Why Zero Knowledge Is the Antidote to Increased Crypto Regulation

By Valerii Brizhatiuk, Chief Product Officer & Co-Founder of Swisstronik

The European Union recently became the first major jurisdiction to introduce robust and comprehensive regulation for the cryptocurrency sector. The Markets in Crypto-Assets (MiCA) regulation encompasses long-debated issues at the heart of the industry, not least transparency, consumer protection, and anti-money laundering (AML), and is due to come into effect in late 2024.

MiCA has been warmly greeted by many in the crypto community, hailed as an ambitious legal framework that offers clarity to platforms, token issuers, and traders. Proponents say it lays the groundwork for further growth in an industry whose regulatory waters have been muddied for far too long. In the US, the Securities and Exchange Commission (SEC) even claims it can serve as a model for Stateside regulation.

But Wait, There’s a Catch

Despite the positive mood music, as things stand many blockchain projects and products will fall foul of the coming regulations due to their design. In particular, exchanges and money management services like custodial wallet providers will struggle to follow certain requirements laid down in the bill.

As noted in one review of MiCA, it “effectively limits the daily average number of transactions and trading volume associated to uses of EMTs (electronic money tokens) and ARTs (asset-referenced tokens) as means of exchange to 1 million and EUR 200 million, respectively.”

MiCA also stipulates an obligation for EMTs and ARTs to abide by strict reserve requirements, to ensure issuers don’t suffer a liquidity shortfall if there is a run on assets. Again, as things stand this will be challenging to say the least for blockchain projects due to their design.

Even top stablecoin issuers like Tether (USDT) and USD Coin (USDC) have struggled to shrug off the notion that their stablecoin reserves are improperly managed. And in fact, the chair of the European Banking Authority (EBA), José Manuel Campa, recently said central banks should veto large stablecoins if they suspect they might upend monetary policy.

The question, then, is how blockchain projects and products can follow this new harmonized set of rules without commissioning wholesale updates of their products and services. Fortunately, there is a solution hiding in plain sight: zero-knowledge (ZK) technology.

Zero-Knowledge Tech Makes Regulation Easy

ZK tech, which emerged in the 1980s, represents an efficient and reliable way to verify information while maintaining privacy and security. In a nutshell, it enables one party to prove to another that something is true without disclosing any information.

Perhaps the best-known implementation of ZK tech, at least in a crypto context, is ZK-SNARKs, the cryptography underpinning privacy-preserving digital currency Zcash. Thanks to ZK-SNARK proofs, Zcash transactions are fully encrypted yet still verified as valid under the network’s consensus rules.

A relatively painless path forward for companies who don’t currently meet MiCa regulations would be to wrap their tokens in a ZK contract, which in one fell swoop would transform a non-legal token into a legal one. Because this could be perceived as security issuance and cause additional legal issues if done in a centralized fashion, projects would have to use third-party decentralized software for such issuance.

It is important to note that implementing ZK-SNARKs would not automatically make tokens compatible with the incoming regulations. But it would certainly be a step forward. It is likely regulators would require a deeper level of data beyond simply assuring privacy and anonymity, encompassing user verification, AML checks, and restrictions for transactions. After all, Markets in Crypto-Assets is probably part of preparations for the issuance of a Euro CBDC – and a US version won’t be far behind.

A flexible form of ZK seems like a natural solution. Which is to say, one that enables exchanges, money management services, and token issuers to adhere to rules and reporting requirements concerning limits, identity, and proof of reserves. An identity-based hybrid layer-1 blockchain ecosystem can facilitate such a solution.

Effectively, such an ecosystem enables both Web3 and traditional companies to build KYC, AML, and DPR compliant applications with enhanced data privacy. Or, if the applications are already in place, to retrofit them according to the contents of MiCA.

What does this look like in practice? Well, after passing KYC, projects bridge and wrap their token into a ZK version capable of high transaction speed and low commission rate. After which, regulators will be assured that tokens/transactions are legal, while the details of transactions themselves remain private.

The utility of ZK tokens issued is such that they adhere to current regulations and also offer the promise of compliance with future regulations that may appear in different jurisdictions. For example, at some stage disclosure of partial transaction data may be mandated. With modified contracts for ZK tokens (ZKM), the activity of suspicious users – those facing legal proceedings, for example, where a court requires disclosure of financial assets – can be partially monitored.

MiCA is a watershed moment for the crypto industry, and meeting the requirements needn’t induce a headache or provoke costly wholesale upgrades. ZK tech represents the best way to please the regulators while keeping users safe and satisfied.

About the author

Valerii Brizhatiuk is the Chief Product Officer and co-founder of Swisstronik, an identity-based hybrid layer-1 blockchain ecosystem that enables Web 3.0 and traditional companies to build KYC, AML and DPR compliant applications with enhanced data privacy.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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