How Private Can DeFi Be?

The importance of privacy in decentralized finance is paramount. But do its promises of absolute privacy live up to reality?

Statue of a human looking at a cube with green liquid inside surrounded by black spikes

Decentralized finance is still an infant industry, and nothing exemplifies that better than the recent FTX failure. The second biggest exchange failing in such a climate is not good news, but this failure, and indeed many others like it, may force DeFi to look inwards and confront some of its biggest questions. And one such question is that of privacy. 

Privacy is one of the primary questions behind DeFi, and indeed one of the reasons for it. No one wants their financial data available to anyone who wants to have a peek. And DeFi promises to deliver this. But does it? 

Or rather, can it?

The Problem of Privacy in Decentralized Finance

When DeFi enthusiasts talk about the blockchain, they make a good case for it. They argue that the blockchain is extraordinary because it is simultaneously transparent and private. In short, they argue that this is the reason why DeFi will eventually “kill” traditional finance. 

This sort of pseudonymous privacy, they argue, will benefit everyone. Unfortunately, that doesn’t quite ring true. The biggest players in the financial market will not adopt blockchain solutions precisely because of the transparency that it provides. After all, nobody wants their financial issues to be transparent. 

But that’s not true for only the biggest players. It’s the same for regular people as well. People have secrets they want to keep, and the transparency of the blockchain is off-putting to them too. 

The Tornado Cash Solution

The blockchain may offer unrivaled transparency, but that comes at a cost. And that cost is secrecy. All blockchain transactions are public information by default, hence by opting to perform transactions in DeFi, you’re opting to make your transactions public. 

But the irony is that while the blockchain is very useful in holding big financial institutions (exchanges and the like) accountable, regular people and smaller businesses hardly want that. 

It’s okay for all of Binance’s transactions to be online and visible. But the small coffee shop on the corner of your street certainly wouldn’t want that. 

Since DeFi is still a fledgling industry, very few people are yet to understand how big this problem is. However, there are some signs that others have taken on the mantle to tackle it. Tornado Cash, for example, used to be one of the most popular tools used for creating stone-cold anonymity. 

Unfortunately, the United States government clamped down on it. While some may argue that this was unnecessary, one could also argue that Tornado Cash had simply accumulated too many misdeeds. After all, the protocol was used multiple times by international criminals. According to TRM labs, North Korea used the platform to launder at least a billion dollars. At some point, the US government had to weigh the benefits of allowing Tornado Cash to exist and decided that it wasn’t worth it. 

In any case, the death of Tornado Cash left DeFi at an impasse. How could blockchain deliver on its promises of privacy without losing the transparency that makes it such an efficient bulwark against the evils of centralized finance? And how can DeFi manage this in a way that doesn’t invite every criminal from New York to Timbuktu? 

These are important questions for sure, and there are certainly no simple answers. But it’s a question that DeFi must try to answer. 

Fixing Privacy In DeFi

For most people, the difference between DeFi and centralized finance is clear. They could either move to DeFi and have their transactions monitored by anyone, or use regular banks and trust that they don’t just let anyone peek. In truth, the question is whether they can trust banks to keep their secrets, or trust that no one is interested enough in their finances to check how they are doing on the blockchain. 

However, those don’t have to be the two choices. There’s a third choice, and some people are already using it. 

Privacy Layers 

Privacy layers are essentially smart contracts that can be deployed on a blockchain to obscure transactions.  These layers obscure the transactions while still keeping them on the blockchain and decentralized. 

The best example of such layers is the Aztec Network. The network is a smart contract platform with inbuilt privacy that is secured by Ethereum. With solutions like the Aztec layer, people can make transactions safe in the knowledge that prying eyes will never get to see them.

Not Too Little, Not Too Much

But even solutions like privacy layers have their problems. If the layer is as laissez-faire as Tornado Cash was, it would attract every money launderer on the internet. 

After all, criminals want secrecy too. If that were to happen, the layer and even the programmers behind it would find themselves on the wrong side of the law pretty quickly. And if the last six months or so have proven anything, it’s that the law can stretch out to catch most people wherever they are. For example, one of the writers of the Tornado Cash code was far away in Amsterdam, yet he was still arrested by the police.

If layers like this were to become successful, they would simply become another Tornado Cash, and the industry would be on its knees once more. 

The ideal situation to guard against this would be for these privacy layers to have some sort of guardrails against criminality. Ordinarily, that could be solved by a basic KYC protocol

But that would merely be replacing the old banks with new digital ones. People have almost no incentives to do that, and it would not solve DeFi’s privacy problem by any stretch.

Zero-Knowledge Proofs 

Zero-knowledge proofs are somewhat of a breakthrough in the world of crypto. While they may be a little technical when being deployed as an actual protocol, they aren’t difficult to understand. 

A zero-knowledge proof is a way to prove that you are something without actually revealing what you are. Hence, a zero-knowledge proof can be deployed in a situation where it’s important to conceal the information in a transaction while convincing a protocol that the transaction is what it says it is. 

By implementing zero-knowledge-proof functionality on these private layers, DeFi can go from being free for all to being free for the right people. 

Of course, the solution isn’t that simple and it has its hiccups. For one, it means that these privacy layers would have to take on the herculean tasks of verifying the identities of the people that want to use the protocol. It also means that they may have some power over who gets to have access to DeFi tools and who doesn’t. 

It could even seem to the average user of traditional finance, that by switching from TradFi to DeFi, they are merely switching one gatekeeper for another. 

However, if there’s one thing the last two years or so of DeFi growth has taught most people, it’s that the financial wild west is a scary place to be. Most people don’t want to be there. They want to keep all the ease and benefits of DeFi and have none of its scary problems.

That is a tall order, and it may come with some compromise. That compromise, in this case, is allowing private layer protocols to have some control over who gets to have secrecy in DeFi and who gets to slug it out on the public blockchain. 

So, how Private can DeFi be?

In the end, the answer to this question is simple. DeFi can be very private. However, that privacy doesn’t come cheap. And it doesn’t have to be paid for in tokens. 

It can only really be paid for in compromises. If people are going to enjoy the privacy that they enjoy with traditional finance, they will have to give roughly the same allowances they gave to traditional finance to DeFi. 

On the Flipside

  • People may not necessarily object to the privacy that the blockchain offers, since it is pseudonymous.
  • Zero-knowledge proofs may be inadequate in deterring many first-time criminals. 
  • An easier solution might be to use privacy tokens like Monero, but they are tainted with criminal activity.

Why You Should Care

If you invest in or use DeFi, you should care about its future. The problem of privacy in DeFi will shape the future of the industry. Hence, it’s important to understand how that problem can be tackled— or even if it can be tackled. 

This article is for information purposes only and should not be considered trading or investment advice. Nothing herein shall be construed as financial, legal, or tax advice. Trading forex, cryptocurrencies, and CFDs pose a considerable risk of loss.

Victor Fabusola

Victor Fabusola is a Blockchain & Crypto Content Writer. He excels in crafting long-form educational guides, opinion pieces, and reviews in niches such as DeFi, NFTs, and Web 3.0. Outside of his work at DailyCoin, he loves conscious hip-hop and classical music and engaging in intellectually stimulating conversations with his friends.