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Privacy Coins Primer: Overview, Pros and Cons, Legal Status and How They Work

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Introduction

Contrary to the popular narrative, cryptocurrencies are not completely anonymous in nature. Cryptocurrencies like Bitcoin are actually pseudo-anonymous. This means that though the transacting parties can transact between themselves without revealing their identities, their transactions are still visible on the public blockchain. Third-party firms such as blockchain analytics companies can easily trace these transactions on the public blockchain, which can, in turn, lead them to the attached crypto wallet addresses. These wallet addresses can be linked to the real-world identities of the wallet holders.

Therefore, transacting parties risk having their data revealed and their account transaction logs traced back to them. Privacy coins seek to solve this problem. Essentially, privacy coins have two key characteristics. Firstly, privacy coins provide anonymity by hiding the identity of the transacting party. Secondly, privacy coins also focus on untraceability, preventing third parties or computer systems from following a transaction trail.

Privacy coins have garnered a lot of attention from regulators and law enforcement agencies because of their ability to facilitate money laundering and terrorist financing activities. The FATF’s Ethnically or Racially Motivated Terrorism Financing report pointed out that cryptocurrencies such as privacy coins are increasingly being used by extreme right-wing terrorists who have been gradually shut out of the traditional payment systems.

What are privacy coins?

Privacy coins are a class of cryptocurrencies that aim to facilitate complete anonymization and privacy in blockchain transactions by obscuring the origin and destination of funds. A few of the techniques employed by privacy coins to obfuscate user information include hiding the user’s real wallet balance and addresses, and mixing multiple transactions with each other to evade blockchain chain analysis. Privacy coins run on decentralized ledgers maintained by a network of anonymous validators.

Pros and cons of privacy coins

Pros

  • Anonymity:  Privacy coins offer anonymity to the users by concealing the identity, transaction history, and wallet balance of the users. Lack of anonymity makes crypto users susceptible to data breaches and leaks, for example, some exchanges may without the consent of the user collect their data and develop transaction trackers. Further, governments of various countries also collect information and statistics related to the ownership and transfer of crypto assets. 
  • Additionally, a lack of anonymity may also make crypto owners more susceptible to bad actors such as hackers. For instance, large bitcoin transactions may be publicized on Twitter accounts like @Whale_Alert,  bad actors may misuse this information to trace associated wallet addresses and discover more information about the holder.
  • They make it harder for third party organizations like blockchain analytics firms to track users funds.

Cons

  • Transactions involving privacy coins have a higher transaction processing fee.
  • They can be used for illegal activities such as money laundering because they obfuscate the source of funds and makes it easier for the bad actors to stay anonymous.
  • More and more ransomware actors are demanding payments in privacy coins For example, the criminal hacking group DarkSide, in the Colonial Pipeline attack demanded payment in both Bitcoin and Monero. Another hacking group REvil, in its supply-chain attack against Kaseya, only accepted Monero as payment.

How do privacy coins work?

To effectively preserve anonymity and untraceability, privacy coins employ a variety of different strategies. The most popular of which include stealth addresses, ring signatures, CoinJoin and zk-SNARKs.

Stealth addresses: Privacy coins that use stealth addresses require users to generate new addresses for each transaction. Basically, the senders will use a one-time address for every transaction, even if multiple transactions are done with the same recipient. Doing so ensures that the third-party entities aren’t able to link any future transactions to the receiver’s wallet address used in the previous transaction. For instance, Monero employs dual-key stealth address protocol (DKSAP), obligates the sender to create random one-time addresses for every transaction on behalf of the recipient. The recipient, on the other hand, can publish just one address, yet have all of his/her incoming payments go to a unique address on the blockchain, which uses a cryptographic technique to ensure that this unique address cannot be linked back to either the recipient's published address or any other transactions' addresses. 

CoinJoin:  The CoinJoin mixer combines transactions from multiple users to create a single transaction. CoinJoin then divides that single transaction into multiple small transactions and sends relevant amounts to each recipient. Therefore, each recipient receives coins from a combination of senders instead of one.

Zero-Knowledge Succinct Non - Interactive Argument of Knowledge (zk-SNARKs): zk-SNARKS is a form of cryptographic tool, through which the crypto holders can prove a transaction’s validity without divulging critical identifying information such as names and wallet addresses of the transacting parties. Z-cash — one of the most popular privacy coins — is powered by zk-SNARKs.

Ring signatures: In a blockchain transaction, the sender has to verify every transaction using a digital signature. Ring signatures are cryptographic tools that combine the digital signatures of one user in the ring signature scheme with that of others in the scheme. The higher the number of additional parties in the scheme, the harder it is for someone to connect it to each individual sender.

Are privacy coins illegal?

Jurisdictions such as South Korea, Japan, and Australia have made the use and possession of privacy coins illegal. Further, top privacy coins like Dash (DASH), Monero (XMR), and Zcash (ZEC) have been delisted by multiple leading trading platforms including Bittrex, CoinCheck, Coinbase and ShapeShift. 

The crypto exchanges that are registered in jurisdictions with strict KYC/AML regulations are obligated to collect identifying information of their users, which is not always possible with privacy coins. To avoid being slapped with fines, fees, and outright bans by regulators, exchanges simply choose not to list the privacy coin. Another reason behind delisting is ensuring compliance with the FATF Travel Rule requirement which requires crypto businesses to obtain, hold, and exchange the required originator and beneficiary when transmitting funds

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