By Paul Sherer F.I.R.S.T. Director Findora Foundation, Stanford MBA
A few years ago, enterprise blockchain appeared to offer significant promise, particularly for the financial sector. The industry is heavily dependent on trusted intermediaries, along with meticulous record-keeping and stringent compliance requirements. While these are all necessary to a functioning finance landscape, the result is that transactions are often slow and costly with most systems extremely cumbersome to navigate.
Therefore, blockchain’s properties of establishing an unalterable ledger of peer-to-peer transactions with fast settlement times should offer many enticing prospects to simplify and streamline the industry.
Unfortunately, all the excitement that was whipped up in 2016 and 2017 following the launch of first-generation smart contract platforms was way too early. Ethereum and its many copycats simply weren’t ready to deliver what the financial sector needs from a blockchain.
The arguments about lack of scalability and high transaction fees are well-worn and perfectly valid. Enterprises would naturally be reluctant to start using clunky technology with volatile costs of operating. Not to mention the many vulnerabilities that can and have emerged in smart contracts coded in Solidity.
However, there’s also a fundamental challenge with public blockchains that’s often not considered in discussions about enterprise blockchain adoption – the trade-off between privacy and compliance.
The Problem with Public Blockchains
In a public blockchain like Bitcoin or Ethereum, every transaction is broadcast and visible to anyone who wants to search for it. If you know who owns an address, it’s possible to trace every movement of funds. For many enterprises, and particularly in the financial sector where confidentiality is a fundamental requirement, this is simply unacceptable.
Therefore, many financial institutions have simply ignored blockchain in favor of maintaining the status quo. A few haven’t – JPMorgan with its JPM Coin is one such example. But any foray into enterprise blockchain has been done using private or permissioned platforms, not public infrastructure. Although private distributed ledgers offer some advantages, they miss the benefits of a decentralized, secure, trustless public blockchain. Furthermore, they operate as “walled gardens,” unable to connect to other networks, limiting their value and ability to gain adoption.
Privacy coins emerged from the cryptocurrency space in response to the fact that public blockchain transactions are too open and traceable. However, privacy coins offer no solutions to financial institutions because their privacy features are designed to make them unauditable. As it happens, so-called privacy coins such as Zcash have “opt-in” privacy features that the majority of users don’t even use, meaning that transactions are just as traceable as they are with bitcoin or ether. Further, these privacy coins have been de-listed from several exchanges under regulatory pressures that require auditability.
A New Wave of Interest
Now in 2021, all eyes are on the cryptocurrency markets once again. Bitcoin’s price rise is making it look extremely attractive, and institutional money is flowing in. However, this time around, there’s an entire ecosystem of decentralized finance that didn’t exist in 2017, enabling automated lending, borrowing margin trading, stablecoin issuance, and more. But as tempting as it may be to get in early and start capturing some of this value, institutions aren’t likely to touch DeFi in its current format.
However, blockchain technology has made leaps and bounds in other areas than DeFi. So much so that it’s now possible for institutions to navigate the tightrope of privacy and compliance using public blockchains.
How Zero-Knowledge Proofs Solve the Privacy Dilemma
Zero-knowledge proofs have been around for several years. In fact, it’s the same basic technology used by Zcash in a more advanced state. Using zero-knowledge proofs, any participant of a network can upload specific information about themselves that serves to identify them to other users. In the context of the financial sector, it may be an individual user who uploads their ID or passport and their credit history.
With zero-knowledge proofs, this data can be wrapped up confidentially on-chain so that the user doesn’t have to disclose the information itself. However, suppose a financial institution wanted to make a decision about issuing credit. In that case, they could receive a guarantee that the counterparty to the loan meets their lending criteria in terms of age, residency, having a good credit score, or any other parameters they choose to apply.
In this way, there’s a verifiable audit trail of events that means the institution can prove it has performed its KYC and AML checks. However, it preserves privacy and confidentiality.
A New Era of Secure Financial Services?
Applying ZK-proofs in this way could also help generate further value within the existing DeFi system. For instance, the vast majority of DeFi lending requires that loans need to be overcollateralized, which is necessary for a sector where lenders don’t know who’s on the other end of a transaction. However, it diminishes the value of the borrowing facility for borrowers as they need access to capital to access credit.
Using zero-knowledge proofs as a means of demonstrating creditworthiness without compromising on confidentiality opens up DeFi to the possibility of uncollateralized / smarter securitized lending. The use of immutable privacy protections will advance significantly the confidence and rate of adoption of enterprise scale applications and services -- without compromising regulatory scrutiny or authorization.
Enterprise blockchain adoption was never going to happen overnight, and there’s still a long way to go. However, blockchain technology has also come far over the years since the last big bull run. This time around, blockchain’s potential to advance financial sector adoption is closer than it’s ever been.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
