Cryptocurrencies have been praised for the anonymity they offer through the decentralized transactions and other services that they offer. Ever since the creation of Bitcoin (BTC), various cryptocurrencies have been created which retain many of Bitcoin’s features.
However, though transactions are decentralized and somewhat anonymous in the blockchain of cryptocurrencies such as Bitcoin, they are not completely private. What this means is that every BTC used in a transaction can be traced to previous transactions.
This reality gave birth to a new idea for cryptocurrencies with coins that are untraceable and completely private, called Privacy Coins. In this article, we will explain what Privacy Coins are, how they work, and what their main characteristics are.
What Are Privacy Coins?
The term “privacy coins” refers to coins which do not give out information regarding a cryptocurrency transaction. One reason privacy coins were created is to take people’s right to privacy, and apply that to digital transactions or other decentralized digitized services.
A second rationale is that cash should be digitized, as well. Since cash cannot actually be traced unless it is deposited in a bank account and used to buy through that account, there is also a need for cash to be used in decentralized transactions. Hence, using privacy coins promotes blockchain technology with the functions of cash built in.
Another reason is fungibility: one coin is completely equal to another coin. For example, if a Bitcoin is used for an illegal transaction, that Bitcoin becomes “contaminated” since Bitcoin can be traced. And if you happen to be the owner of that tainted Bitcoin, it may become harder for you to sell it because many people won’t accept Bitcoin with such a history. Privacy coins, on the other hand, are untraceable. Therefore, each coin is equal to any other, no matter the history of the coin — even if it’s been used for illegal transactions.
The two key components of privacy coins are anonymity and untraceability.
Anonymity hides the user’s private information (identity) in every decentralized transaction or service. Untraceability makes the transaction information untraceable from third parties. Because of these two components, privacy coins are banned in some countries, such as South Korea. Though the nature of privacy coins seems mysterious, they are beginning to grow in value as well as in terms of community.
Some of the most prominent privacy coins include Dash, Monero, Zcash, Beam, Verge, and Grin.
Before examining each of these currencies to see what makes them unique, let’s take a brief look at how privacy coins work.
How Do Privacy Coins Work?
Just like other cryptocurrencies, privacy coins work through blockchain technology. Every transaction is decentralized, meaning that no third party is required to regulate the transactions.
Transactions are verified by nodes that are part of the network. In order to verify these transactions, nodes need to solve complex mathematical problems that prove that the transaction is valid. After the transaction is confirmed, the information is added to the blockchain, and other nodes update their information.
As a consensus mechanism, privacy coins use Proof-of-Work (PoW), Proof-of-Stake (PoS), or a hybrid version of both PoW and PoS. Each privacy coin may differ in terms of functionality when it comes to what makes it different from other cryptocurrencies — in other words, what makes it “private.”
Here are the main strategies that privacy coins use.
As the name suggests, stealth addresses mean privacy. Every time you receive a coin, a new address is created, making it impossible for others to use your address as a destination in the future. This is one of the simplest ways to ensure privacy in the blockchain.
Some privacy coins use a more complex model of stealth address. This is known as the dual-key stealth address protocol (DKSAP). Each user on this blockchain gets a hold of a private view key, private spend key and a recipient address. The recipient address is the only thing that is visible to others during a transaction. However, the coins you receive do not go to this address, but rather to a different, private, and unique address in the blockchain. The private send key is used to send cryptocurrencies. The private view key is used to look at the funds that are being received.
Ring signatures are another way to ensure privacy. When you sign a transaction with a private key, others can easily link that signature with your address. Ring signatures prevent that. Through a “ring” of random signatures that cosign the transaction with you, it becomes harder for others to link the transaction with your address because there are many signatures taking place. The larger the ring of signatures, the more private your address becomes.
Ordinary signatures. Source: Boolberry
Ring signatures. Source: Boolberry
In addition to ring signatures, one way to ensure more privacy based on their model is Ring Confidential Transactions (RingCTs). In the same way that the address becomes private employing ring signatures, the amount of money involved in the transaction is also hidden.
CoinJoin is a method whereby different transactions join together into a single and larger transaction. Then, a custodian using a never-before-used address takes the coins and distributes them to the desired recipients, as initiated by the senders.
Visual representation of CoinJoin. Source: handwiki
Zero-Knowledge Succinct Non-Interactive Argument of Knowledge (zk-SNARK) is a way of proving or verifying a transaction in the blockchain without requiring transaction details such as amount, sender or recipient address. In this way, transaction information remains private. Moreover, this model of verifying transactions has proved useful in terms of blockchain scalability.
Mimblewimble is a relatively new way of ensuring privacy. It also provides a new model of the blockchain, and many cryptocurrencies are beginning to implement it in their own blockchains. Each block of information consists of the outputs, inputs and signature information. The transaction is simply verified if the inputs equal the outputs. This way, Mimblewimble maintains privacy in the blockchain in a simple and efficient way.
The Onion Router (TOR) is a form of encryption of your IP addresses through many various layers of encryption, resembling the layers of an onion — hence the name “onion routing.”
Visual representation of TOR. Source: 1technation
Pros and Cons of Privacy Coins
So far, we’ve discussed the key features of privacy coins that increase the level of privacy in cryptocurrencies. But as with every other cryptocurrency, privacy coins have their pros and cons.
- Without a doubt, privacy is the biggest advantage. Users are protected from people who want to know more information about a cryptocurrency transaction.
- Financial Security
- Companies and governments are in constant pursuit of people’s financial data. Hence, more and more people are turning to cryptocurrencies as a way to escape this scrutiny. Although Bitcoin and other altcoins do offer financial security by way of decentralization, they don’t offer the same financial security as privacy coins, since every transaction is publicly viewable on the blockchain.
- Same as Cash
- In the same way that cash can be untraceable, privacy coins aren’t traceable. Since using cash is one of the safest and easiest ways to complete a transaction in person, privacy coins as digital cash do so in a decentralized manner.
- Perhaps the biggest disadvantage of privacy coins is that they can be used for illegal activities. Not only that, but they can be used to purchase illegal goods on the black market. They can also be used for money laundering or tax evasion.
- Government Ban
- Because of all the possible ways that privacy coins can be misused, some countries have banned their use. Whenever a privacy coin is banned in a country, its price may drastically decline. This harms the people who have invested in them.
- Transaction Fees
- Since privacy coins have all these extra privacy features not normally present on the blockchains of other cryptocurrencies, they also have slightly higher transaction fees.
Most Popular Privacy Coins
That said, what are some examples of privacy coins with the characteristics we’ve mentioned so far?
One of the biggest privacy coins in the crypto market, Monero uses Proof-of-Work (PoW) as a consensus mechanism. In terms of privacy models, Monero uses both RingCT and Stealth Addresses.
The IRS has offered a bounty prize of $625k for any entity able to solve the privacy technology of Monero. According to Cointelegraph, Chainalysis and Integra FEC are two firms that have managed to come with a solution and collect the bounty.
Price of Monero throughout the years. Source: CoinMarketCap
Dash is another privacy coin that has grown in recent years. It is a Bitcoin fork, meaning that many of its components are the same. The difference is that Dash consists of a hybrid version using both PoW and PoS.
Dash uses PrivateSend and InstaSend on its transactions. Every “round” of PrivateSend is the equivalent of performing one CoinJoin transaction in order to distribute coins to one recipient. InstaSend is a feature of Dash that makes transactions much faster when compared to those using Bitcoin.
Price of Dash throughout the years. Source: Coinmarketcap
Zcash (ZEC) is also a Bitcoin fork. It uses PoW as a consensus mechanism. Zcash uses zk-SNARK as a privacy mechanism, which keeps the amount, sender, and recipient address private from other people not involved in the transaction. A feature that distinguishes Zcash is that privacy is optional, and users can choose which transactions to make private and which ones not.
Price of Zcash throughout the years. Source: CoinMarketCap
Verge (XVG) has also proved to be efficient in terms of maintaining privacy. Originally named DogecoinDark in 2014, the network was rebranded into Verge two years later. Verge uses Tor (or onion routing) as a privacy mechanism. With Verge, the IP addresses of users are encrypted using several layers that make it practically impossible for others to decrypt them.
Price of Verge throughout the years. Source: CoinMarketCap
Beam is a privacy coin that uses Mimblewimble as a privacy mechanism. This model of privacy is relatively new, and is simpler compared to other blockchains. Each block consists of outputs, inputs and signature information, while keeping other information private. Beam also uses Dandelion ++ as a mechanism to promote anonymity.
Price of Beam throughout the years. Source: CoinMarketCap
In addition to Beam, Grin uses Mimblewimble to ensure privacy in the blockchain. Grin is one of the best privacy coins in terms of scalability.
When it comes to mining, Grin differs from other cryptocurrencies because the rate of reward is the same for everyone. It is expected to remain the same in the future, meaning that a miner today may receive a reward equivalent to that of a miner 50 years from now.
Price of Grin throughout the years. Source: CoinMarketCap
The Bottom Line
What can we conclude — after everything we’ve covered so far?
Privacy is an important aspect of cryptocurrencies because of the vast number of hackers that are looking for potential slips from users. Privacy coins have offered a tantalizing glimpse of complete privacy and untraceability.
The dark side of privacy coins is that they’ve been used for tax evasion, money laundering and the purchase of various illicit products. Perhaps programmers can find a way to maintain complete privacy while also prohibiting the use of privacy coins for illegal activities. Even though it may seem impossible for now, the future brightly beckons.
So, with the new found knowledge in crypto, why not sign up to Bybit?