Know your customer, or KYC is short-hand for a range of guidelines used by financial institutions to verify their customers’ identities. One of the primary purposes of KYC is to prevent money laundering and terrorist funding. Robust accounting and KYC protocols can only strengthen customer and regulatory trust in blockchains used in financial transactions. There is a real need to prevent money laundering and fraud, and this need does not contradict the commitment many blockchain users have to anonymity.
There is a seeming dichotomy between the rigid need to know who is conducting financial transactions and the trustless foundation of blockchain transactions. After all, one of the greatest strengths of blockchain is that it is trustless: you can trust a transaction on a blockchain even if you don’t trust the agent making that transaction, or without even knowing who the person making the transaction is. In other words, a trustless transaction is one in which the transaction itself is trustworthy. This trustless security is supported by blockchains’ consensus methodology, built on the code, asymmetric cryptography, and protocols of the blockchain network itself.
So doesn’t KYC implementation — needing to know who customers are — require that we remove the trustless aspect of blockchain transactions? The reverse is true. It is the trustless security offered by blockchain that allows a scenario where individuals verify their identity and create a secure, non-destructible, on-chain record of that verification, not of the details of their identity. This decentralized digital identity represents the verification of a person’s identity — in short, it provides KYC information without revealing personal information.
Current identity verification methods rely on non-specialized groups, third parties, or other intermediaries looking at, and often holding on to personally identifying information about individuals. For example, a consulate conducting verification of a visitor’s identity for visa issuance may ask the individual to upload copies of their passport, driver’s license, and other personal identification. The transaction itself is susceptible to hacking, and the information could be stored in a database held by the consulate, a potential target for malicious hacking.
By using trustless blockchain technology, however, an individual could verify their identity in a protected, trustless manner, and retain control over their personal information. Consider, for example, NFTs — non-fungible tokens — often created as digital representations of physical objects. NFTs could also be digital representations of identity information, or more precisely, of verifying a person’s identity. Institutions that require KYC information about an individual could use an NFT verified by a trusted operator and side-step the need to send personal, private identity information to multiple companies. An individual could create their own identity NFT or decentralized digital identity based on verifying their identity and using that information instead of their actual identity information.
The strong bent towards anonymity and individual ownership of identity prevalent in blockchain communities is not impeded by financial KYC regulations, and in fact, blockchain can be a robust platform for supporting the laudable goals of curbing money laundering and fraud through robust and secure KYC operations.
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