Zero-knowledge proofs, decentralized identifiers and more could help DeFi protocols maintain regulatory compliance without exposing their users.
Decentralized finance (DeFi) has been a rapidly growing sector of the cryptocurrency industry, but it has also faced significant regulatory challenges. With regulators struggling to keep up with the pace of innovation, the lack of clarity around regulations tends to create uncertainty for DeFi projects.
Cointelegraph spoke to Alastair Johnson about regulatory challenges facing the DeFi industry. Johnson is the CEO of an identity “super-wallet” called Nuggets that seeks to deliver verified self-sovereign decentralized identities to users. He said that one of the main regulatory challenges is the anonymity of DeFi platforms, which makes it difficult to comply with Anti-Money Laundering (AML) and Know Your Customer (KYC) regulations.
Although privacy is a cornerstone of DeFi, regulatory compliance is essential to protect users and ensure that DeFi platforms are operating within the law. “Regulatory compliance will involve implementing AML /KYC procedures,” Johnson said. “This can be done without compromising user privacy by using non-correlatable peer Decentralized Identifiers (DIDs) and zero-knowledge proofs. In addition, auditable data can be encrypted to protect the participant’s private keys but still in accordance with regulatory requirements.
“DeFi platforms can incorporate privacy-enhancing technologies like zero-knowledge proofs and homomorphic encryption to protect user privacy while still adhering to regulation,” he added.
According to Johnson, DeFi platforms can take measures to ensure compliance with regulations while maintaining their decentralization. He explained that “DeFi platforms can incorporate decentralized identity solutions to verify the identity of users while still maintaining decentralization. These solutions can use blockchain-based identity protocols, such as Decentralized Identifiers (DIDs) and Verifiable Credentials (VCs), to provide secure and privacy-preserving user identification — enabling DeFi platforms to continue to innovate and grow while still complying with applicable regulations.”
Speaking on the impact of regulation within the space, Johnson noted that increasing regulation in the DeFi sector could have both positive and negative impacts. While regulation could provide legitimacy and protect users from fraudulent activities, excessive and burdensome regulation could stifle innovation and decrease competition, undermining the decentralization and trustlessness of the DeFi ecosystem.
In the future, balancing privacy, regulation and decentralization will continue to be an ongoing challenge for the DeFi space. However, Johnson said he hopes that by embracing privacy-preserving technologies, implementing self-regulatory measures, and collaborating with regulators, DeFi platforms can find ways to balance the need for regulatory compliance with the principles of privacy and decentralization that underpin the DeFi ecosystem.