Regulators are cracking down on financial privacy, but ZK-proofs can help

The convergence of ZK-proofs and decentralized identity systems could create more compliant privacy-preserving protocols, without sacrificing user privacy.
The convergence of ZK-proofs and decentralized identity systems could create more compliant privacy-preserving protocols, without sacrificing user privacy.

Regulators are cracking down on privacy-preserving protocols like cryptocurrency mixers, but zero-knowledge proofs (ZK-proofs) could offer a solution for both developers and regulators.

Offering privacy-preserving features in a legally compliant manner is among the biggest concerns of today’s privacy-focused blockchain protocols, which can be used by virtually anyone with internet access.

However, the evolution of ZK-proofs, along with other privacy-preserving paradigms, like decentralized identity verification systems, could help protocols maintain privacy and ensure they aren’t servicing any terrorist organizations or money launderers, according to Matthew Niemerg, the co-founder and president of AlephZero.

In an interview with Cointelegraph, Niemerg explained:

Matthew Niemerg for Cointelegraph. Source: Cointelegraph

Regulatory compliance became even more critical for privacy-focused protocols on May 14, after Dutch authorities sentenced Tornado Cash developer Alexey Pertsev to five years and four months in prison, for allegedly laundering $1.2 billion worth of illicit digital assets on the platform.

The sentencing came despite Tornado Cash being a noncustodial crypto mixing protocol — meaning that the funds that go through the protocol are never held or controlled by it.

In a promising development for open-source code developers, ZK-proofs could be used to guarantee that none of the cryptocurrencies on a set platform were previously related to any illicit activities, according to AlephZero’s Niemerg:

“From the time of the last 20 transactions or from block XYZ, [ZK-proofs] can create various types of proofs guaranteeing that these funds never touched anybody associated with the sanctions list.”

With a decentralized Web3 identity for each user, ZK-proofs could be used to verify that funds and wallets are not related to criminal activity while maintaining the anonymity of the user.

However, Niemerg noted that both ZK-proofs and decentralized identity systems need more development before facilitating such complex functions.

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Financial privacy is not a crime

For AlephZero, helping developers build compliant privacy tools is a priority, according to Niemerg:

“There's plenty of actual real-world use cases whenever it comes to private transactions… Just because you want privacy, that doesn’t mean that you’re doing something wrong.”

Financial privacy has been a growing concern since 2022 when the United States government blacklisted Tornado Cash for alleged money laundering.

The concerns intensified on April 24, after the arrest of the Samourai Wallet founders. The cryptocurrency wallet’s CEO Keonne Rodriguez and chief technology officer William Hill will each face one count of conspiracy to commit money laundering and one count of conspiracy to operate an unlicensed money transmitting business.

The arrest was classified as an attack on crypto privacy pioneers, according to Ki Young Ju, the founder and CEO of CryptoQuant:

“Privacy stands as a core value of Bitcoin. Mixing itself is not a crime. Even crypto exchanges use mixing to safeguard user privacy. It's like punishing the inventor of the knife instead of the one who uses it.”

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