Know Your Customer: The Future of KYC in Crypto

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Crypto and Know Your Customer (KYC) guidelines appear to be an unhappy marriage – pseudonymity in the TAUT of digital currencies does not match the old-school centralized protocols of traditional finance, but cohabitation is inevitable for the industry in full maturity.

The tension never really goes away, but even before the crypto market failures in recent months, regulators clearly grabbed the cover, pushed established platforms toward stricter authentication procedures, and forced hardliners out of the market. in terms of confidentiality.

Cardano co-founder Charles Hoskinson voiced a popular opinion on the industry side of the US Congress when he told lawmakers that no regulator was doing a good job with KYC and anti-trust safeguards. money laundering (AML) at the moment. But, will the crypto community reach the point both technically and reputationally where they have the opportunity for a more decentralized and private KYC system?

From passport snapshots to third-party databases

It’s hard to imagine today, but KYC – while it was a standard for the traditional financial system for a few decades – has only recently become a default feature for the biggest players in the world. cryptography.

For example, Binance announced a stricter identification procedure for users only in 2021 after a series of legal controversies around the world. Needless to say, there are still a myriad of smaller exchanges that manage to evade the attention of regulators and ignore the global call for stricter KYC.

But things won’t go so well for those who prefer to exploit the gray area, and they aren’t the only over-executors and managers who threaten the existence of this segment.

Pressure is mounting from both individual and institutional newcomers. The former, while not necessarily familiar with the ideological heritage of crypto, is willing to trade sovereignty for convenience on an established platform. The latter are reluctant to risk their funds by placing them in an under-regulated market. Justin Newton, Founder and CEO of Netki – a crypto-focused KYC company – explained to TAUT:

“As crypto becomes a mass market, it is likely that the vast majority of users will choose to use services that have at least some points of centralization. In the real world, most people value privacy and the civil liberties, without being ultra-libertarian.When given the choice between a reasonably regulated platform and potentially shady and opaque alternatives, most people will opt for the former.

Speaking to TAUT, Lisa Fridman, co-founder and president of Quadrata – a Spring Labs spin-off focused on developing Web3 passports – called the underdevelopment of KYC in crypto a growth issue:

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“There are a number of financial institutions with trillions in total assets that cannot engage in decentralized finance today because they lack compliance frameworks or ways to mitigate the possibility of mingling with ‘bad actors’.”

With all its acronym mystery, KYC in crypto works quite simply. Typically, it includes identity confirmation with a passport shot and basic data against public and private records, as well as cross-checking with other provided data such as phone number or email-address. A selfie with a handwritten note is also a common request.

A more advanced approach includes, unique to lending or lending platforms, tracking decentralized assets or a customer’s credit status. Financial institutions will also typically check the name of the potential customer against appropriate sanctions and Politically Exposed Persons (PEP) lists. Certain types of financial transactions might also require additional steps, such as verifying accredited investor status.

As little KYC as possible is not a solution

The combination of heavy pressure from regulators and enforcement officials and the lack of uniform international standards contribute to the general stress around KYC in a maturing industry.

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Metal Pay CEO Marshall Hayner told TAUT that the crypto industry globally is nowhere near the understandable standard for electronic data exchange between traditional financial institutions, such as ISO20022. Newton agrees with this, adding that the lack of clear standards and freedom of interpretation often leads to malicious cost-cutting by market players:

“Regulators provide advice and guidelines, and companies interpret those guidelines for their own business. This leads to industry inconsistencies and a somewhat natural effect of companies wanting to do as little KYC as possible to reduce costs as well as onboarding friction.

This state of affairs could not last long, given the ambition of the industry to merge, if not disrupt, the traditional financial system and to gain momentum by attracting institutional investors.

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At first glance, the ball is on the side of regulators, who are gradually moving towards some kind of holistic framework or at least several big ones – like the Markets in Crypto-Assets regulation in the European Union or a Lummis-Gillibrand “crypto bill” in the US. United States.

While the passing of the permissionless era of early crypto surely is causing major anxiety among crypto evangelists, there is clear win-win potential. The irony of the situation, Fridman explained, is that non-disclosure of data actually limits the range of potential use cases and the possibility of being rewarded for establishing a solid reputation. Besides a vital link between a good and transparent credit history and the possibility of using more capital-efficient solutions, some underestimate the all too real risks, she believes:

“As recent developments in the crypto markets have indicated, a number of participants may be underestimating the risks involved. A constructive regulatory framework could help manage these risks.

Verifiable IDs, ZKP and KYC on-chain

The good news is that the industry has no shortage of innovative solutions to bridge the gap between regulatory requirements and users’ desire for privacy. One of them is verifiable credentials – an open standard for digital credentials that uses an easily verifiable digital signature. This signature fits the individual (holder), the issuer, and the verifier in a sort of triangle, where the former does not have to provide sensitive data directly to each entity it interacts with. This technology has already caught the attention of the medical sector which has had to face new challenges during the COVID-19 pandemic.

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Another promising concept is zero-knowledge proofs, a protocol by which a digital authentication process can be facilitated without the use of passwords or other sensitive data. There are examples of standalone identity platforms that allow third parties (e.g. law enforcement agencies) to determine if a person has a valid driver’s license without the person having to surrender something other than its identification number. A use case more familiar to the crypto community is ZCash (ZEC), which uses a special iteration of zero-knowledge proofs that allow native transactions to remain fully encrypted while being verified against network consensus rules.

And, of course, there are a number of on-chain solutions for KYC. Quadrata aims to protect sensitive customer data and preserve on-chain pseudonymity while enabling a more compliance-conscious crypto ecosystem to evolve. One can still have a pseudonymous identity that won’t be exposed to anyone without the proper credentials while tying the underlying real identity to the places that matter, believes Hayner, who works on decentralized identity (DeID) with the Proton Blockchain:

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“If I can’t see into your bank account, why should I see into your crypto account? We’re working on compliant privacy coming to the Proton blockchain, we see this as the future of crypto. Secure, private, compliant.”

Ultimately, it is not just KYC that is set to change the crypto industry, but vice versa as well. Increasingly focused on privacy and data ownership, consumers are driving demand for options that allow end users to be able to transact with confidence, knowing their credentials are not at risk. As Newton noted with a touch of optimism:

“The limit here will not be the technology, but rather the willingness of regulators to study and accept these new technologies.”