The proliferation of blockchain technology is being witnessed in finance, gaming, and decentralized applications. However, regulators around the world have started demanding robust KYC (Know Your Customer) measures to mitigate money laundering and other illicit activities. As these KYC norms come into place, users continue to adopt blockchain technology for self-sovereignty and privacy. To resolve the two concerns, on-chain KYC wallets have been developed to determine verified identity to compliant services without disclosing sensitive personal information on the public ledger. In this post we discuss the why behind on-chain KYC, privacy-preserving identity schemes, the lone trade off between compliance and anonymity, and the future prospects of wallet technology.
The Imperative for On-chain KYC
The classical onboarding process within finance requires centralized service providers to collect government issued IDs, Proof of Address, and at times, biometric scans. For blockchain, the requirement of users uploading such documents is a complete contradiction to the concept of decentralization. In addition, the need to upload personal documents creates single points of failure. The data breach of a DeFi protocol or NFT marketplace has the potential to leak millions of user records. Furthermore, a large section of crypto users highly value public address pseudonymity and the fear associated with linking pseudonyms to real-world identity.
Opposing views are that global regulators alongside banking partners seem to demand that any service providing fiat on-ramp, token swap, or yield products must implement KYC down to the user’s wallet. Newer travel-rule designs require crypto businesses to identity proof data and share details when transactions surpass certain limits. Without an architectural way to prove compliance on chain, these projects may face de-banking or shutdown risk. These projects also face shut down risk, or losing banking services without on-chain compliance structures. On-chain KYC systems embed identity verification directly into user’s wallet addresses, allowing protocols to check compliance markers without the requirement of personal documentation.
Creating Plans For Preserving Identity Privilege
Achieving a balanced measure of compliance while maintaining adequate privacy is possible through cryptographic credential systems along with decentralized identifiers (DIDs). Instead of a blockchain database, information subjecting to personal identification exists on chain. A trusted identity provider or a regulated KYC issuer provides a signed credential affirming the verifiable status of a user guarantees the blockchain database containing the PCI does exist.
While using a DeFi protocol or NFT marketplace, a user creates a ZKP claiming they have a “KYC-passed” credential without revealing their age, nationality, or address details. The identity verifier issues public keys on-chain and the smart contract checks the proof against those keys. If the proof is valid, the contract will allow the user to unlock compliance-gated features such as claiming certain jurisdictions, token launches, higher withdrawal limits, or other restricted features. Ethereum shows that the wallet holds a KYC credential and nothing else is detailed on the blockchain. At no point is sensitive information stored on the blockchain.
The implementation of Hyperledger Aries frameworks for DID exchanges and zkSNARK based proofs from circom or Polygon’s zkEVM SDKs have sped up the development. Other platforms use multi-factor identity attestations, in which credential co-signers are two or more, to buy out the trust level of a single vulnerable verifier.
Navigating Compliance and Anonymity Trade-Offs
There is no denying that ZKP-based KYC has its elegance, but on-chain identity systems have their own challenges. First, users must have faith that the providers of identity will accurately check and respect the privacy of credentials. An issuer gone bad or breached could leak the metadata that could link DIDs to real identities, or worse: issue false attestations. Systems that allow some kind of decentralized governance in which a consortium of issuers has majority votes and stakes that can be slashed for bad behavior mitigate this somewhat.
Second, credential revocation must be dealt with in a very meticulous manner. An issuer must be ready to retract attestations when a user under KYC faces changes because of sanctions, court orders, or evidence showing active unlawful conduct. On chain, the revocation lists or registries must be efficient to minimize on chain bloat, as well as timely to make sure compliant users don’t get locked out of the system. Only cryptographic revocation hashes are published instead of individual indentifies, making anonymity possible.
Third, each protocol must determine how extensive their checks on identity are. Some applications call for proof of jurisdiction but not proof of identity while others only need age verification with no need to reveal a person’s nationality. Designing minimal-disclosure policies that observe these regulations while not overcollecting data remains a persistent challenge in policymaking and engineering. What is needed is obvious legal boundaries describing what sufficient proof for Anti-Money Laundering (AML) and Counter Financing Terrorism (CFT) is in order to support developers.
Skeleton KYC Wallets Trends
As the blockchain networks regulations become mature, KYC wallets will enhance in the following ways. To start with, Self Sovereign Identity Networks will have inter operability across blockchains thus making one credential usable on Ethereum, Solana and Layer 2 roll ups. Initiatives like the Decentralized Identity Foundation has pioneered standardized schemas for identity attestations, which considerably minimize fragmentation and lessen integration work for developers.
Next, identity wallets will contain dynamic scopes of data. Users will have the ability to grant temporary access to certain credentials like proof of being an accredited investor for DeFi launch and revoke that access when they see fit. Users will also be able to manage control settings that allow them to decide which applications have what attestations with easy privacy management tools integrated in the wallets.
Third, new zk-RAM and bulletproofs prover techniques could optimize proof sizes and reduce gas costs for verification even more. Together with Layer-2 gas-efficient execution environments, verifying a KYC proof might become negligible in cost, even in micro-transaction scenarios.
In the end, we might witness the creation of regulatory sandboxes where identity issuers, wallet providers, and other protocols work together under the guidance of compliance frameworks to implement on-chain KYC solutions. Such collaborations between the private and public sectors will drive initial development, increase confidence in emerging technologies, and establish global interoperability standards. With on-chain KYC wallets, users can seamlessly pass even the most rigorous compliance procedures while safeguarding their personally identifiable information, enabling decentralized finance and Web3: all without compromising privacy.
