Privacy-Preserving Compliance Through ZK Proofs – A Potential Path Forward

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A critical debate continues around cryptocurrency privacy and regulation. Recent actions against services like Tornado Cash highlight tensions between anonymity and compliance. But Ethereum founder Vitalik Buterin argues properly implemented zero-knowledge (ZK) proofs could enable regulatory needs while protecting user privacy.

In a new research paper, Buterin and colleagues examine “privacy pools” using ZK proofs for “membership” and “exclusion” from transaction sets. This allows users to prove funds are from approved sources, without revealing full transaction histories.

Balancing Privacy and Compliance

Privacy has become a major concern as government crackdowns increase globally. Tools like Tornado Cash provided transaction anonymity. But authorities targeted the platform for extensive criminal abuse.

The paper suggests extending Tornado Cash’s approach could better differentiate legitimate from illicit uses. ZK proofs would let users prove funds are from approved sources, without exposing their full transaction graph.

For example, someone could generate a ZK proof showing their withdrawal comes from previously deposited funds, excluding any from flagged addresses. This satisfies regulators while preserving privacy.

Enabling On-Chain Compliance

According to the paper, this “core idea” helps balance honest and dishonest uses:

“The core idea of the proposal is to allow users to publish a zero-knowledge proof, demonstrating that their funds (do not) originate from known (un-)lawful sources, without publicly revealing their entire transaction graph. This is achieved by proving membership in custom association sets that satisfy certain properties, required by regulation or social consensus.”

Users specify an “association set” of approved deposits when withdrawing funds. They can customize this set to exclude flagged addresses. The ZK proof shows the withdrawal links to this approved set, without exposing anything further.

Practical Applications

The paper provides examples of how this approach could work:

  • Proving funds don’t originate from a set of known illegal sources
  • Associating withdrawals with approved deposits, without revealing links
  • Allowing merchants/exchanges to verify sources are legitimate

Per the authors, ZK proofs enable privacy and compliance that often seem incompatible:

“In many cases, privacy and regulatory compliance are perceived as incompatible. This paper suggests that this does not necessarily have to be the case, if the privacy-enhancing protocol enables its users to prove certain properties regarding the origin of their funds.”

Ongoing ZK Proof Advancements

Solutions using ZK proofs are advancing across blockchains, especially Ethereum according to recent research.

Developers like Buterin continue researching ZK applications for real-world regulatory needs. Their pioneering efforts could prove fundamental for enabling private yet regulated blockchain ecosystems.

As government scrutiny rises globally, proper ZK proof implementations may emerge as a crucial balancing technology. Allowing compliance without sacrificing privacy.

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