Could Onchain KYC Be Beneficial for Defi Following the Regulatory Backlash?
The rise of proof-of-stake has been great news for the cryptocurrency community as a whole. For many years, proof-of-work was the go-to consensus of choice for blockchains, modelled on Bitcoin’s security. However, PoW is notoriously energy-hungry. But also, paradoxically, the bigger Bitcoin grew, the higher the barrier to entry became for Bitcoin miners. These days, high-end mining hardware can cost upwards of $10,000.
In contrast, proof-of-stake generally has low barriers to entry and is a far greener option. The increasing popularity of proof-of-stake platforms, such as Solana, Cardano, and Polkadot, provides cryptocurrency holders ample opportunities to generate passive income on their investments, ranging from 5-12% depending on the platform. It’s a significantly more generous yield than any bank can currently offer.
However, as is often the case in the crypto universe, regulation could prove to be a fly in the ointment. The problem is that most regulators don’t seem to know how to treat staking. Is it an investment contract? If so, who’s on the other side of it offering the returns? Is it the same as DeFi or something different?
And ultimately, surely it must need regulating somehow?
Fast Innovation, Slow Regulation
The pace of development in crypto is so rapid that it’s hardly surprising that regulators can’t keep up. One challenge, particularly when it comes to US regulation, is that there’s no separate legal recognition of cryptocurrencies as a standalone asset class. Therefore, the only fallback is to use decades-old laws governing paper-based know-your-customer rules and securities legislation.
But even Coinbase, known for its willingness to engage with regulators, is struggling to figure out how to navigate this complex juxtaposition of old and new. Earlier this year, the company was forced to shelve its plans to roll out a lending program after the SEC threatened to sue if it went ahead.
However, Coinbase continues to offer access to its staking program, sharing rewards of up to 5% with customers. Bloomberg notes that regulators have yet to comment on this matter, but the regulatory treatment of staking remains unclear.
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Then there’s the added complexity of the US infrastructure bill, which passed in early November. The bill includes a new reporting requirement for digital asset transactions that’s been labelled “badly flawed” and “unworkable.” It effectively puts industry participants such as software developers and node operators under the same obligations as brokers in the financial system. Yet, despite intensive lobbying from several lawmakers, the bill passed without any amendment to the requirements.
Identity is the Missing Piece
Eventually, lawmakers will need to wake up to the idea that we need a legal recognition of digital assets that allows for some of what’s needed to recognise cryptocurrencies and blockchain infrastructure as different asset classes worthy of their legislation. However, that would involve more radical changes.
In the meantime, it’s worth asking what is the issue that regulators are trying to solve? In the case of the infrastructure bill, it’s an attempt to ensure proper taxation of crypto wealth, with the added advantage of reducing opportunities for money laundering. And the way to achieve this is through some identity check, which would make enforcement possible.
So a more straightforward way to tackle the problem, rather than put the responsibility on network operators, is for stakers to verify their identity. Selfkey, a decentralised identity project that started life as KYC-Chain, has devised a unique and elegant new way to stake based on a user’s credentials, which it calls Proof of Individuality.
The Selfkey system has two tokens, KEY and LOCK. KEY is the staking token of the network. Anyone wanting to participate must place an initial stake of KEY tokens against their own identity. For doing so, they’re rewarded in LOCK tokens. LOCK is the governance token of the Selfkey DAO, meaning that the longer a user is prepared to stake against their own identity, the more significant their influence in the Selfkey ecosystem. The gamification element means that users are invested in ensuring valid proof of identity on the network to maintain its security and integrity.
Selfkey points out that this approach has an added advantage for blockchain networks in preventing Sybil attacks. This is the term used when a malicious actor attempts to manipulate the network using multiple nodes operating under pseudonyms.
“More Likely to Succeed”
Selfkey’s identity solution can be integrated with blockchain-based apps and DeFi platforms. Such a solution would certainly align with SEC Commissioner Caroline Crenshaw’s comments that she wants operators in the DeFi markets to become more transparent. She recently penned an opinion piece for the first issue of the International Journal of Blockchain Law, in which she covered some of the regulatory concerns surrounding pseudonymity in DeFi. She wrote:
Pseudonymity makes it much easier to conceal manipulative activity and almost impossible for an investor to distinguish an individual engaging in manipulative trading from normal organic trading activity.”
However, she went on to state:
I expect that projects that solve for pseudonymity are more likely to succeed because investors can then be comfortable that asset prices reflect actual interest from real investors, not prices pumped by hidden manipulators. Projects that address this problem are also more likely to be able to comply [with regulatory requirements.].”
As such, it seems likely that more projects will adopt solutions such as Selfkey’s that will allow them to demonstrate compliance to users and regulators without compromising on decentralisation. With more users and enterprises flocking to profit from the gains on offer in staking, DeFi, and more, there needs to be a sustainable solution that balances sensible regulation with support for innovation.