The future of unhosted or private wallets - anonymity or full disclosure?

Regulators tighten controls

In its original conception, transactions and the storage of digital assets on the blockchain were anonymous. With the gradual emergence of global AML regulations, the digital assets industry is becoming more like a traditional financial market, where regulators in many countries require digital assets service providers to fully disclose the identity of customers and their assets.

The question remains whether anonymity will be possible when dealing with virtual currencies in the future. In addition, requiring transparency of transactions conducted by licensed entities, regulators around the world have long raised alarms about the risks associated with an illicit financial activity, such as money laundering and terrorist financing from the use of private wallets for digital assets. On the one hand, the FATF's recent 12-month review acknowledges the limited risk that private digital asset wallets currently pose compared to traditional financial channels. However, their assessment urges the global regulators to monitor closely the situation and take restrictive measures if risks increase. Proposed measures include placing limits on transactions with unhosted or private wallets, limiting the ability of regulated financial institutions to conduct transactions with those, not allowing the licensing of such platforms, or even outright banning them.

The private or unhosted wallet’s future has not yet been defined

It is important to note that there are currently no global regulations governing private wallet providers. Private wallet providers have no access to customer data and cannot exert influence by the platform developer, thus they cannot conduct transactions or dispose the assets on behalf of third parties. The client using such providers is comparable to the holder of cash in a traditional pocket wallet or the owner of a safe deposit box. It is up to the customer to decide how and when to dispose such virtual funds, but they have access to such a private wallet anywhere in the world via the internet.

The main reasons for the regulators' concerns are a rapid development of decentralised networks and emerging technologies, where services are provided via mobile phones, bypassing central banks, and regulatory requirements between countries (cross border issues). The regulators are aware of the danger of not being able to access such networks in case of criminal activity.

Anonymity has limits

Referring back to anonymity, it is only relevant if the wallet users remain in the virtual currency blockchain environment, maintaining the ability to transfer virtual coins from one wallet to another anonymously. However, as we know, the virtual currency finance environment is still not fully accepted in the real economy, and owners of such virtual coins will sooner or later be forced to convert virtual funds into local currencies to meet their daily needs. To convert, they will have to turn to a regulated intermediary. Consequently, this is where the anonymity ends. As mentioned earlier, most regulators try to comply with the FATF requirements by conducting full customer identification and transaction monitoring. So, the question arises, whether the regulator should actually impose restrictions on private wallet holders since at some point the customer will enter the regulatory environment anyway and by then at the latest traditional KYC rules will be applied to them.

Balance between regulation and DeFi development needed

Given the weak agility of traditional market participants, the potential and advantage of new blockchain technologies, which could significantly transform the architecture of financial services and the meaning of the internet by disrupting the existing order of physical things, is well established. In terms of transparency and efficiency, such changes are most beneficial to the regulators themselves. Unhosted/private wallets are a derivative of the evolution of the digital assets industry and are being developed by third parties to provide private key storage services to the public. Restricting or limiting such a process may have the effect of inhibiting the spread of the technology itself, but will not inhibit illicit financial activity.

The question of how to treat unhosted wallets is not straightforward and requires joint consultation between regulators, developers and the private sector. Without a full understanding of the situation, no fateful decisions should be made for the future of the financial and DeFi industry.