

Last updated 5th Aug 2022
Disclosure

Author Matthew Niemerg, Ph.D., is the co-founder of the Aleph Zero Foundation — a Swiss non-profit offering a scalable privacy-enhancing smart contract infrastructure suitable for enterprise-grade applications.

Since its inception, cryptocurrencies like Bitcoin have been a bit of a thorn in the side of government regulators, at least those that were aware of them. However, as time passes, regulators are waking up, with many of them seeing the inherent pseudonymity of these systems as a threat. This has led to legislation that trends towards draconian, or at least threatens to be so. Now, developers are looking for ways to make blockchain networks that are regulatory compliant, but still protect the privacy and rights of their users. To do this, they are developing what could be described as a hybrid blockchain, in essence, a public blockchain enabling private computations (transactions), which could be just what the financial system is looking for. 

Current regulatory woes

If you’ve been paying any attention to the news as of late you have probably noticed that globally, financial regulators have become aware of cryptocurrencies. China has been overtly against Bitcoin and the like for years, but recently doubled down by effectively kicking all miners out of the country. Then, there’s the EU, which recently tightened restrictions of cryptocurrency transactions, prompting some to worry that they were actually banning wallets themselves.

That panic turned out to be unwarranted, but it highlights the fact that regulators are starting to craft actual rules that have effects on both individuals and the market alike. In the US, regulations are well-established for taxes and money transmission, but notably further behind on decentralized finance protocols or even when crypto assets may be securities under existing laws. A recent attempt to add language expanding the definition of broker in the USA’s infrastructure bill received a vociferous outlash from the community. The language suggested by the US Treasury Department could be interpreted to require reporting by what many would consider non-traditional brokers, such as miners or software developers, despite the Treasury Department’s assurances. This could be the beginning of a real push towards the de-anonymization of addresses and accounts, not just those that interact with centralized exchanges or OTC brokers or other entities that provide traditional broker-like financial services, and surveillance over all transactions (which is in line with the current war against cash). 

There is plenty of room for healthy debate about what is necessary, but soon the entire discussion may become a more irrelevant point than it is now. What makes regulators so wary is also what they are trying to undo, and that’s anonymous money transfers. It is important to note that this phrasing is wrong (and, possibly, is purposeful) as transfers are actually pseudonymous and not “anonymous.” The concern of course is that “anonymity” is the key to money laundering. In many ways this is understandable, but many law enforcement agencies find that the transparency of the blockchain helps in identifying suspicious activity and any potentially money laundering. Indeed, the current regulations of on-ramps and off-ramps, which often requires the collection of know your customer (KYC) data coupled with the transparency of the blockchain provides a means to stop bad actors.

Ignoring the technical nuances, but what if blockchain wasn’t an all or nothing data system when it comes to privacy? And why stop at only talking about private value transfers between two counterparties? What if you extended privacy to data that is stored (files) or even computed? What if some data could be completely transparent with other data remaining hidden?

Currently, most blockchains are either public or private, aka permissioned. Because the data on a blockchain is stored on a completely transparent ledger, public blockchains can be accessed by literally everyone. Private blockchains simply put the chain behind a type of firewall, only letting certain people have access, but once they do, they again can see everything. 

There are pros and cons for both, and neither works to fully solve the issues being raised by regulators. Deanonymizing a public chain would mean now the government could literally see everything about everyone’s financial history, which is a bit more than heavy handed and worrisome to say the least. Furthermore, private chains would inevitably have to grant access to enforcement agents of some kind, again leading to what amounts to extreme government oversight.

Hybrid approach can fix this

However, it doesn’t need to stay this way. Decentralized technology is developing fast, and new models for these networks are able to do more than their predecessors. There is an emergence of what are known (at least as defined for the purposes of this article) as “hybrid blockchains.” These systems are made up of multiple different chains that can have varying levels of permissions and be public, private, or in-between. 

This allows for one or more main, transparent chains that anyone, including regulators, can monitor. There can additionally be private wallets, smart contracts, or entire chains that can contain sensitive data. What is important is that, thanks to the math that powers this technology, this can allow for data to be cryptographically verified without the need to reveal what the data itself is. 

This innovation stands to be huge because, if properly set up, this system could offer the type of monitoring that regulators are demanding, all while keeping the private information for both individuals and businesses invisible. It will take some time to balance out what should and shouldn’t be accessible, but this type of system erases the need for the current “completely transparent/completely opaque” dilemma.

This also means that the regulatory concern over money laundering which conflicts with people’s right to financial privacy should be far less of an issue. If nothing else, it would become much easier to monitor known avenues for funneling money to dangerous organizations via the existing regulations of on-ramps and off-ramps while still protecting users’ privacy. Law enforcement would be able to detect and deal with these instances without needing to look into the pockets of every single user on the network to do so. 

Users have every right to a high degree of opaqueness in their financial history. This applies to businesses and individuals evenly. Whatever your payment history reveals about income, investments, supply purchases, medical payments, insurance, luxury items or even basic grocery spending, there’s no reason for all of these budgets to be visible to the government or private businesses. 

Then there’s more explicit use cases such as citizens who live under oppressive regimes being potentially targeted by their governments and even cut off from their resources simply for being outspoken or otherwise deemed problematic. This is a very real concern historically, and now the exact systems that stand to free individuals through decentralization also run the risk of becoming tools of control when centralized.

This basic concern has been touched on by many before. At the same time, it has fairly been pointed out that absolute anonymity can provide bridges for illicit activity, and this can’t be ignored completely. However, a system that leaves the majority of financial activity alone is actually finally possible, specifically because it can now be verified what the money isn’t being used for.

This stands to actually bridge the gap between what the government wants and what cryptocurrency enthusiasts demand. Legislation that seeks to ban or deanonymize crypto would be unnecessary, as would the general push for overreach into citizens’ private information. Instead of turning to the law, turn to code, and build a system that cannot be abused by either side. It’s already happening, and it’s most likely the future of the financial world. 

About The Author
Matthew Niemerg, Ph.D., is the co-founder of the Aleph Zero Foundation — a Swiss non-profit offering a scalable privacy-enhancing smart contract infrastructure suitable for enterprise-grade applications.

Matthew earned a Ph.D. in Mathematics in the area of numerical algebraic geometry from Colorado State University. He is a Simons-Berkeley Fellow and an IBM Center of Excellence Fellow in High-Performance Computing and has held numerous visiting and postdoctoral positions around the globe. Active in the blockchain space since 2014, in 2017 Matthew began working in the space full-time.
LinkedIn: https://www.linkedin.com/in/matthew-niemerg/

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