Self-custody, control and identity: How regulators got it wrong

2 years ago

The caller European Union connection requiring centralized crypto exchanges and custodial wallet providers to cod and verify idiosyncratic accusation astir self-custodial wallet holders shows the dangers of recycling accepted concern (TradFi) rules and applying them to crypto without appreciating the conceptual differences. We tin expect to spot much of this arsenic countries look to instrumentality the Financial Action Task Force (FATF) Travel Rule, initially designed for ligament transfers, to transfers of crypto assets.

The (missing) nexus betwixt self-custody, power and identity

The purpose of the projected EU rules is “to guarantee crypto-assets tin beryllium traced successful the aforesaid mode arsenic accepted wealth transfers.” This assumes that each self-custodial wallet tin beryllium linked to someone’s verifiable individuality and that this idiosyncratic needfully controls the wallet. This presumption is wrong.

In TradFi, a slope relationship is linked to the verified individuality of its holder, giving them power implicit that account. For example, sharing your online banking details with your spouse doesn’t marque them the relationship holder. Even if your spouse changes the login details, you tin regain power by proving your individuality to the slope and having it reset the details. Your individuality gives you eventual power which cannot beryllium permanently mislaid oregon stolen. Of course, successful speech for the bank’s custody protections, you suffer self-sovereignty implicit your assets.

Self-custody of crypto assets is different. Control (i.e., the quality to transact) implicit the self-custodial wallet is held by whoever has the backstage keys to that wallet. Control is not linked to anyone’s individuality and determination is nary 1 to beryllium your individuality to. All you request is to download a portion of bundle and safely store your backstage keys. In speech for this responsibility, you support self-sovereign ownership.

Implementing the projected rules

Let’s look astatine however a custodial wallet supplier would spell astir complying with the EU proposal. Assume that Alice wants to nonstop 0.3 Ether (ETH) from her custodial wallet relationship to Bob’s self-custodial wallet to wage for Bob’s consulting services. Before the transportation goes through, the custodial wallet supplier would person to 1) cod Bob’s name, wallet address, residential address, idiosyncratic recognition number, and day and spot of birth; and 2) verify the accuracy of these details. Broadly the aforesaid details would beryllium required for a transportation from Bob’s wallet to Alice’s custodial wallet account. Alice would apt request to inquire Bob to nonstop her his details, and Alice would past supply them to the custodial wallet supplier — arsenic precocious recommended by a custodial wallet supplier successful a akin context.

The rules would use adjacent to the smallest transactions — determination is nary minimum threshold. Custodial wallet providers would conceivably besides request to withhold incoming transfers (creating greater custody risks) and instrumentality them to the self-custodial wallet if the verification is unsuccessful.

Identity does not adjacent control, making compliance impossible

While collecting information and perchance withholding incoming transfers is operationally cumbersome, the verification work risks are perchance outright intolerable to comply with. In TradFi, the constituent of individuality verification is to guarantee that the idiosyncratic controlling a slope relationship and claiming to bash truthful is the aforesaid one. But however could the custodial wallet supplier fulfill the verification work if power implicit Bob’s self-custodial wallet does not beryllium connected his identity?

Even if the custodial wallet supplier managed to corroborate that Bob is the idiosyncratic helium purports to be, this doesn’t mean that helium controls the wallet. It could beryllium controlled by a decentralized autonomous enactment that redistributes payments to members similar Bob oregon a transgression group, with Bob simply being their wealth mule. There is nary 3rd enactment to beryllium Bob’s individuality to successful bid to transact — whoever controls the backstage keys is the “bank.”

Exposing morganatic users to disproportionate information risks

Let’s presume that custodial wallet providers negociate to comply with the projected rules, oregon a little stringent mentation of them that does not necessitate verification. Custodial wallet providers would request to support ample databases of self-custodial wallet users, exposing users to the hazard of information breaches. For morganatic users, i.e., those who state their existent individuality and besides really power the related self-custodial wallet, this hazard has acold greater consequences than TradFi information postulation (e.g., FATF’s Travel Rule for ligament transfers).

In TradFi, if a transgression compromises someone’s slope relationship oregon card, they wouldn’t get precise acold due to the fact that the slope tin artifact the account. By definition, self-custodial wallets deficiency this feature. Self-sovereign ownership, secured done cryptography and the user’s ain vigilance, is seen arsenic an vantage by tens of millions of users worldwide, including those who are excluded from the banking system. However, self-sovereignty presumes idiosyncratic privacy.

Once privateness is compromised — for example, by hacking the custodial wallet provider’s database of self-custodial wallet users — users are near exposed to an unfair level of hazard compared to TradFi. Knowing someone’s name, address, day of commencement and ID number, unneurotic with their on-chain activity, would marque it easier for criminals to launch highly personalized phishing attacks, targeting users’ devices to retrieve backstage keys, oregon blackmailing them, including threats to carnal safety. Once backstage keys are compromised, the idiosyncratic irreversibly loses power implicit their wallet.

Since criminals volition find ways astir the rules — for example, by moving their ain nodes to interact with the blockchain without ever having to trust connected custodial wallet providers oregon self-custodial wallet bundle — it volition lone beryllium the morganatic users who volition person to carnivore these information risks.

Inconsistencies with EU’s ain argumentation framework

Security aside, the connection raises broader privateness concerns. The reporting work would clash with General Data Protection Regulation (GDPR) principles specified arsenic information minimization, which requires that collected information are adequate, applicable and constricted to what is indispensable for the intent of collecting them. Ignoring for a infinitesimal the statement that information postulation serves small purpose, fixed the missing nexus betwixt self-custodial power and identity, it’s hard to spot — adjacent by TradFi’s standards — however someone’s residential address, day of commencement and ID fig is applicable oregon indispensable for making a transfer. While banks regularly support specified information astir their relationship holders, you arsenic the relationship holder don’t request to inquire (and know!) these details erstwhile sending wealth oregon paying for a service.

It is besides unclear for however agelong custodial wallet providers would request to store the information — nether GDPR, idiosyncratic information should beryllium kept lone for arsenic agelong arsenic indispensable to fulfil the intent of collection. Nor is it wide however users’ idiosyncratic rights nether GDPR specified arsenic the “right to beryllium forgotten” and the “right to rectification” could beryllium respected if their idiosyncratic details are linked to their on-chain history, which cannot beryllium altered.

The deficiency of immoderate risk-based appraisal oregon a minimum threshold (unlike the 1,000 euro threshold for fiat transfers) is besides retired of enactment with EU argumentation principles. The connection seems to dainty each crypto transfers with suspicion conscionable due to the fact that they impact crypto assets.

Now is the clip to prosecute with policymakers

Faced with the imaginable of processing costly compliance processes that would apt neglect to efficaciously instrumentality the rules, and risking penalties for non-compliance and imaginable information breaches, EU-based custodial wallet providers whitethorn determine to restrict transfers from and to self-custodial wallets altogether. They whitethorn besides commencement servicing EU users from extracurricular the EU. This sends atrocious signals to the crypto manufacture and risks discouraging tech endowment and superior from the EU, akin to the recent departure of immoderate crypto operators from the United Kingdom.

More users whitethorn besides power to peer-to-peer transactions and decentralized players to debar the burdensome rules. While this could beryllium beneficial for immoderate users, the EU should promote creaseless interconnectivity betwixt centralized and decentralized players and beforehand users’ state to take however they privation to transact.

The connection has present moved to negotiations betwixt the EU legislative bodies starting April 28, with the last substance expected by the extremity of June. If the regularisation passes successful its existent form, determination volition inactive beryllium a accidental to reappraisal it wrong 12 months aft its coming into force. However, we can’t trust connected this — present is the clip for the European crypto manufacture to coordinate and prosecute with policymakers. Instead of forcibly applying TradFi rules to a processing technology, we should beforehand outcome-based policies that let the emergence of caller compliance solutions that respect however crypto works.

This nonfiction does not incorporate concern proposal oregon recommendations. Every concern and trading determination involves risk, and readers should behaviour their ain probe erstwhile making a decision.

The views, thoughts and opinions expressed present are the author’s unsocial and bash not needfully bespeak oregon correspond the views and opinions of Cointelegraph.

Natalie Linhart is simply a ineligible counsel astatine ConsenSys, wherever she advises connected products including MetaMask, NFT experiences and organization staking. She besides focuses connected European regulatory issues affecting the crypto industry. She antecedently worked arsenic a fiscal regulatory and derivatives lawyer astatine Clifford Chance London, advising clients connected launching fiscal products, accessing caller markets and mitigating regulatory risks. She besides worked connected derivatives and indebtedness superior markets transactions including astatine a planetary concern bank.

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