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A Balanced Approach To Compliance: From Public Ledgers To Privacy Pools

399154 03: A South Korean bank employee gives change in euro banknotes January 2, 2002 at the ... [+] headquarters of the Korea Exchange Bank in Seoul, South Korea. South Korea brought in 40 million dollars worth of euro cash last month for the currency changeover. (Photo by Chung Sung-Jun/Getty Images)

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Ethereum ETH and other blockchains today are public by default. Why? Because that visibility allows users to securely transact in a peer-to-peer fashion at a global scale.

However, this feature is also a bug that hinders many potential real-world use cases. Financial transactions can't just be secure on the blockchain; they must also be private for regulatory, compliance, and commercial reasons. A business running on-chain payroll would risk exposing the salaries of all their employees to anyone with a block explorer — a bank approving on-chain loans might accidentally reveal the credit scores of their applicants.

Privacy pools are a proposal by Ethereum founder Vitalik Buterin alongside members of the Ethereum community as well as researchers from blockchain analytics firm Chainalysis that offer a compelling solution to this problem. While imperfect, privacy pools are a promising first step in demonstrating that user privacy AND regulatory compliance don't have to be mutually exclusive concepts.

What Are Privacy Pools?

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Privacy pools are a novel concept designed to balance transaction privacy and with the need to ensure compliance while still allowing users to benefit from the public nature of the blockchain.

In this model, users complete a KYC (Know Your Customer) process through a third-party and create an associated zero-knowledge proof to demonstrate that they meet certain requirements — for instance, that their funds were not acquired from unlawful sources — without revealing the details of their transaction history publicly.

Once that proof is validated, their wallet address would be added to an "allowlist" by a smart-contract protocol, allowing them to join a group of users whose transactions are batched and mixed together. This mixing provides user privacy by making it difficult to identify which user in the pool was ultimately the sender of the transaction.

The key innovation here is that because each wallet has already been verified before entering the pool, regulators do not need to monitor individual transactions to ensure compliance.

Criticisms Of Privacy Pools

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A lingering concern with privacy pools lies in their vulnerability to private key transfers. Even with rigorous KYC procedures, the system can't inherently prevent a verified user from simply handing over their private keys – and thus their KYC-approved identity – to someone else. This loophole means that while a wallet might appear compliant, there's no absolute guarantee that the person transacting is the one who initially passed the KYC process.

Others have criticized the notion of privacy pools on a more fundamental, philosophical level. For example, Zooko Wilcox, founder of Zcash ZEC , one of the earliest and most prominent blockchain networks that uses zero-knowledge proofs for private transactions, believes the strongest possible privacy guarantees for individuals come from systems that look as close to "cash" as possible. His criticism of privacy pools focuses on the fact the construction is expressly the opposite of the “innocent-until-proven-guilty” principle upon which U.S. and European legal systems are based.

Beyond philosophical criticisms, one other practical drawback of privacy pools is the explicit expectation that every user has to pass through a KYC provider, which acts as a trusted intermediary. If customers have to KYC through some intermediary they already trust with their personal information, say, a bank or a crypto exchange, then why not just trust that party to forward transactions on their behalf?

In effect, this is how the digital banking system already works. But it is a distinctly different model than cash, which is a bearer asset, meaning that it is owned by whoever physically holds or "bears" the bill. In other words, ownership and the right to claim value or assets associated with a bearer asset are determined by possession rather than by the name of a registered owner. As services and currencies increasingly go digital, should people give up the right to own and transact in the digital equivalent of cash?

Who Is Right About Privacy Pools?

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Until now, privacy protocols that leave no room for regulatory compliance are slow to see adoption and integration in the broader financial sector. Some developers have been deterred from building on top of them because they don't want to be potentially liable for the illicit activity of others. For example, developers of the Tornado Cash protocol face indictment for their alleged role in "enabling" the transfer of assets to North Korea, a case that will surely have implications not only for cryptocurrencies but for open-source developers and cryptographers at large. But one thing is clear: some level of privacy is essential for real-world use cases. Just as encryption enabled credit card information to be sent securely over the web, so too will technologies like zero-knowledge cryptography cultivate and enable real-world uses for blockchains. Privacy pools, though imperfect, represent a pragmatic step in the right direction by attempting to find the right compromise between individual privacy and compliance with government regulations.

As human interaction increasingly goes digital ('cashless' or not), blockchains such as Ethereum must adopt solutions to support real-world transactions. Privacy pools offer a promising direction. But, as is often the case with blockchains, they also rekindle the age-old cryptocurrency debate about the importance of decentralization.


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