Zero-knowledge protocols and the rise of a decentralization index

Transparency, egalitarianism, and inclusiveness — these are the fundamental principles behind bitcoin (BTC), the software that spawned the rapidly evolving crypto industry.

However, with the acceleration of this relatively nascent sector, it has become evident that these values aren’t always fully realized, as underlined during the “Crypto Integrity: Zero Knowledge Protocols and the First Decentralization Index” panel at the recent Money20/20 event.

Participants Aggelos Kiayias from the University of Edinburgh and Joel Telper from Input Output Global delved into the critical challenges the industry is grappling with, highlighting the potential of zero-knowledge protocols and the development of a decentralization index.

Transparency and the role of zero-knowledge protocols

One of the key themes addressed was the vital importance of transparency within the crypto ecosystem. Recent events involving Tara and FTX, as well as ongoing litigation cases, underscore the issue of information asymmetries and mismanagement of funds.

Zero-knowledge protocols, although technically complex and resource-intensive to develop, could provide a robust tool for ensuring transparency. In essence, these protocols allow one party to prove to another that they possess specific knowledge without revealing any information about that knowledge.

The promise of these protocols lies in their ability to maintain privacy while ensuring secure, reliable transactions, adding a vital layer of integrity to blockchain systems.

The decentralization index

An equally compelling point of discussion was the level of decentralization inherent in blockchain systems.

Decentralization is a fundamental characteristic of these systems, and a significant appeal for those involved in crypto. It’s also drawing attention from a regulatory standpoint due to concerns about information asymmetry and systemic risk.

However, the lack of a common definition of decentralization complicates the assessment of this aspect in blockchain systems.

Researchers at the University of Edinburgh are addressing this issue with the development of a decentralization index. This open resource aims to provide a holistic and accessible measure of a system’s level of decentralization.

This innovative tool will allow parties interested in assessing the decentralization of a system to do so with a robust, open methodology.

Staking and regulation

The panel discussion further tackled the complex subject of staking in crypto and its regulatory implications. Staking is the act of holding a cryptocurrency in a digital wallet to support a blockchain network’s operations, such as transaction validation.

The nuances of staking, however, can significantly impact its legal and regulatory standpoint.

For example, forms of staking resembling hedge funds — where crypto is pooled with others’ and potential penalties (slashing) exist — differ greatly from liquid staking, where ownership of the crypto is maintained and no slashing is present.

The panelists suggested that types of staking, such as liquid staking without slashing and transfer of ownership, should be exempt from the traditional regulatory framework.

However, the process becomes complex when impermanent losses may occur with liquidity proof staking on decentralized exchanges like Uniswap.

The combination of staking and potential losses based on another party’s performance can resemble traditional investment vehicles, possibly prompting closer regulatory scrutiny. Additionally, loss of asset custody could lead to legal concerns and potentially classify LP tokens as derivatives.

Regulation in the crypto industry

A central theme of the discussion was the need for crypto legal systems to aid regulators without burdening non-traditional financial institutions with the same regulations as traditional banks.

The transparency, standardization, and accessibility of data provided by blockchain technology could make regulation more efficient and effective.

As regulators become more comfortable with blockchain technology, they can leverage its capabilities to apply oversight to non-traditional financial services providers. This oversight can be managed algorithmically, fostering a shift in the dynamic of the regulatory system.