Since its inception, the cryptocurrency industry has been characterized by offering increased transparency in financial transactions through public blockchains. However, heightened transparency isn’t always in line with the financial privacy desires of some participants. This is where the debate over the use of privacy coins or anonymous cryptocurrencies comes into play.
On one hand, the transparency of most public blockchains allows for analyzing transaction flows to detect illegal activities. On the other hand, some argue that the same right to privacy existing with physical money should apply in the digital realm.
In this guide, we will address various aspects related to privacy coins: what they are and how they technically function, their legal status and applicable regulatory frameworks, arguments about their benefits and risks, and highlight the most relevant ones currently in existence.
What Are Privacy Coins About?
Privacy coins, also known as “anonymous cryptocurrencies”, incorporate cryptographic features to conceal the identity of users and the details of their transactions. They aim to enhance the anonymity and confidentiality of financial operations on the blockchain.
Unlike traditional cryptocurrencies like Bitcoin (BTC) and Ethereum (ETH), where transactions are public and traceable, privacy coins employ various techniques to make money transactions very difficult or nearly impossible to trace. Therefore, they act similarly to physical cash, which doesn’t leave a public record of every purchase or transaction made by users.
Some of the key features used by privacy coins include:
- Stealth addresses. Single-use addresses are generated randomly for each transaction, making it challenging to link multiple transactions to the same identity.
- Ring signatures. These allow the signing of a transaction on behalf of a group, uniting users in a “ring” so that the actual signer and executor cannot be identified.
- Confidential transactions. This is about concealing the transferred amount in a transaction, allowing external observers to see only that a transaction occurred, but not between which accounts or the amount.
- Zero-knowledge proofs (zk-SNARKs). zk-SNARKs use cryptographic methods to prove the validity of a transaction without revealing any additional details, such as the involved accounts or amounts.
Regulation of Privacy Coins
Privacy coins are under intense regulatory debate regarding their legality and appropriate policies for supervision, due to their features enhancing transaction anonymity.
The legality of privacy cryptocurrencies varies by jurisdiction. Some countries (for example, the United States) still lack specific regulations for them, keeping them in a legal gray area that can impact both the project and its users.
However, other countries have imposed outright bans on their use. For instance, in Japan, privacy coins have been entirely prohibited since 2018. South Korea and Australia have also prohibited their trading on local exchanges.
The main arguments against privacy coins involve their potential use for money laundering and terrorism financing. Nevertheless, there are also legitimate users of these cryptocurrencies seeking to safeguard their financial privacy for various reasons.
Similarly, many centralized exchanges (CEXes) have voluntarily delisted well-known privacy coins like Monero, Zcash, and Dash. This is because their high level of anonymity hinders compliance with regulations such as Know Your Customer (KYC) or Anti-Money Laundering (AML).
Non-compliance with these regulations has resulted in hefty fines for several exchanges, such as Binance, which in November 2023 agreed to pay a $4.3 billion fine for violating regulations and allegedly allowing the use of cryptocurrencies on its platform for terrorism financing.
Benefits and Risks of Using Privacy Coins
Among the main benefits offered by privacy-focused cryptocurrencies are the following:
- They preserve financial privacy and avoid unwanted economic surveillance by making transactions anonymous, and keeping spending patterns, balances, and user data concealed.
- Privacy coins facilitate sensitive transactions such as donations, purchase of prescription-free medicines, remittances to sanctioned countries, etc.
- Privacy coins protect political dissidents, activists, or persecuted minorities from receiving and sending funds without being detected by authoritarian regimes.
- They also prevent economic discrimination by keeping transaction details and amounts hidden, among other reasons.
However, the use of privacy cryptocurrencies also entails some risks, such as:
- Use for financing illegal activities like tax evasion, money laundering, terrorism, and drug trafficking, among other crimes.
- Loss of transparency in the economic and financial system, which is required for auditing, supervision, and combating white-collar crimes.
- Facilitating scams and financial fraud by not leaving a transaction and fund trail for victims to prove the crime.
- Being more private, it is nearly impossible to regain access to funds in case of losing crypto keys.
Examples of Privacy Coins
Here are some noteworthy and popular examples of privacy coins existing:
- Monero (XMR). Launched in 2014, XMR is considered the quintessential privacy coin. It employs cutting-edge cryptographic resources like ring signatures, ring confidential transactions, and stealth addresses to completely hide the details of all transactions. It has solidified its position as one of the most used cryptocurrencies on the dark web.
- Zcash (ZEC). Launched in 2016, ZEC relies on the innovative zk-SNARK technique to validate transactions without revealing the underlying information. While it allows both public and private transactions, its “shielded” mode ensures absolute anonymity of participants and involved amounts.
- Dash (DASH). Launched in 2014 as Xcoin, the project rebranded to Dash, distancing itself from the darker uses attributed to anonymous cryptocurrencies. While Dash stems from a Bitcoin fork, it implements the CoinJoin method (a privacy feature where several users gather to mix their coins and execute a single transaction) under the name PrivateSend to blend funds from various users and blur their origin.
- Oasis Network (ROSE). Launched in 2018, ROSE is a blockchain platform focused on privacy and computational confidentiality concerning smart contracts. It employs trusted execution environments (TEEs) to ensure confidential processing without third-party access to data.
Privacy coins have emerged as a solution in the crypto ecosystem for those who believe that the transparency of public blockchains poses a threat to financial privacy. Through innovative cryptographic techniques, they can conceal the identity of users and transaction details.
However, this increased anonymity conflicts with regulatory efforts to prevent financial crimes and maintain transparency in the system. Therefore, while some celebrate the potential inclusion of anonymous cryptocurrencies, others warn about their inherent risks.