Introduction
Decentralized Finance (DeFi) has taken the financial world by storm (at least in the OpEd pages of Bloomberg and Fortune), offering a permissionless and transparent alternative to traditional financial institutions with a total locked value (TVL), as of this writing, of nearly $100Bn. However, this very decentralization creates a major hurdle: compliance. Unlike conventional institutions with central control, DeFi protocols are often governed by self-executing code and lack a single entity responsible for enforcing regulations.
This raises a critical question:
How can these innovative protocols integrate compliance rules into their DNA without compromising their core principles of decentralization and autonomy? This challenge lies at the heart of DeFi’s future, as regulators grapple with finding the right balance between fostering innovation and protecting consumers since nearly all the ~ $100Bn in TVL and billions of dollars daily trades on Decentralized Exchanges (DEXs) according to DeFi Lama have not undergone any proper compliance checks. Sadly, and very recently, regulators have resorted to legal action against the likes of Uniswap, Tornado Cash, and other DeFi protocols.
After thumbing their noses at regulators for many years, the organizations building DeFi protocols are now realizing two things:
The words decentralization and No-Control do not protect against expensive legal actions.DeFi mass adoption requires better UX and compliance enforcement — both financial and data privacy, and at the same time.
Even if DeFi protocols wanted to implement compliance checks immediately, it would not only upset their best client’s apple carts but would require protocol rewrites. In other words, completely new versions of the protocol with older versions still operating without any compliance checks. That is not a tenable situation, since, very likely, the foundations or DAOs governing DeFi protocols would still be held to account for non-compliant versions of their protocol since “smart contracts are forever” — yes, Marilyn Monroe pun quote intended.
Luckily there is a way forward for these protocols. Leveraging blockchain-native compliance mechanisms – a combination of smart contracts, and blockchain-verifiable zero-knowledge proofs, representing assertions that a user and submitted asset transaction are compliant with the applicable law in a jurisdiction, yields a comprehensive framework to ensure regulatory compliance, risk management, and transaction reporting for any digital asset. The suggested framework extends the work originally done by Azgad-Tromer et. al (2023) that combines robust regulatory compliance actions with privacy protection, enabling, for example, the creation of compliant versions of digital assets that enforce jurisdictional policies while being privacy-preserving.
The original framework by Azgad-Tromer et al. preserves digital assets’ economic value and technological capabilities while ensuring that sensitive information is selectively visible only to authorized law enforcement authorities – Fincen, SEC, OFAC, etc. This enhances the security and integrity of digital asset transactions while maintaining privacy for legitimate users. Moreover, the framework’s compatibility with different types of digital assets such as fungible and non-fungible digital assets makes it a versatile solution.