What are Privacy Coins and How Do They Work?

Cryptocurrency in its many forms, from the pioneering Bitcoin (BTC) to privacy coin Monero (XMR), has the world in rapture and it is not difficult to see why. With coins come blockchain technology as well as a rollercoaster of emotions when their values skyrocket and plummet – perhaps all in a single month. The transparency of the blockchain ledger makes a powerful case for cryptocurrencies. Transactions, including those related to criminal activity, can be traced to certain addresses and can be blacklisted.

And as cryptocurrency is decentralised (there is no one managing institution), criminals cannot simply hack one ‘central bank’ steal all your crypto funds. Does that not sound like a great idea? However, one flaw of its total transparency might be its total transparency. However, this does mean that the ledger is accessible for anyone to check.

To own cryptocurrency, first, you need to set up a digital wallet.

This wallet contains your public (a.k.a the address) and private keys. The address is a string of 34 random alphanumeric characters and is what you use when sending coins to someone. Each address keeps a record of all the transactions (incoming and outgoing) the wallet has been involved in. For non-privacy coins, ledger transparency means that anyone can access transaction history of an address at any point in time.

Privacy Coins

Privacy coins work differently. One popular example of a privacy token is Monero (XMR). XMR is similar to BTC and Ethereum (ETH) in its usage of blockchain technology. However, XMR provides security, privacy and lack of traceability where regular coins do not. For XMR, this is achieved via three types of technologies – ring signatures, ring confidential transaction (RingCT) and stealth addresses. They hide not only the amount of coin being transacted but also the recipient’s address (wallet ID) so that others will not be able to track coin movement.

Zero-knowledge proof (ZK proof) is another method used in cryptocurrency privacy and security. It is a means for someone (the prover) to assure someone (the verifier) that they know “a secret or statement without revealing the secret itself”. Think of it as the ability to gives clues to the location of a treasure, clues that only someone who actually knows the location would be able to give (see the example of “Where’s Wally?”).

For Zcash (ZEC), the zk-SNARKs technology enables someone to prove that a valid cryptocurrency transaction has occurred, even if they do not show a ‘receipt’ for it (addresses involved or amount transacted).

Further obscuring the transaction of privacy coins is the modus operandi of the transfer itself.

In an actual transaction such as with BTC, the coin transfer is straightforward. It goes from Wallet 1 (sender) to Wallet 2 (recipient). Privacy coin transactions work differently.

Take XMR as an example. The transfer is split into multiple parts that bounce around nodes and stealth addresses (not real addresses used by coin owners). Think of it as playing pool. Begin your transaction to send coins by hitting the white cue ball. This delivery, represented by the white ball, then splits into a ton of other parts (number balls) that head in different directions and toward different addresses (table pockets). The overall movement becomes harder to track.

Why the Demand for Privacy Coins?

While we laud the transparency of the cryptocurrency ledger, there are also safety implications such as easy identification of the ‘big fish’. Needless to say, having one’s transaction history laid out for another to see is not particularly reassuring. In this respect, privacy coins provide a higher level of security. 

Another advantage privacy coins such as XMR, ZEC and Dash (DASH) have over Bitcoin is their fungibility. This means that one coin will always have the same intrinsic value as another coin of the same cryptocurrency.

A bitcoin does not always have the same value as another bitcoin. The reason for a depreciated value is in its history, say if it was once involved in criminal activity. This can easily be tracked from its transaction history. ‘Tainted’ bitcoin have a lower intrinsic value than ‘pure’ bitcoin.

While XMR and ZEC are inherently fungible, DASH is not. However, DASH comes with the added function of PrivateSend, which ‘erases’ the transaction history of a ‘tainted’ coin. This coin is now considered mixed. While merchants could still reject my mixed coin, I could still pay him with the same amount in unmixed coins, thereby making DASH ‘fungible’.

Another point for privacy coins comes with their advantages in online payment systems. At the moment, PayPal is a de-facto online shopping payment mode for many (227 million active registered users as of end-2017). However, cryptocurrencies have a strong case as a contender for a few factors:

a) Transaction fees (PayPal fees range from 5-7% while cryptocurrency fees range from USD27 cents (ETH) to free (Nano).

b) Speed of payment

c) Security (hacking my PayPal account is atrociously easy)

d) Cross-border payments (those accursed exchange rates!)

An example of how privacy coins are taking up arms against PayPal is Dash Evolution.

In June 2017, Dash released a “three-year roadmap” for Evolution. According to Dash Core CEO Ryan Taylor, Evolution will be “similar to PayPal or Venmo” and will be“incredibly inexpensive, with no cross-border fees or restrictions.”

How Secure and Private are Privacy Coins?

Despite their namesake, privacy coins are not 100% private. For example, cryptocurrency ZEC allows for selective privacy while XMR is by default, private.

Even the process of coin mixing (which allows coin owners to ensure fungibility of coins by hiding their ‘tainted’ history) is not 100% secure. During mixing, people pool their coins in a cryptocurrency tumbler to be shuffled. The coins are then redistributed in the amounts that they were given. No one knows who the coins first belonged to, thereby allowing privacy.

Coin mixing involves a tumbler, also the middleman, during the mixing process. Thus,  coin mixing begins with you having full trust in the tumbler to not steal your coins. While certain mixing systems such as Coin Join, SharedCoin and CoinSwap negate the risk of theft, there are other caveats to coin mixing such as:

a) If a user is not careful with browser cookies, his or her address can be tracked during payment.

b) All parties must be cooperative in providing the right denomination of coin otherwise the process will be delayed.

c) The number of people who can join the mixing process is limited.

Is there a future in Privacy Coins?

Is privacy negating the raison d’etre of the blockchain?

The blockchain tech sells because of its transparency. For coins like XMR and ZEC, transparency gives way to privacy and security. It would appear then that there are now two main factions in the cryptocurrency community, and the one for privacy is moving towards centre stage. As BTC continues to suffer a lack of privacy, ETH has already made the first move with Metropolis. Phase 1 Byzantium (which includes zk-SNARKs) was implemented in 2018, and Phase 2 Constantinople (to smooth over the issues arising from Byzantium) is slated for 2018.

Does this mean that non-privacy coins will be phased out?

That is not likely as bitcoin is still the global base currency for all the other cryptocurrencies. While ETH, NEO, and litecoin are gaining strength as base currencies, their volume is still much lower than Bitcoin’s. Meanwhile, although 100% blockchain privacy might seem preferable, some transparency is required for auditing. And as governments move toward either acceptance or the banning of cryptocurrencies, factors such as accounting for coins as taxable financial assets also come under consideration.

Indeed, it appears that the world is still in the nascent stages for blockchain and cryptocurrencies. What about you? In which direction do you think cryptocurrencies will head in the future?