Regulators are coming for crypto: Is digital identity the answer?

It’s time to give control over personal data in megadatabases managed by a handful of corporations and governments back to the people.

The regulators are closing in. It’s one thing to unbundle market functions to their parts ― custody, aggregators and Prime Brokerage ― to satisfy institutional compliance departments. It’s another to keep regulators happy.

From the Financial Action Task Force pushing forward with its guidance for Travel Rule compliance to the still-evolving European Markets in Crypto-Assets regulatory framework, and the somewhat clumsily-handed U.S. infrastructure bill, the regulators are slowly tightening their noose, and I fear this may be the start of a multi-year staring match ― with the decentralized finance (DeFi) market now firmly in their sights, too.

Related: DeFi: Who, what and how to regulate in a borderless, code-governed world?

Could digital identity help?

Whenever I’ve been asked what Bitcoin’s (BTC) killer app would be over the past 10 years, my response has always been “digital identity.”

Today, the world stands at a crossroads. One turn leads to ever-increasing and privacy-invading oversight now that money finally follows information onto the rails of the internet. Down the other is a road that sees personal data returned into the hands of individuals and out of mega AI-crunching databases controlled by a handful of corporations and governments.

It might have been anathema to early Bitcoin purists but reality bites and, throwing the growing debate regarding COVID-19 digital passports into the mix, we’re seeing the clouds of a perfect storm on the horizon that is likely to become the key narrative for the years ahead.

As central banks everywhere dismiss crypto assets as nothing more than chips on the roulette table in favor of their own thoroughly “groundbreaking” CBDCs, the excitement at their realization that they can now do both monetary policy and oversight is palpable.

The crypto markets have, unfortunately, already become a victim of their success, getting regulators all in a tizz to boot. The higher those “market cap” numbers have gotten (reaching $2 trillion earlier this year), the more itchy regulators have become. The Chinese have simply taken the sledgehammer approach and banned everything (apart from their recently launched CBDC, of course) while, in the West, regulators are (at best) taking a nuanced approach or else fighting with each other over whose purview it should come under.

Related: Authorities are looking to close the gap on unhosted wallets

With the majority of crypto economic activity still flowing through the major crypto exchanges and OTC desks, FATF forcing Travel Rule compliance on Virtual Asset Service Providers (VASPs) may well keep the genie in its bottle for now while these on/off ramps remain easily identifiable. But what happens if, or when, a self-sustaining crypto economy emerges where the majority move beyond speculation and, instead, get “in” and stay “in”?

Or if DeFi grows beyond its sizeable, yet niche, playpen?

Fungibility, transparency and ‘tainted’ currency

Having spent the last decade or more forcing anonymous “physical cash” out of the system, requiring the reporting of transactions over a measly few hundred bucks, can you imagine the brouhaha should Satoshi’s original vision of an “anonymous cash system” actually proliferate?

If you want to know the answer to that, just look at what happened when Mark Zuckerberg had the temerity to suggest such a notion through his Diem (formerly Libra) stablecoin project that might have ended up in the hands of three billion users overnight ― and Diem has (what should be a regulator’s dream) a digital identity hard-baked into the protocol by design from the very beginning!

Related: Stablecoins present new dilemmas for regulators as mass adoption looms

Sometimes these guys really can’t see the wood for the trees.

There has already been an endless debate over the recent years regarding Bitcoin’s (or other crypto’s) fungibility given how they may become “tainted” if or when traced to nefarious use. Transparency of blockchains has proven to be a useful tool not otherwise at their disposal to law enforcement agencies, whilst hackers have mostly found it far from easy to convert their swag back into “useful” fiat as exchanges blacklist their visible wallet address trails.

But surely “money” itself can’t be “clean” or “dirty”, “good” or “bad”? Surely it’s just a dumb object (or database, or “block” entry)? Surely it’s only the identity of a transacting party that can be deemed (albeit subjectively) good or bad? Not that this is remotely a novel debate. You can go back to an 18th Century British legal case to find it’s all been argued over (and rectified) a long, long time ago.

Leaving aside Zuck’s true intentions for Diem, thankfully I’ve not been alone in my long-held opinion on the role that decentralized identity (DID) might play in both our crypto and non-crypto futures.

Related: Decentralized identity is the way to fighting data and privacy theft

Self Sovereign Identity and the tech giants

For all the excitement on crypto Twitter from even a whisper of interest in Bitcoin from any well-known tech brand, the fact that boring old Microsoft started exploring digital identity as its chosen use-case for “blockchain” as far back as 2017 has garnered relatively little attention.

Not that others within the crypto industry weren’t equally cognizant that this would become a critical piece of infrastructure. Projects such as Civic (2017) and GlobalID (2016) are already a good few years in development and the topic of Self Sovereign Identity, whereby the individual — not a gargantuan central database — maintains private control of their identity and decides for themselves who to share them with rather than a tech conglomerate, is back high on the agenda.

With data protection becoming such an issue for regulators and a challenge for the majority of firms with an online user base, you’d have thought that these ideas would be embraced by regulators and companies alike.

And maybe, just maybe, regulators will join our side if the crypto industry proves that it can build safer and more robust systems. Those systems need to satisfy regulatory requirements for identifying transacting parties in a peer-to-peer payment — and by doing so, enable more institutional participants to safely enter the crypto markets with their compliance officers able to sleep at night.

It is, after all, the Googles and Facebooks that have most to lose should decentralized digital identity prevail. Without our data to pimp, they’re royally screwed.

Related: The data economy is a dystopian nightmare

Murmurings of dissent are already being heard relating to the responses to the current World Wide Web Consortium (W3C) Call for Review regarding Decentralized Identifiers (DIDs) v1.0.

Will the turkeys willfully vote for Christmas or will they ultimately have to find a way to live with the inevitable in the same way that the major telcos had to in the 90s when they were up in arms at the idea that VOIP-utilising upstarts such as Skype might get away with enabling free telephony for everyone?

My hunch is that the masses, once armed with the right tools, will eventually win out but one thing is for sure: The battle lines have been drawn. So grab the popcorn and sit back. This fight is just beginning and has a good few years to run but, when it’s over, crypto nerds everywhere might finally see the global adoption they dream of.

This article does not contain investment advice or recommendations. Every investment and trading move involves risk, and readers should conduct their own research when making a decision.

The views, thoughts and opinions expressed here are the author’s alone and do not necessarily reflect or represent the views and opinions of Cointelegraph.