The Stablecoin Balancing Act

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Title: The Stablecoin Balancing Act
Authors: DARRELL DUFFIE, ODUNAYO OLOWOOKERE, ANDREAS VENERIS
Publication: F&D Magazine
Date: September 2025
Core proposition: "Smart-compliant" payment systems—compliance-by-design embedded in stablecoin blockchains—can simultaneously fight financial crime, protect privacy, and enable efficient large-scale payments.

Problem statement:
- Digital assets such as stablecoins can be "washed" through many accounts, complicating law enforcement efforts to stop money laundering and financing of terrorism.
- Current approaches often force a trade-off between privacy for law-abiding users and effective compliance enforcement.
Key contextual references:
- The approach aligns with the 2023 IMF–Financial Stability Board policy framework for crypto assets, which calls for compliance measures for stablecoin providers.

Core features:
- Identity verification by licensed credential issuers places users within a KYC perimeter; verification is stored on the ledger as a "hashed" certificate.
- Transactions must include zero-knowledge proofs (ZKPs) that demonstrate eligibility within the KYC perimeter without revealing personal data.
- Ledger-embedded smart contracts monitor transactions for risk indicators and enforce responses in real time (on-chain), replacing much of today's off-chain reactive reviews.
Expected user segmentation:
- Some institutions and individuals will select compliance-by-design networks if they value both compliance and confidentiality.
- Others may continue using legacy pseudonymous stablecoin systems with looser compliance.

Zero-knowledge proofs (ZKPs):
- ZKPs allow proving a statement without revealing the underlying data (analogy: proving which poker hand wins without revealing cards).
- In payments, a ZKP proves KYC compliance without revealing identity or personal information.
zkKYC and selective disclosure:
- The KYC perimeter could be implemented using zero-knowledge KYCs (zkKYCs) (Pauwels 2021), combining ZKPs with selective disclosure.
- Verifiable credentials are issued by a government agency or authorized financial institution and stored off-chain in a private digital wallet.
- During a payment, a zkKYC token is embedded on-chain proving KYC status, indicating whether the user is an individual or institution, transaction-amount thresholds, and wallet thresholds—without revealing identity.
Law enforcement access:
- Privacy preserved unless risk indicators (unusual patterns, transfers exceeding designated thresholds, links to known high-risk wallets) trigger smart-contract-generated suspicious activity reports (SARs).
- Authorities may unmask identities only with a legal process that depends on jurisdiction (e.g., warrant or administrative subpoena).

Typical transaction flow:
- Both sender and recipient must be verified by a credential issuer before transacting.
- Wallet generates a zkKYC token that cryptographically proves KYC certification and other relevant flags.
- Smart contracts analyze encrypted zkKYC tokens for SAR criteria and can:
- Allow white-listed routine transfers to proceed seamlessly.
- Delay or flag suspicious transactions and automatically generate SARs.
- Block high-risk transfers involving known offenders.
Interoperability and anchoring:
- For natural persons, verifiable credentials may be anchored to standardized legal documents (passports, driver’s licenses) to mitigate identity spoofing.
- The same approach could be applied to decentralized payment systems based on central bank digital currencies and other digital representations of money.

Performance and computational constraints:
- Significant computational burden for large-scale payment systems to interpret complex and evolving regulations at near-real-time throughput.
- Privacy-preserving mechanisms impose computational costs, risking delays during peak-payment periods.
- Overly simplistic rule implementations risk many false positives and false negatives, potentially overwhelming enforcement authorities.
Friction and interoperability costs:
- Compliance-by-design systems may add frictional costs and delays when moving funds between different payment systems.
Potential mitigations:
- License and manage smart contracts via regulated providers offering compliance-as-a-service, allowing limited access to payment data in exchange for compliance services.
- Advances in applied cryptography and zero-knowledge-proof implementations could improve speed; multiparty computation techniques may help distribute computational burden.

Governance requirements:
- Trusted ecosystem of credential issuers is critical; credential issuers and smart contract operators must be carefully licensed, transparent, and accountable.
- Uniform standards for KYC verification are needed, with verification interoperable across multiple ledgers.
- System-wide compliance quality depends on the least rigorous credential issuer.
Legal due process:
- Laws may need adaptation to specify thresholds for triggering SARs and conditions for authorities to unmask identities.
- Different jurisdictions likely to set distinct due-process thresholds (example: one country may require administrative subpoenas, another may demand judicial warrants).
Cross-border enforcement:
- Effective cross-border enforcement relies on cross-jurisdictional cooperation similar to correspondent banking today.
- Project Mandala (Bank for International Settlements 2024) is cited as an analogous proposal using zero-knowledge proofs for cross-border compliance coordination.

Practical potential:
- Compliance-by-design stablecoin systems can offer a balance between privacy and legal compliance and may make large-scale payment systems both private and compliant.
- The approach is not mandated by the authors; adoption may vary across jurisdictions, and offshore alternative stablecoin systems could persist without this approach.
Policy implications:
- Establish licensing, transparent operation, and interoperability standards for credential issuers and smart-contract operators.
- Consider legal frameworks specifying when SARs are triggered and under what legal processes authorities may obtain identity data.
- Encourage research and development in scalable zero-knowledge-proof implementations and complementary cryptographic techniques.
Broader benefits:
- Stablecoins, if designed with compliance-by-design, could improve financial inclusion, increase payment efficiency, and impede illicit actors.

Source: "The Stablecoin Balancing Act," F&D Magazine, September 2025, DARRELL DUFFIE; ODUNAYO OLOWOOKERE; ANDREAS VENERIS.

The Stablecoin Balancing Act
- The Stablecoin Balancing Act (Markdown version)
- The Stablecoin Balancing Act (PDF)