Since the 1970s, the significance of KYC (Know Your Customer) and AML (Anti-Money Laundering) regulations in preventing financial crimes has been growing. In the wake of significant financial scandals, governments worldwide began introducing regulations to ensure banks and other financial institutions have processes designed to identify customers, detect suspicious activities, and report suspicious transactions.

With KYC regulations, financial institutions must verify their customers' identity and gather basic information like name, address, and date of birth. The purpose of KYC checks is to safeguard both businesses and individuals against various criminal activities. AML regulations go one step further by requiring additional measures for businesses to detect and report suspicious activities.

However, due to users' privacy concerns in the crypto world, KYC and AML pose a challenge. The rise of decentralized cryptocurrencies has intensified the demand for secure identity verification that is both efficient and reliable. Keeping up with these demands is where zero-knowledge proofs (ZKPs) come into play — allowing customers to maintain their privacy while still proving their identity.

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Zero-knowledge proofs in KYC crypto: "I don't know the answer, but I can verify if you know it"

Suppose that in a cryptographic setting, Alice, the prover, aims to prove to Bob, the verifier, that she possesses a private key corresponding to a given public key without revealing the actual private key.

To achieve this, Alice generates a commitment by encrypting the private key with a random value and shares it with Bob. Bob then challenges Alice with a random binary value. Based on the challenge, Alice generates a response that convinces Bob of her knowledge of the private key without disclosing any specifics. Bob verifies the response using the agreed-upon scheme, ensuring Alice possesses the private key without learning additional information. Through this process, Alice can prove her possession of the private key while preserving its confidentiality. This briefly illustrates how zero-knowledge proofs would work in KYC crypto.

In 1985, zero-knowledge proofs (ZKPs) were introduced by Shafi Goldwasser, Silvio Micali, and Charles Rackoff. They published a seminal paper titled "The Knowledge Complexity of Interactive Proof Systems," which laid the foundation for the concept and theoretical framework of ZKPs. The paper explores their applications in cryptography and computational complexity theory. Shafi Goldwasser and Silvio Micali were awarded the Turing Award in 2012 for their fundamental contributions to the cryptography field, including the development of zero-knowledge proofs.

Check out ourSilicon Valley June Summit recording, in which Shafi Goldwasser explains ZKPs in her own words.

In cryptocurrencies, ZKPs allow for the verification of certain properties without disclosing sensitive information. Here're the common steps involved in the ZKP process:

Statement and commitment

• The prover in the ZKP protocol is typically a cryptocurrency user who wants to prove a particular property, such as ownership of a specific set of coins, without revealing the actual coins or private keys.
• The prover creates a commitment, which is a cryptographic representation of the property or information they want to prove. This commitment serves as evidence without disclosing any specific details.

Challenge and response

• The verifier, often a blockchain network or another party, challenges the prover by requesting proof of the property or information.
• In response, the prover generates a response that convinces the verifier of the validity of the statement without revealing sensitive data. The response is constructed using cryptographic operations and algorithms.

Verification

• The verifier checks the validity of the response received from the prover without gaining any knowledge of the underlying sensitive information.
• By applying cryptographic protocols and algorithms, the verifier can verify the correctness of the response and determine if the prover has proven the desired property or information.

ZKPs are widely used in KYC crypto for various purposes, such as proving ownership of funds, verifying transactions, and ensuring the integrity of cryptographic systems. By employing ZKPs, individuals can demonstrate specific knowledge or assertions about cryptographic data without compromising security or privacy. This is especially useful when it comes to compliance with regulations like KYC and AML.

Staying safe in crypto: ZKPs solutions for KYC and AML

• QEDIT is a company that specializes in privacy-enhancing solutions using ZKPs. It offers a privacy layer for blockchain technology that enables secure data sharing while maintaining confidentiality. Its solutions can be applied in various domains, including KYC and AML compliance.
• The Sovrin Foundation is an organization focused on the development of self-sovereign identity solutions. It's exploring the integration of ZKPs to enhance privacy and security in digital identity systems, including applications in KYC and AML processes.
• Notebook Labs is a platform that uses ZKPs to set a decentralized and verifiable identity for Web3, which is used to access KYC crypto solutions. Notebook enables creators and communities to conduct airdrops resistant to Sybil attacks. DAOs can utilize it to validate the identity of participants and combine their credentials. Additionally, lending protocols can establish credit-scoring mechanisms to provide loans with lower collateral requirements.

The Future of ZKPs and KYC crypto

Several limitations still need to be addressed for ZKPs to realize their full potential. For example, ZKPs require high computational power, making them difficult to implement on smaller-scale projects or systems with limited resources. Some ZKP protocols need a trusted setup phase in which they generate initial parameters. This phase may create a risk if the trusted setup is not executed correctly or compromised. Finally, a lack of legal recognition and acceptance of ZKPs could prevent some organizations from taking full advantage of the technology. Thus, it’s essential that governments provide clear regulations and guidance on the use of ZKPs to ensure their widespread adoption.

Nevertheless, we can expect advancements in KYC, AML, and ZKPs to enhance privacy and efficiency in the future crypto world. This could include more sophisticated privacy-preserving KYC crypto solutions leveraging ZKPs, interoperability standards for secure data sharing, and deeper integration of ZKPs with AML compliance systems for automated audits. We can also see the development of regulatory frameworks to guide the implementation of privacy-enhancing technologies. These advancements would promote privacy, security, and regulatory compliance in identity verification and financial transactions.