Anonymity versus regulation in cryptocurrency trading: what’s the trend?

With mass adoption, hopefully, around the corner, a smaller and smaller proportion of the growing cryptocurrency user base knows where the debate about anonymity - regulation comes from. At the same time, cryptocurrency anonymity is actually a concept that underlies the whole crypto movement.

Early in the 1990-es, the first seeds of the idea that technology can help people retrieve the control over their privacy were dropped into the fertile soil of the Cypherpunk circles. It was a group of people interested in cryptography, computer science and technology, but not only. In the cypherpunk mailing list, a sort of an early days Internet forum, the trending topics also concerned philosophical questions, democracy, privacy, the financial system and how their inherent inefficiencies could be fixed thanks to technology. Among them, there was the issue of middlemen corporations that had assumed the function of guaranteeing trust in peer-to-peer transactions. 

The cypherpunks discussed the idea of eliminating the middleman thanks to cryptography and immutability of transaction records that would make trust-less relations between peers possible, restoring their full control over their privacy. The birth of most cypherpunk main ideas and concepts is usually associated with the name of cryptographer David Chaum, creator of DigiCash. As early as in 1985, he authored the paper “Security without Identification: Transaction Systems to Make Big Brother Obsolete” where anonymous digital cash and reputation systems were first mentioned and described. It took more than twenty years for these ideas to find their way into the Bitcoin whitepaper:

The traditional banking model achieves a level of privacy by limiting access to information to the parties involved and the trusted third-party. The necessity to announce all transactions publicly precludes this method, but privacy can still be maintained by breaking the flow of information in another place: by keeping public keys anonymous. The public can see that someone is sending an amount to someone else, but without information linking the transaction to anyone. This is similar to the level of information released by stock exchanges, where the time and size of individual trades, the "tape", is made public, but without telling who the parties were” (Bitcoin whitepaper, p. 6, https://bitcoin.org/bitcoin.pdf).

The idea of making “Big Brother Obsolete” appeared to be appealing also to those who aimed rather at bypassing Big Brother for other reasons. The anonymity of transactions is definitely an asset for those whose transactions, if traced, could cause them trouble. This is how in the early days, cryptocurrencies attracted users involved in money laundering, crime, or tax evasion. However, in the case of Bitcoin, in particular, anonymity is an illusion. Bitcoin is pseudonymous, which means that the user’s identity is represented by an alphanumeric code, which is the public address. All transactions between these public addresses are registered in an open and public register, the blockchain ledger. And even if the public address is the only information available, law enforcement agencies have their ways to track this address. Moreover, if the wallet is custodial, it is even easier to trace the real identity of the user. Indeed, when law enforcement authorities started investigating criminal transactions in the blockchain, it appeared to be a golden mine since all transactions are recorded publicly and are immutable.

Probably, there still may be ways to maintain privacy on the Bitcoin blockchain, but it’s a dungeon sieged by the regulators with increasing success. While Bitcoin is a pseudonymous cryptocurrency, some others are designed and developed as totally anonymous, something that in the conditions of cryptocurrency adoption growing causes real headache to governments and the traditional financial system. While technological advantages of cryptography are certainly recognized at all levels, the balance between privacy and security remains an unresolved dilemma. 

What does the future hold for the "anonymity VS regulation" dilemma?

Last week we asked our Twitter users whether they were on the anonymity or the regulation side and the distribution was the following:

  • Anonymity - 34,5%
  • Regulation - 34,5%
  • In the middle - 30,9%

When analyzing possible developments, it’s important to distinguish between what is possible and what is probable. While everything is possible in this nascent cryptocurrency market, what is probable is that the traditional financial system will end up absorbing blockchain technology while molding its underlying principles to suit the existing framework.

For what Lykke is concerned, since the very foundation, we envisioned blockchain technology as a solution able to level the playing field on the financial market for all kinds of players and, importantly, to digitize any object of value by creating a corresponding crypto token. If a digital asset represents an object of value, it is clearly a security. In the current framework, securities, even if digitized, are subject to regulation. This is the reason why, from the very beginning, Lykke embraced the vision of regulation compliance as a necessary component for the crypto industry to gain mass adoption.

As if confirming our early days predictions, the European authorities have been consistently taking steps to create a legal framework for the nascent blockchain industry. At the moment, the trend is expanding the existing regulation principles, which means that the rules applicable to fiat currencies start applying to digital assets as well. Among the latest regulations it is worth mentioning the New DLT Law in Switzerland and the developments around the Travel Rule in the European Commission.

New DLT Law in Switzerland

The Swiss Financial Markets Supervisory Authority (FINMA) has been showing itself quite open-minded and proactive in fostering the development of the fintech industry in Switzerland. Indeed, since 2018, the government has launched a Crypto-Initiative and set up a working group for blockchain and initial coin offering (ICOs). The new legislation being designed is deliberately technology neutral. The latest innovations regarding blockchain technology are comprised in the Distributed Ledger Act whose first part entered into force in February 2021 and the second part is expected on Aug 1, 2021. The innovations concern mostly the DLT-based securities and the underlying rights of the investors. In addition, the act addresses the segregation of DLT-based assets in the event of a custodian’s bankruptcy. In summary, the existing legal framework is being extended to comprise various forms of DLT and digitized assets. 

The EU intentions to impose the Travel Rule on VASPs

The famous tweet by Mairead McGuinness, the E.U. Commissioner for Financial Services, had the crypto community spend lots of ink on discussing what the upcoming measures were going to be.

In reality, it appears that the new rules are going to be similar to the existing FATF’s Travel Rule guidelines. They aim at prohibiting providing anonymous services, such as third-party crypto custody or exchange accounts, but not the provision of software for self-custody. The understanding that the Travel Rule, a provision that requires financial institutions to utilize users’ identifiers in all transactions, would eventually be extended to crypto transactions has been on the scene since long ago. Indeed, the industry has been developing technical solutions to be prepared for such a regulation to come into force. One of such solutions is the OpenVASP initiative.

The OpenVASP is a decentralized protocol that came in response to the Financial Action Task Force (“FATF”) 2019 crypto industry travel rule guidance. The initiative came together thanks to the collaboration of the founding members Bitcoin Suisse, Seba Bank, Sygnum, Avaloq, MME and Lykke. The open protocol works very similar to the SWIFT messaging system, relating to the transfer of sender and beneficiary information during blockchain transfers between virtual asset service providers (“VASPs”). As one of the founding members, Lykke has developed a solution to address precisely the Travel Rule requirements - The VaspSuite - that enables the travel rule compliance with a messaging system designed specifically for crypto. At Lykke, we view compliance not just as an opportunity to serve our customers maintaining the highest security standards but also as an opportunity to raise the bar for the overall industry.

To summarize, crypto is a very interesting and intriguing subject with very progressive ideas lying behind various projects. Some of them have chosen the strategy of integrating with traditional finance, others are working on disrupting it with authentic DeFi solutions. Technology makes radical innovation possible, but is society ready for it?

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