Why Zero Knowledge is the Antidote to Increased Crypto Regulation

By Valerii Brizhatiuk, Product Manager and Co-Founder of Swisstronik

The European Union recently became the first major jurisdiction to introduce strong and comprehensive regulation for the cryptocurrency industry. The Crypto-Asset Markets Regulation (MiCA) encompasses long-debated issues at the heart of the industry, including transparency, consumer protection and anti-money laundering (AML), and is expected to come into effect at the end of 2024.

MiCA has been warmly welcomed by many in the crypto community, hailed as an ambitious legal framework that provides clarity for platforms, token issuers and traders. Proponents say it lays the foundation for future growth in an industry whose regulatory waters have been murky for far too long. In the United States, the Securities and Exchange Commission (SEC) even claims that it can serve as a model for regulation in the United States.

But wait, there’s a catch

Despite the positive mood music, as things stand, many blockchain projects and products will fall foul of upcoming regulations due to their design. In particular, exchanges and fund management services like custodial wallet providers will struggle to meet some of the requirements set out in the bill.

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

MiCA also stipulates an obligation for EMTs and ARTs to adhere to strict reserve requirements, to ensure that issuers do not suffer from a lack of liquidity in the event of a run on assets. Again, as things stand, this will be challenging for blockchain projects to say the least due to their design.

Even major stablecoin issuers like Tether (USDT) and USD Coin (USDC) have found it hard to ignore the idea that their stablecoin reserves are mismanaged. And in fact, the chairman of the European Banking Authority (EBA), José Manuel Campa, recently said that central banks should veto large stablecoins if they suspect they could upset monetary policy.

So the question is how blockchain projects and products can follow this new harmonized set of rules without ordering bulk updates to their products and services. Fortunately, there is a hidden solution in plain sight: Zero-Knowledge (ZK) technology.

Zero-Knowledge technology makes regulation easier

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

Perhaps the best-known implementation of ZK technology, at least in a cryptography context, is ZK-SNARKs, the cryptography that underpins the privacy-preserving digital currency Zcash. Thanks to ZK-SNARK proofs, Zcash transactions are fully encrypted but still verified as valid according to network consensus rules.

A relatively easy route for companies currently not complying with MiCa regulations would be to wrap their tokens in a ZK contract, which would turn a non-legal token into a legal one in one fell swoop. Since this could be perceived as a security broadcast and lead to additional legal issues if done centrally, projects should use third-party decentralized software for such a broadcast.

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

A flexible form of ZK seems like a natural solution. That is, which enables exchanges, fund management services and token issuers to comply with rules and reporting requirements regarding limits, identity and proof of reserves. An identity-based layer 1 hybrid blockchain ecosystem can facilitate such a solution.

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

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

The usefulness of the issued ZK tokens is such that they adhere to applicable regulations and also offer the promise of compliance with coming regulations that may appear in different jurisdictions. For example, at a certain stage, the disclosure of partial transaction data may be mandatory. With the modified contracts for ZK tokens (ZKM), the activity of suspicious users – those facing legal action, for example, when a court demands the disclosure of financial assets – can be partially monitored.

MiCA is a watershed moment for the crypto industry, and meeting the requirements shouldn’t cause headaches or cause expensive bulk upgrades. ZK technology is the best way to please regulators while ensuring user safety and satisfaction.

About the Author

Valerii Brizhatiuk is Chief Product Oficer and co-founder of Swisstronic, an identity-based hybrid Layer 1 blockchain ecosystem that enables Web 3.0 and traditional businesses 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.