Cryptocurrencies and decentralized finance (DeFi) protocols are coming under increased scrutiny from law enforcement and regulators at a time when traditional financial institutions are showing more interest in them.
With some of the world’s biggest banks and hedge funds looking to leverage these Web3 technologies, governments are getting serious about the need to impose measures that enable the verification of users.
Why is KYC Needed?
For decades, traditional banks and other financial services have operated under strict rules that prohibit them from doing business with unverified individuals. As a result, customers have to undergo a process called “KYC”, or “Know Your Customer”, which involves verifying their identities and providing various other details on their financial and employment status.
Now, governments want to bring the Web3 industry in line with traditional finance and are pushing decentralized protocols to impose the same KYC process on its users, but it’s not that simple. The anonymous nature of DeFi makes it tricky to implement, and the very idea faces a lot of pushback from users, who believe it goes against everything crypto stands for.
Indeed, some Web3 projects that have imposed KYC found that their users consequently voted with their feet. For instance, when the crypto exchange platform ShapeShift started insisting its users undergo KYC checks, it lost more than 95% of its users.
The challenge for KYC in Web3 is to find a solution that satisfies the demands of regulators, without infringing on user’s privacy, and it’s an area that’s seeing a lot of innovation.
Why Doesn’t Web3 Like KYC?
KYC is seen by governments and law enforcement as essential for fighting financial crime and preventing illegal activities such as money laundering. When financial institutions implement KYC, they have to collect various documents from their users, such as their passport or ID card, to verify their identity.
In doing this, the banks can ensure that the individuals they’re dealing with are not wanted by law enforcement or under any sanctions that might prohibit doing business with them. The information collected can also aid in criminal investigations, should an account later be flagged for suspicious activity.
Depending on the service provided, banks and financial institutions may require more information than the customer’s identity. For instance, opening a basic savings account is quite simple, with the only requirements being ID and proof of address. But when someone is trying to take out a $50,000 loan, the bank will want to know a lot more – it will demand employment records, work contracts and so on. For customers, it can feel pretty invasive.
This kind of invasiveness is one of the main reasons why crypto exists. Satoshi Nakamoto designed Bitcoin to be decentralized, so that people wouldn’t have to deal with banks and so they could transact entirely anonymously, without having to tell anyone who they are or how much funds they have.
The lack of privacy is a major annoyance for Web3 users when they’re asked to undergo KYC, but it’s not the only one. Having to dig up the right documents every time is a major inconvenience, and it’s one that’s becoming more and more frequent. It’s not just that every single protocol and service requires users to undergo the same checks—sometimes, protocols may even demand users provide their documents a second time, to check that everything is still up to date, or to ensure compliance with evolving regulations.
KYC is also a burden for Web3 protocols, which have to invest in the infrastructure and tools required to implement these checks and verify user’s identities. In most cases, the process is outsourced to a third-party, which means higher costs. But users don’t like this either, for it means their private information is being shared and stored in multiple servers, making it less secure.
ID Verification Without Disclosure
If the Web3 industry wants to be taken seriously, there’s no way around the need for KYC. Despite its best efforts to improve security, Web3 remains an industry where cyberattacks and scams are rife, with endless headlines of protocol hacks and rugpull schemes that see the bad guys getting away with millions of dollars. Moreover, crypto continues to be a useful tool for criminals looking to launder the proceeds of illicit activities.
Mainstream adoption of crypto and digital assets is not going to happen if it doesn’t find a way to adhere to KYC. In particular, there are a lot of traditional financial institutions that are itching to explore the possibilities of decentralized finance and tokenized real-world assets, but because they’re operating under strict compliance regulations, these organizations can only do so if the protocols they use implement KYC.
The challenge is that Web3 needs a way to adopt KYC without alienating its users, who insist on being able to maintain their privacy and anonymity. So there’s a need for some clever solutions.
Fortunately, the Web3 industry happens to be a hotbed of innovation, and a lot of its best thinkers have been focused on solving this problem. An especially promising idea is ICB Labs’ “KYC NFT”, which leverages non-fungible tokens that can verify someone’s identity without revealing who they are.
KYC NFTs might sound contradictory, but they simply take advantage of the unique transparency and security of blockchain technology to satisfy the concerns of regulators and users. They provide a secure, decentralized system for individuals to verify their identities in a way that’s compliant with global regulators, while ensuring users remain anonymous and in control of their personal data.
To create a KYC NFT, all users have to do is submit basic details including their name, email and password, and then submit their identity documents to a secure system that will verify they are who they say they are, without sharing this information with anyone. The process is entirely automated, so no human ever sees the user’s documents.
These verification details are stored on the blockchain, and then the user can “mint” a KYC NFT that acts as their digital identity, allowing them to access any protocol on the ICB blockchain that requires ID verification. The clever part is that the KYC NFT basically acts as a kind of guarantee that says – yes, this person has proven their identity – but it doesn’t actually reveal their identity to the service the user is trying to sign up for. In this way, individuals can prove they are verified, without revealing their name, age and other personal information.
Every time the user attempts to use a protocol that requests they pass a KYC check, they can simply show the KYC NFT that lives in their digital wallet, and that will instantly authorize them to continue. They can do this continuously, without ever having to submit any documents ever again. It’s a convenient solution that allows users to remain anonymous, while simultaneously preventing fraud and money laundering and ensuring compliance with global regulations.
KYC With Full Privacy; Is It Even Possible?
The Web3 industry needs more liquidity to grow and achieve mainstream adoption, but the institutions that have this kind of capital cannot participate if it remains unregulated. In other words, KYC compliance is vital for the industry’s future growth. Governments simply won’t accept unregulated financial services that could potentially be used to launder millions of dollars in illicit funds and facilitate illegal activities.
That’s why KYC NFTs are such a compelling innovation for identity verification, providing enhanced security and more convenience for end users. The beauty of blockchain is it allows users to remain in control of their identities and retain their anonymity while remaining in full compliance with the laws that govern the use of financial services.
