What Are Privacy Coins and Are They Legal?

Privacy coins are cryptocurrencies that preserve anonymity by obscuring the flow of money across their networks. They make it difficult to work out who sent what to whom – which is useful if you don’t want anyone snooping on your financial activity.

On Aug. 8, 2022, the U.S. Treasury Department barred customers in the U.S. from using Tornado Cash, a decentralized mixer protocol that enables private transactions on Ethereum, sparking questions around privacy protocols and privacy coins generally. This guide will tackle the questions around privacy coins and how they work.

See Also: Decentralized Mixer Tornado Cash Makes Its User Interface Open-Source

How do privacy coins work?

Take away the privacy-preserving technology, and privacy coins appear pretty similar to coins like bitcoin. They run on blockchains – decentralized ledgers – and are maintained by a network of anonymous validators. But it is the advanced privacy techniques that distinguish privacy coins from the rest of the pack. The largest privacy coins by market capitalization are Zcash and Monero.

Dash originally started life as a privacy-focused coin named “Darkcoin,” but rebranded in 2015 and opted to focus on digital payments instead. Though the project boasts its own branded coin joining feature, CEO Ryan Taylor asserts Dash should not be construed as a privacy coin.

Monero is one of the only privacy coins that is private by default. Unlike Zcash, you can’t turn its privacy functions off. To hide transaction data, Monero uses one-time-use “stealth addresses” for each transaction; “ring signatures”, which group genuine transactions with old “decoy” transactions to make it difficult to work out which transaction is legitimate, and “ringCT”, which hides the amount of Monero sent in a transaction.

Zcash is a privacy coin that also allows for transparent transactions. Private transactions use zero-knowledge proofs: a type of mathematical calculation that signals to the network that something is definitely true – like the validity of a transaction – without publishing additional information about that transaction, like the addresses and the transaction amounts.

Are privacy coins legal?

Privacy coins have come under intense scrutiny from regulators around the world in a bid to crackdown on black markets fueled by privacy coins. Australia and South Korea have banned exchanges from offering privacy coins, while Japan has banned them entirely.

Tightening of “know your customer” laws imposed by anti-money laundering regulators may continue to make life difficult for users of privacy coins. These include the FATF Travel Rule and the AMLD-5 directive set by the European Union.

Is bitcoin a privacy coin?

You might have heard that one of the big advantages of using bitcoin is the anonymity it provides and is why a vast majority of bitcoin’s early years were spent fueling dark web marketplaces as the payment method of choice for criminals.

But the reality is quite the opposite. Bitcoin’s blockchain is public, meaning you can view all of the transactions ever made by any address on the network at any time on public blockchain explorers.

The Bitcoin protocol, like most blockchain networks, does not preserve anonymity. Instead, it preserves pseudonymity: Unless someone has claimed ownership over an address – which looks like a string of letters and numbers – you can’t tell who owns it.

That said, a number of blockchain analytics companies like Chainalysis have produced tools that can considerably narrow down the search. These tools look for relationships in transactions that help companies and law enforcement agencies trace criminals.

That being said, a recent upgrade has launched on Bitcoin’s protocol called Taproot that makes it possible to enhance the privacy of certain transactions by allowing complex smart contract transactions to look like “regular” transactions. However, until Taproot becomes widely adopted and integrated by developers, its effects are limited.

In the meantime, one way of enhancing the privacy of Bitcoin transactions is to use a mixer or tumbler. When you send bitcoin using a mixer, the mixing service jumbles your bitcoin with the bitcoin of other people who want to use the mixer at the same time.

After being sufficiently tumbled, the service will spit out an appropriate amount of random bitcoins to your intended recipient. Since your bitcoin is mixed up with everyone else’s, it is difficult to work out who sent what to whom. Popular examples of mixers include CoinJoin and CoinSwap.

Are privacy coins really private?

Because new analytical tools are being developed all the time, and computers may one day become powerful enough to crack modern encryption methods, it is difficult to label privacy coins truly private. That said, under current encryption methods, they have proven resilient.

Law enforcement agencies are keen to crack Monero transactions to uncover any criminals that use the network. In September 2020, the IRS offered $625,000 to anyone who could crack the network. A company called CipherTrace has filed a patent claiming it has cracked the network, but those within Monero’s community dispute its claims.

Read More: What Is KYC and Why Does it Matter for Crypto?