- Privacy coins are cryptocurrencies that obscure transaction information on the blockchain.
- The demand for privacy on the blockchain is largely pushed by companies as retail cryptocurrency users care less about privacy.
- Decentralized, anonymous cryptocurrencies pose a problem for government agencies fighting against financial crime.
- Read more stories from Personal Finance Insider.
Hundreds of thousands of Bitcoin transactions happen every day. Each transaction and the people involved are recorded on Bitcoin’s blockchain, viewable by anyone. Yet, let’s imagine that you’re buying something you shouldn’t be buying — think bigger than the order of fries you bought with cash so nobody would see it on your credit card bill.
Using Bitcoin would mean your transaction is on display, along with your identity, for prying eyes and law enforcement to see. This is where privacy-enhanced cryptocurrencies come in. Also known as privacy coins, these cryptocurrencies obscure your identity, freeing you up to buy whatever you want.
What are privacy coins?
Privacy coins are cryptocurrencies that obscure transactions on their blockchain to maintain the anonymity of its users and their activity. Participants within a transaction will know the amount transacted and parties involved. However, the same information will be unobtainable to any outside observer.
The anonymity that privacy coins provide offer a potentially appealing outlet for money laundering or other criminal transactions. As such, privacy coins are a point of contention in the ongoing debate around cryptocurrency privacy and regulation.
How do privacy coins work?
For cryptocurrencies operating on public blockchains, any recorded transactions will show the sender, the receiver, and the amount exchanged. The two main privacy coins on the market, Zcash and Monero, obscure this information through different methods.
Zcash offers private and transparent transactions. Users can choose between a t-address, which operates like a non-private cryptocurrency address, or a z-address, which will conceal the identity of the seller. These z-addresses operate on zero-knowledge proofs, which validate that the transaction occurred for both sellers and buyers without revealing any information about the transactions. So in a transaction between two z-addresses, you can identify that a transaction occurred at a certain time on the blockchain, but you don’t have any information on who participated in the transaction and how much money was involved.
Monero has several features that, combined, make it very difficult to identify any transaction information on the blockchain. To start, Monero uses stealth addresses, also known as one-time public keys, which dissociates the two accounts participating in a Monero transaction to outside viewers of the blockchain. At the same time, Monero uses ring signatures, which further hides the identity of the sender by mixing their identity with decoy identities. In 2017, Monero implemented RingCT, which obscures transaction amounts.
What is the purpose of privacy coins?
Privacy coins were designed to preserve the anonymity of people making a cryptocurrency transaction. Yet, for most cryptocurrency users, this is a solution looking for a problem. According to Nirmal Aryath Koroth, co-founder and chief technology officer at Merkle Science, the average cryptocurrency “retail user” doesn’t care about privacy. A study from the University of Massachusetts Lowell came to the same conclusion, finding that Bitcoin users tend to disregard privacy in favor of the simplicity that Bitcoin provides.
Instead, the demand for privacy developments in cryptocurrencies are driven by companies and organizations. For example, if you’re a company like Facebook or Google making a large transaction, “you don’t really want the rest of the world to know that, ‘Hey, I’ve done a transaction,'” Aryath Koroth says. “Because of the need for large enterprises to have privacy, there was a whole new segment of blockchains which came up around privacy.”
Even transactions using publicly traded cryptocurrencies can be concealed. Coin mixers are a prominent method of obfuscation, especially when trading Bitcoin. Two or more transactions are mixed together on the blockchain with decoy transactions so instead of multiple transactions showing up on a blockchain with clear senders, receivers, and amounts, a coin mixer results in one transaction on the blockchain listing all the senders and receivers. Though not as private as a privacy coin, it is still impossible to see who sent what to whom.
Are privacy coins legal?
The legality of privacy coins vary depending on the country. In the US, privacy coins remain legal. However, the Secret Service recommended that Congress regulate privacy-enhanced cryptocurrencies. Deputy assistant director of the Secret Service Office of Investigations Robert Novy told Congress in a 2018 testimony that “criminals are increasingly leveraging anonymity-enhanced currencies and services such as cryptocurrency tumblers and mixers to obscure transactions on the blockchain.”
Countries like South Korea and Japan have banned trading or holding privacy coins altogether, citing them as a potential outlet for financial crimes such as money laundering or terrorist financing. The Financial Action Task Force (FATF) has similarly listed the use of privacy coins as a potential red flag for money laundering through virtual assets.
Some cryptocurrency exchanges have also stopped offering privacy coins as a result of anti-money laundering guidance. In January of 2021, Bittrex, the eighth largest cryptocurrency exchange by volume, announced that it would drop Monero and Zcash from its offerings. Kraken, the fourth largest exchange, delisted Monero in the United Kingdom in November 2021 following guidance from the UK’s financial markets regulator.
A study from the RAND Corporation found that Bitcoin still makes up the majority of cryptocurrency volume on the dark web. A search of cryptocurrencies on the Dark Web Observatory (DWO), which gathers listing information that includes vendors’ accepted forms of payment, shows that Bitcoin was mentioned 57% of the time, followed by Monero at 27% marking a shift in the preferred form of cryptocurrency towards privacy coins.
According to Aryath Koroth, privacy coins are another additional layer to a form of currency that is already an issue for governments. “I’ve spoken to a few law enforcement people. None of them are fans of cryptocurrencies,” Aryath Koroth says.
“Suddenly I can send a million dollars almost instantly, and there’s no geographic restriction,” Aryath Koroth says. “So I think privacy coins? Sure. But I think [law enforcement] dislike cryptocurrencies in general as well, because it’s borderless and it’s instant.”