What are privacy coins and why do we need them?

This post is part of a broader series on blockchain technology. In prior posts, I’ve discussed the historical context of blockchain networks and have provided detailed explanations of protocols, DApps, and ICOs.

In my next few posts, I’m going to slightly shift gears and discuss the issue of privacy. This article will examine what it means to have privacy on the blockchain and provide an argument for why we need it. In follow-up posts, I’ll explain how the top privacy protocols work and debate the pros and cons of each. Alright, enough of the overview, let’s dive in!

In recent years, cryptocurrencies such as Monero, ZCash, and Dash have become increasingly popular by promising to provide users with “privacy” that public blockchains like Bitcoin and Ethereum cannot. But what exactly does it mean to have privacy on the blockchain? It means that users can (i) complete anonymous transactions and (ii) maintain private account balances.

Privacy coins provide these benefits by obscuring the sender’s address, the receiver’s address, and the transaction amount when executing each transaction. They do this by implementing a number of complicated cryptographic techniques into their protocols. Monero uses Ring Signatures, Stealth Addresses, and Ring Confidential Transactions, ZCash uses zk-snarks, and Dash uses CoinJoin. I’ll be providing additional detail on the mechanics of each of these techniques in my next post but for right now, the takeaway is that these protocols enable truly anonymous payments.

That leads us to an important (and highly controversial) question: why do we need anonymous cryptocurrencies if we aren’t doing anything illegal? Surprisingly, there are several legitimate arguments for why we need anonymous blockchain networks. That’s what we’re going to be discussing next.

There are two core issues with public blockchains like Bitcoin and Ethereum that are addressed by privacy coins. First, public blockchains provide pseudonymity rather than anonymity, which will likely lead to full financial transparency. That would be a huge invasion of privacy. Second, the transparency provided by public blockchains threatens the fungibility of their cryptocurrencies. I know that was a bit of a mouthful so let’s break down each of those issues through a series of questions.

Issue #1: Public blockchains are pseudonymous rather than anonymous; as such, every transaction can be linked to its participants. This will ultimately lead to full transparency, which is an invasion of privacy.

To understand this argument, we must first ask: what exactly does it mean for a network to be pseudonymous?

Pseudonymous simply means that users interact under a false name (similar to a singer using a “stage name” or a writer using a “nom de plume”). To illustrate, let’s consider an example. Have you ever heard of Joanne Murray? I’m guessing not. That’s because Joanne uses a pseudonym. When Joanne publishes her content, she publishes under the name “J.K. Rowling”. Why would she do that? Most likely because she wants to live a normal life. Using a pseudonym allows her to walk around and introduce herself as Joanne Murray without anybody knowing that she is one of the most prolific fiction writers of all time. Unfortunately, the problem with using a pseudonym is that once you are linked to the fake name, the pseudonym becomes useless. Aka once I know that Joanne Murray is J.K. Rowling, I immediately link her to every work she’s ever written and understand that she will likely make more in one year of royalties than I will earn in my entire lifetime.

Public blockchains like Bitcoin have the exact same issue. As I discussed in my prior post, blockchain protocols typically use public / private key cryptography. With public / private key cryptography, each user’s public key essentially acts as their pseudonym. Every payment that they send or receive goes through their public key and is recorded on Bitcoin’s transparent ledger for all to see. Similar to our J.K. Rowling example, as long as the world cannot link you to your public key, they cannot tie you to your transaction history. However, the second that somebody connects you to that number, they can comb through the blockchain and link you to any transactions completed by your public key.

Is there any way to keep people from linking us to our public keys?

Unfortunately, that’s not really an option. If you want to make or receive a payment using a public blockchain protocol, you will need to distribute your public key. For instance, if your friend needs to pay you 1 BTC because he bet you that the Yankees would make it to the World Series this year, the only way for him to send you that 1 BTC is to send it to your public address. Of course, as we discussed above, once he knows your public address, he’ll be able to see every financial transaction that is tied to it.

Will anybody else be able to see my transaction history?

You might be thinking, well I guess it’s not that big of a deal if my friends and colleagues can see my financial history. I don’t love that they can see how much I spent on Yuengling last year but I trust them. Unfortunately, your friends aren’t the only ones that will have access to this information. As blockchain networks gain in popularity as a medium of exchange, it will be easier for third parties to link people to their public keys, eliminating any remaining privacy. If you don’t believe me, check out this article in the MIT Technology Review, which details how online merchants often leak information to third parties that can be used to link customers to their public addresses. If that’s not enough, take a look at the website for Chainanalysis, a company whose sole purpose is to track transactions and provide transparency to the blockchain.

Clearly, the pseudonymity provided by public / private key cryptography will eventually give way to full transparency as blockchain networks increase in popularity.

Why should we be worried about full transparency if we have nothing to hide?

There are a few reasons. First, this level of transparency will hinder the adoption of cryptocurrencies. Most people consider financial transparency to be a huge invasion of privacy and will not be willing to switch from centralized services to decentralized services if their activity is publicly available. Second, privacy is critically important for business. Businesses may want to use smart contracts with customers and suppliers; however, they will not be willing to do so if those contracts are visible to the world. Why? Because this level of transparency could tip their strategy to competitors, which would be detrimental to their long-term success. Third, privacy matters for the fungibility of cryptocurrencies, which we describe in more detail below.

Issue #2: Full transparency threatens the fungibility of cryptocurrencies.

What does it mean for a currency to be fungible?

Fungibility means that goods / commodities / currencies are completely interchangeable. It means that a one dollar bill is worth $1 no matter where it came from or what is was previously used for. Similarly, for cryptocurrencies like bitcoin, fungibility means that 1 BTC is worth 1 BTC no matter what. Unfortunately, the radically transparent nature of cryptocurrencies may impact their fungibility. Because we can track all of the previous transactions that are tied to a particular coin, it is possible for people to reject coins that have been stolen or previously used for illicit activities. Does that sound a little far-fetched? It’s not. There have actually been numerous cases where users and exchanges have rejected coins due to their past history. If that occurs en masse, those cryptocurrencies will no longer be fungible because “clean” coins will have greater value than “dirty” coins.

Why does it matter if a currency is fungible?

It matters because currencies that are non-fungible place an additional burden on exchanges and consumers. If cryptocurrencies lose their fungibility, exchanges and consumers will be forced to check the transaction history of every coin that they purchase. If they don’t, they might be the last person standing with a “dirty” coin that has limited value. That is unacceptable if cryptocurrencies are expected to act as legitimate mediums of exchange.

Luckily, privacy coins solve both of these issues. By obscuring transaction addresses and amounts, they provide users with privacy and make it impossible to view a coin’s history, mitigating the issue of non-fungibility.

 

Clearly, there are very legitimate reasons why privacy coins should exist. Unfortunately, there is also a pretty strong argument against them, which has been articulated by a plethora of governments and regulatory agencies. Authorities are terrified that privacy coins provide the perfect mechanism for obscuring criminal activity by enabling untraceable money transfers. In fact, Robert Novy, the deputy assistant director of the Secret Service’s office of investigations, went as far as to say that privacy coins are “one of the greatest emerging threats to U.S. national security”. He’s not the only one that’s concerned. Japan, a country that has historically been one of the biggest proponents of crypto, has banned all cryptocurrencies that provide any degree of anonymity to end users. It’s clear that regulators are worried and are starting to implement policies that will have a big impact on the development and use of the technology.

With strong arguments on both sides of the issue, it’s a little bit unclear what the best solution is. While regulators have well-founded concerns, I don’t think that an all-out ban is appropriate as the need for privacy is legitimate and is not going away any time soon. On the flip side, providing a wall for criminals to hide behind doesn’t seem like an appropriate solution either.

Therefore, as is the case with most innovative technologies, my guess is that the winning protocol will lie somewhere between the radical transparency of public blockchains and the full anonymity provided by today’s privacy chains. This hybrid solution will need to incorporate some functionality that allows it to be monitored for illegal activity; however, it will also need provide sufficient privacy to end users, meaning that transaction histories and account balances must not be publicly accessible.

Is that solution possible? TBD but I’m excited to continue to learn about the issue, be a part of the conversation, and see how everything unfolds!

That wraps up my overview of privacy coins, I hope you found it interesting! Stay tuned for my next post, which will break down how these privacy coins work and discuss the pros and cons of each. If you enjoyed this post and would like future posts sent directly to your email, please subscribe to my distribution list or reach out to me at [email protected].

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