The next wave of DeFi will be driven by decentralized identity solutions

Today, decentralized finance (DeFi) is still something of the “wild west.” With many different players, each with their own demands and ambitions, there is no clear law of the land.

Unfortunately, this has resulted in some users getting a bad hand after deciding to experiment with the ecosystem. Stories from scam and carpet pulls are still common, and algorithmic protocols are coming undone undermining user confidence due to adverse market conditions. DeFi can seem insecure and confusing to many users, even when projects and the teams behind them have the best of intentions.

It doesn’t help that regulators in many jurisdictions tow their feet about clear rules or enforcement for the sector. While it took years for the first signs of legislation to appear, DeFi’s growth has finally caught the attention of legislators around the world. However, the jury is still out on how strict or flexible the laws will be.

The combination of risky services and an unregulated environment has understandably made many suspicious of the crypto community. Private investors and institutions alike are wary of DeFi and don’t fully understand it. The question of the hour is, when and how will we get to a point where DeFi can be embraced by people other than Degens?

One step that could be huge in satisfying regulators and potential investors is the introduction of identity solutions. These solutions allow tracking of different actors within the DeFi space. Cryptopurists and privacy advocates may frown at the idea, but a solution that meets regulators’ demands, allays investor concerns and doesn’t infringe on individual rights is closer than most people think.

Enter decentralized IDs

The very technology on which DeFi is built also offers the solution to the current roadblock. That solution comes in the form of decentralized identities, or DIDs. By leveraging blockchains, smart contracts, and non-fungible tokens (NFTs), DIDs can provide accurate information to lawmakers while preserving user sovereignty and privacy.

This is possible thanks to a number of different aspects of the crypto infrastructure, with NFTs delivering particular value. An NFT acts as an asset into which any type of data can be encoded and is provably unique from all other assets, complete with its own history. Due to the underlying decentralized protocols, no one can fake or modify an NFT.

Understandably more is required for a true digital identity. There should also be accountability and assurance over the ownership of DIDs. For this purpose verification of the physical identity can be linked to the DID. There are multiple ways this can be done, including biometrics, explicitly verifiable real-world documents, or similar confirmations. By linking all this information together in an NFT, an unfalsifiable profile can be created.

Power to the user

Privacy advocates may shy away from the idea because they are very strict and all-encompassing. After all, an immutable record of someone’s data captured forever on a public blockchain doesn’t sound all that private. This is where the next benefit of DIDs comes into play, when combined with zero-knowledge proof (ZKP) technology. Information can be verified once by an independent party and then used to confirm someone’s credentials using ZKP technology. As a result, an individual can prove their access, data or history without necessarily disclosing their name or other identifying information to the verifier.

In this model, individuals have full control over their own data and can grant permissions to verifiers about what can be seen and when. IDs no longer need to be an open book for companies and governments to use as they see fit. While these goals are important for preserving individual rights, they also entail practical use cases.

Imagine someone being able to pick up a prescription without having to show the pharmacist anything and instead just scan a QR code on their phone. Their doctor had the prescription requirements embedded in their DID, and it could even expire after the correct number of refills. You can also imagine a bank customer applying for a loan without disclosing the actual balance of their accounts. Instead, users can simply provide proof that they have the predetermined minimum account value that makes them eligible for the loan.

How this opens up the DeFi future

Bringing this back to DeFi, it becomes increasingly clear how DIDs can bring accountability and trust to this realm without undermining decentralization and privacy. These profiles can be used by both customers and providers, creating knowable entities on decentralized platforms without actually revealing who the customer is. For example, DIDs with proper authentications may be required to access certain features or dApps without requiring the necessary service to see the holder’s identity.

Speaking of credentials, DeFi services can also “badge” DID profiles to indicate performance, merit, or behavior in general. These can be non-transferable tokens that indicate certain metrics and stay with that ID forever, known as “soulbound tokens.” For example, if a particular user has attempted an attack on an exchange in the past, their DID may be sent a token indicating malicious behavior to exchanges. On the other hand, long-standing and reliable liquidity providers can get a similar identification, giving those IDs VIP status even as they join new platforms.

DeFi services themselves can have their own DIDs that work in a similar way, acting immediately and irreversibly as a complete history and reputation document. Once implemented, such a system would discourage bad behavior and have meaningful consequences for those affected by it. All of this could be done without invasive surveillance or the holder’s full knowledge.

Enabling trust

This approach could open the door for everyone from individual investors to large corporations to join the DeFi revolution. DIDs can be designed to always stay in compliance with the law in a given jurisdiction, meeting the regulators halfway and avoiding violations of regulations. Customers could rely on their services and vice versa, making all forms of finance and commerce run much more smoothly and with a significant reduction in fraud. Best of all, the average citizen actually has control over all of their own information, protecting them from malicious activity.

What needs to be acknowledged is that this isn’t just a great theory; it is already a fact. Decentralized protocols have been developed to allow for exactly these types of IDs and are already in use in some industries. Soon others will begin rolling out similar solutions for their customers, bringing greater security and peace of mind to everyone.

This is the last puzzle piece holding back mass adoption in DeFi.

While it is true that the actions of regulators will play a role in helping risk-averse investors plunge into this new realm, their actions alone will not be enough. That’s because accountability has to be balanced with freedom. Decentralized identification provides what DeFi needs today and well into the future wherever this exciting new industry takes us.

Amit Chaudhary is Head of DeFi Research at Polygon.