Solving the Privacy Paradox in DeFi

Leveraging Midnight for both Confidentiality and Compliance

Originally published on Medium, 16 November 2025.

Decentralized finance (DeFi) has traditionally forced a choice between privacy and transparency.

Most blockchains opt for 100% transparency, making every transaction and balance public. While this creates a trustless system, it’s a non-starter for institutions that need to keep their portfolios and trading strategies confidential from competitors.

The alternative — 100% private system — creates dangerous silos and “blind spots”. Without the required visibility, protocols can’t effectively engage users while managing systemic risk at the same time.

This “mutually exclusive” problem — protocol safety (transparency) versus user confidentiality (privacy) — is solved by a new architecture that separates what is done from how it is proved. Newer generation of blockchains like Midnight.network have native support for this.

And by leveraging Midnight.network, we can achieve both financial transparency and confidentiality for DeFi protocols deployed on EVM chains, like Arc.network.

Arc.network has opt-in privacy on the roadmap

Let’s explore this further with an example.

The Problem Traditional Blockchains Cannot Solve

Consider a high-yield DeFi protocol on Arc.network with a public rule:

The 10% Concentration Limit

No single entity can deposit more than 10% of the protocol’s Total Value Locked (TVL). So that the solvency of a single entity doesn’t put the entire protocol at risk.

On a transparent public blockchain, this check is simple. But the investor is exposed. So how is the privacy of the investor enforced on a public chain?

The Flaw in the “Obvious” Solution

A simple solution is to use Trusted Execution Environments (TEEs) and store a private list of all depositor balances. To enforce the 10% rule, this TEE would need a master view key to read every user’s private balance. This centralized “God-Mode” component is flaw in this solution. It is a single point of failure that, if compromised, destroys the entire protocol’s privacy.

Also Arc.network can offer native privacy for Confidential Transfers (hiding sender, receiver, amount), but the 10% rule requires Programmable Private State — running logic on data you can’t see.

The Correct Architecture: Separating Settlement from Private Logic

Our solution uses three components:

1. Arc.network (The Settlement Layer): This is our “public bank.” We deploy our DeFi protocol on this EVM-compatible chain that holds all the assets and settles the final, verifiable movement of funds.
2. Midnight.network (The Private State Layer): This is our “private logic engine.” It’s a decentralized ZK-VM that runs smart contracts on encrypted data. It can answer questions about private data without revealing it to anyone.
3. TEE (Trusted Execution Environment): The trusted orchestrator that safely handles the user’s private key. Using cryptography and remote attestation, DApp proves that the TEE is running audited code. Through hardware isolation, TEE encrypts the user’s sensitive data while a zero knowledge (ZK) proof is generated, preventing platform operators or hackers from viewing it.

Case Study: Recursive Capital’s Compliant Investment

Here is the flow for an institution like “Recursive Capital” to invest in the DeFi protocol on Arc:

Step 1: The Private Loan (Confidential Transfer on Arc)

First, Recursive Capital needs capital to invest in the DeFi protocol.

1. Recursive Capital collateralizes a tokenized T-Bill to borrow $1M in private stablecoins (pUSD) from a “Vault” on Arc.
2. An off-chain TEE generates a ZK proof using Midnight to attest that Recursive Capital is KYC’d, not sanctioned, and verifiably owns the T-Bill which it will use as collateral to secure the loan.
3. The TEE sends this proof_of_solvency to the Vault on Arc.network. Arc’s Universal Verifier confirms the proof, locks the T-Bills, and issues $1M in pUSD.

Step 2: The Private Investment (Programmable Privacy on Midnight)

The protocol’s “Private Position Ledger” is a ZK smart contract on the Midnight.

1. The Intent: Recursive Capital attempts to deposit $1M.
2. Maintain Privacy (on Midnight): The orchestrator submits a transaction to the ZK-contract on Midnight. It asks: “Recursive Capital wants to deposit $1M. Does this violate the 10% rule?”
3. Decentralized ZK Logic (on Midnight): The Midnight ZK-VM executes the logic in private:

• Information to be shielded or kept private in this instance is identity of the investor and their investment amount in the protocol
• It privately loads Recursive Capital’s current balance (e.g., $0) and the protocol’s private(?) TVL (e.g., $50M).
• It runs the compliance check: Is ($0 + $1M) < 10% of ($50M + $1M)? The check passes.
• It atomically updates its private state: Recursive Capital’s balance is $1M, and private TVL is $51M.
• It returns a “receipt of compliance” to the hybrid dApp.

Final Settlement (on Arc): The orchestrator bundles this receipt, sends the $1M pUSD to the DeFi contract on Arc, and Arc’s Universal Verifier confirms the proof, accepting the deposit.

Conclusion: The Right Tool for the Right Job

We have achieved three key outcomes:

• Financial Transparency: The DeFi protocol mathematically proved its 10% concentration limit was respected, making it verifiably safe from a “whale attack.”
• User Privacy: The institution remained compliant without revealing its identity or total balance to any centralized party.
• Decentralized Trust: We avoided the “God-Mode” TEE with a private investor portfolio. The logic was enforced by Midnight’s decentralized ZK-VM, not a centralized server.

The dilemma is solved by using Arc.network as the ultimate Settlement Layer for compliant transfers, and Midnight.network as the Private State Layer for decentralized, programmable logic on private data.

Together, they enable a financial system that is provably private, compliant, and safe.