Solving DeFi’s Trust Issues: Addressing the Anonymous Elephant With Blockchain-Based Identity

By Robin Gonzalez Kristensen, Communications Manager at Concordium

Despite persistent interest in DeFi over the past couple of years, institutions remain somewhat hesitant to dive in. One of the biggest culprits has been the lack of comprehensive and clear regulation, however regulation is only part of a larger issue holding them back: a lack of trust.

According to a recent Ernst & Young report, 89% of institutions consider regulatory uncertainty as one of their top concerns with entering the DeFi space and 87% of them say the lack of trusted players fall into that category as well.

Part of the complexity around trust that institutions experience with DeFi is linked to blockchain’s anonymity. Anonymity constitutes a founding principle of blockchain because it grants privacy to users engaging in the DeFi sector; however, it has found resistance with institutions who cannot verify—and in turn, trust—the identity of the entity on the other end of the transaction. With both their own and their clients’ funds at stake, we can’t expect institutions to fully embrace blockchain unless they have the reassurance that the parties they are transacting with are who they claim to be.

Bringing institutions to blockchain therefore boils down to providing them with a safe, transparent, and private framework, while also holding all players to a certain standard of accountability. Regulatory clarity is a major part of establishing both trust and accountability and, while still lacking, it does have an obvious solution: the introduction of greater regulation on behalf of governing bodies. The question now becomes: what else is needed to bring trust, and therefore institutions, to DeFi?

The secret ingredient is one that addresses institutional concerns surrounding trust: blockchain-based identity layers.

Blockchain ID frameworks ensure optimal privacy, cybersecurity and KYC compliance by reducing the risk of identity theft or fraud, meaning that every entity knows exactly who they’re interacting with, without parties needing to reveal unnecessary or private information. This, in turn, adds enhanced safety and transparency to every transaction, bolstering trust in an industry that is in dire need of it.

The financial world involves the management and flow of capital between users and entities, meaning it is of critical importance that the former can verify that the users they are transacting with are who they claim to be. Otherwise, funds risk landing in the wrong hands, leading to potential major financial losses. It is no surprise, then, that institutional investors are weary of engaging in DeFi, if the industry cannot give them the confidence they need that their funds will be protected from fraudulent activity and that their own privacy will be maintained.

These concerns have merits: the blockchain industry has been rife with scams linked to fraudulent identities, both past and present. In October, a Web3 gaming project hired actors to pretend to be executives and came away with $1.6M in stolen funds; a prime illustration of the danger posed by the misuse and lack of verification of identities.

With accessible and trustworthy identity verification tools, fraud and scams such as these can be prevented. Institutions can not only be sure that all of their transactions are thoroughly verified, private, and transparent, but they can also give their clients and partners that assurance, establishing confidence and trust within their own networks. Institutions have reputations to maintain and clients to satisfy, so they cannot easily enter a space that has been riddled with fraud and scams without being able to reassure those clients with the required certainty.

Blockchain-based ID layers help drive regulatory compliance while preserving privacy

Identity verification has been the subject of debate, as many in the DeFi industry fear that it will compromise their privacy given blockchain has been touted for its ability to provide users with complete anonymity. Somehow, anonymity and institutional adoption are seemingly at odds with one another.

A compromise that DeFi must be willing to make to fulfill its potential to reshape our financial system for the better is to leverage privacy-preserving, digital identity verification methods. Zero-knowledge proof (zk-proof) technology, which enables one party to prove a statement is true without revealing the information that was needed to provide that proof, rises as DeFi’s saving grace. Players can prove they are who they say they are, without actually needing to give away sensitive information.

This, in turn, enables institutions to meet KYC compliance requirements without asking other parties to divulge sensitive information, which isn’t actually necessary for those institutions to have access to. Therefore, zk-proof-powered digital identity solutions not only give institutions the trust and assurance they need to participate in DeFi, but also enable them to meet the regulatory requirements they are beholden to with rigorously high standards of security and minimal risk.

Bringing decentralized ID frameworks—and institutions—to DeFi can’t happen on its own

Discussing the impact of blockchain-based ID verification on institutional trust in DeFi is one thing, but actioning it is another. DeFi players must integrate these frameworks into their products by building on Layer 1 protocols with built-in ID verification layers or integrating these privacy-preserving verification tools.

It’s also important to consider that while institutions are demonstrating interest in DeFi, many are still seeking to understand how the technology can directly benefit their specific business models and may require support throughout the onboarding process. By ditching the “one-size-fits-all” solution and tailoring their offerings to different institutions, DeFi companies could better drive adoption. And, of course, robust identity verification is a critical part of that, as it signals to institutions that they can trust that their first steps into the realm of DeFi will take place in total safety.

DeFi is ushering in a new era of finance, bringing greater efficiency and transparency to the financial world. It can’t meet its full potential, however, if players fail to prioritize security and accountability through privacy-preserving digital verification frameworks; these very structures are required to unlock trust and unleash institutional migration to the industry.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.