Opinion from Dr. Andreas Freund. 21 August 2024
TL/DR
There are platform options for DeFi protocols to combine regulatory compliance with out compromising decentralization. Utilizing blockchain expertise and cryptographic protocols, DeFi protocols can guarantee safe and clear transactions that meet regulatory requirements whereas sustaining person privateness. Such protocols implement compliance guidelines on digital property and their holders. Due to this fact, they’ll present a strong and versatile system to assist DeFi protocols navigate the advanced regulatory panorama, contributing to a safer and extra dependable decentralized monetary ecosystem.
Introduction
Decentralized Finance (DeFi) has taken the monetary world by storm (a minimum of within the OpEd pages of Bloomberg and Fortune), providing a permissionless and clear various to conventional monetary establishments with a complete locked worth (TVL), as of this writing, of practically $100Bn. Nonetheless, this very decentralization creates a serious hurdle: compliance. In contrast to standard establishments with central management, DeFi protocols are sometimes ruled by self-executing code and lack a single entity chargeable for imposing rules. This raises a essential query: how can these revolutionary protocols combine compliance guidelines into their DNA with out compromising their core ideas of decentralization and autonomy? This problem lies on the coronary heart of DeFi’s future, as regulators grapple with discovering the best steadiness between fostering innovation and defending shoppers since practically all of the ~ $100Bn in TVL and billions of {dollars} each day trades on Decentralized Exchanges (DEXs) in line with DeFi Lama haven’t undergone any correct compliance checks. Sadly, and really lately, regulators have resorted to authorized motion towards the likes of Uniswap, Twister Money, and different DeFi protocols.
After thumbing their noses at regulators for a few years, the organizations constructing DeFi protocols at the moment are realizing two issues:
- The phrases decentralization and No-Management don’t defend towards costly authorized actions.
- DeFi mass adoption requires higher UX and compliance enforcement — each monetary and knowledge privateness, and on the similar time.
Even when DeFi protocols wished to implement compliance checks instantly, it might not solely upset their finest consumer’s apple carts however would require protocol rewrites. In different phrases, utterly new variations of the protocol with older variations nonetheless working with none compliance checks. That isn’t a tenable scenario, since, very seemingly, the foundations or DAOs governing DeFi protocols would nonetheless be held to account for non-compliant variations of their protocol since “good contracts are without end” — sure, Marilyn Monroe pun quote meant.
Fortunately there’s a method ahead for these protocols. Leveraging blockchain-native compliance mechanisms – a mixture of good contracts, and blockchain-verifiable zero-knowledge proofs, representing assertions {that a} person and submitted asset transaction are compliant with the relevant regulation in a jurisdiction, yields a complete framework to make sure regulatory compliance, threat administration, and transaction reporting for any digital asset. The steered framework extends the work initially executed by Azgad-Tromer et. al (2023) that mixes sturdy regulatory compliance actions with privateness safety, enabling, for instance, the creation of compliant variations of digital property that implement jurisdictional insurance policies whereas being privacy-preserving. The unique framework by Azgad-Tromer et al. preserves digital property’ financial worth and technological capabilities whereas making certain that delicate info is selectively seen solely to licensed regulation enforcement authorities – Fincen, SEC, OFAC, and many others. This enhances the safety and integrity of digital asset transactions whereas sustaining privateness for reliable customers. Furthermore, the framework’s compatibility with several types of digital property equivalent to fungible and non-fungible digital property makes it a flexible answer.
In brief, the framework augments blockchains with further details about actors’ identities and asset provenance in a privacy-preserving method and was first carried out by Sealance. This revolutionary strategy allows the framework to deal with the challenges posed by the decentralized nature of digital property. Attaching Compliance-Related Auxiliary Data (CRAI) to transactions involving digital property in encrypted kind ensures that essential compliance knowledge, equivalent to person identities, credentials, transaction historical past, and fund provenance, stays safe and tamper-proof – see FinCen steering on Anit-Cash-Laundering for example. The framework incorporates cryptographic protocols that may mechanically implement compliance insurance policies assigned to digital property — what holders can and can’t do with such a digital asset — and digital asset holders — what property people can and can’t maintain and/or commerce. It could additionally replace CRAI throughout the recording of transactions on the blockchain. This integration permits real-time compliance monitoring and reporting, enhancing transparency and accountability within the digital asset ecosystem.
Be aware, that earlier work on this space was performed by Kaira et al. in 2021 for the case of a centrally managed Hedge Fund. Whereas complementary to this dialogue, it doesn’t contact on KYC/AML compliance, which is the central query we’re discussing on this paper.
The way to make DeFi Protocols Regulatory Compliant
So how does such a framework function within the context of DeFi protocols, given that almost all property on these platforms usually are not natively regulatory compliant?
Fig. 1: Excessive-Degree DeFi (ZKP) Compliance Structure as an extension of Azgad-Tromer et al.
The important thing perception within the extension of the Azgad-Tromer et al. framework is {that a} good contract pockets used, for instance, in Account Abstraction (see EIP-4337) as a consultant of a number of Entity Owned Accounts (EOA) has considerably extra flexibility as a result of its programmability than an EOA. If a sensible contract pockets is mixed with different good contracts that implement compliance guidelines and work together with a DeFi protocol we’ve got all of the substances we want. Consider a sensible contract pockets as functionally equal to a standard Dealer-Vendor, a regulated and registered entity, that locations trades for his or her shoppers, and a DeFi protocol with a number of compliance imposing good contracts as a registered inventory or commodity alternate with its buying and selling and compliance capabilities. Be aware {that a} Dealer-Vendor is a *registered entity* that could be a *authorized delegate* of an everyday investor to put trades on the investor’s behalf and implement commerce compliance guidelines. The inventory alternate is one other *registered entity* – registered with regulatory authorities such because the SEC or Fincen – and its compliance and buying and selling capabilities are separate by design — separation of considerations is a big compliance rule.
With this analogy in thoughts, we will now assemble a regulatory-compliant DeFi protocol stack built-in with a compliance framework such because the one pioneered by Sealance by way of coverage supervisor contracts with related compliance insurance policies, and a compliance coverage and compliant account registry. Essentially the most simple implementation is thru “good contract hooks” in DeFi protocols as they permit customized compliance enforcement extensions to the protocol, for instance, Uniswap V4 or Seaport. Nonetheless, this doesn’t resolve the problem for DeFi protocols that don’t have such capabilities; presently nonetheless the bulk.
There’s a basic protected sample to work together with DeFi protocols that don’t have contract hooks for compliance checks when a person receives a yield-bearing instrument such because the Compound yield token (YT) e.g. cDai. In our description under, we implicitly assume that DeFi protocol contracts such because the Uniswap Router or Place Supervisor are registered contracts such that the compliance coverage enforcement mechanism embedded in “compliant” property can determine them as compliant and never require an extra zkp compliance assertion to be embedded with, for instance, a switch perform.
Fig. 2: Instance zkp-Compliance Stack utility with Unsiwap and compliant good contract pockets
A compliance-safe DeFi interplay sample is described under utilizing the instance of including liquidity to a Uniswap Liquidity Pool for specificity:
- A person (EOA) calls a DeFi Protocol compliance (wrapper, also referred to as a logical abstraction) contract instantly or by way of the person’s Good Contract Pockets in an account abstraction state of affairs.
Be aware: the good contract pockets has already been given a Energy-Of-Lawyer certificates by way of an accepted KYC/AML supplier, equivalent to a financial institution or an alternate. This certificates is utilized in the identical method as a real-world Energy-Of-Lawyer works; it marks the good contract pockets as in a position to make use of the zero-knowledge proof (zkp) assertions of compliance that the zk-based compliance platform creates for a person’s asset transactions. - The DeFi (wrapper) contract verifies the submitted zkp compliance assertions utilizing the zk-based compliance stack – a sensible contract system see Fig 1 – routing compliance assertions within the type of zk-proofs to (compliance) coverage enforcement factors (PEP) – good contracts as a part of the zk compliance stack) the place proofs are verified and actions aka transactions are both allowed or denied. If the compliance checks are profitable, liquidity is added to a pool — both a pool of compliant or uncompliant property — on behalf of the person by the DeFi (wrapper) contract. Let’s assume for the next a compliant asset pool
- The DeFi compliance (wrapper) contract receives the YT and creates a compliant YT asset using one of many zkp assertions supplied by the person.
- The DeFi compliance (wrapper) contract then transfers the now compliant YT to the EOA or the good contract pockets — this additionally requires a zkp compliance assertion.
This prevents customers from buying and selling non-compliant YTs except the person manually unwraps the asset. Be aware that each one the yield now accumulates to the compliant YT. A variant of this strategy is utilizing DeFi compliance library contracts with the identical performance as a compliance wrapper contract whereas not requiring…
