In the previous Ethereum Classic (ETC) course, we explained stablecoins, particularly algorithmic stablecoins, how they work, and their risks.
This lesson focuses on privacy coins. We will start with the default privacy level in standard blockchains, introduce the main methods privacy coins use to achieve deeper privacy, and discuss the risks associated with them.
Upcoming lessons will cover:
- Lesson 29: What Are Decentralized Finance (DeFi) Coins?
- Lesson 30: What Are File Storage Coins?
Default Privacy in Standard Blockchains
Blockchains like Ethereum Classic (ETC) and Bitcoin (BTC) are highly transparent. All transactions, smart contracts, balances, and even the code of software clients are public. This openness allows anyone to audit them and verify that they function as designed.
Privacy in these systems comes from users controlling their addresses with private keys, which are kept secret. Public addresses aren't directly linked to identities, individuals, or entities. If users are careful to keep their blockchain activity private, a certain level of privacy is possible.
However, with advances in data science, it's becoming easier for external observers to gather information from multiple sources and analyze economic transactions. This makes it more common for ownership in transparent systems to be uncovered.
What Are Privacy Coins?
Privacy coins aim to enhance individual user security. They make a trade-off: reducing system transparency to increase confidentiality for transactions, addresses, and balances.
These coins use various methods to encrypt or hide sender addresses, amounts, and receiver addresses on their blockchains.
Several privacy-focused cryptocurrencies have been launched, some of which are widely used and see significant transaction activity. The privacy coin sector has reached a notable market capitalization.
Privacy Methods: Zero-Knowledge Proofs
Zcash uses zero-knowledge proofs
Imagine two parties handling secret information. One sends information to the other in a hidden way. The receiver can modify the data or not, then show it to the sender and ask if it was changed. Since the sender knows the original information, they can answer correctly without revealing the content.
After many such interactions, if the sender answers all questions perfectly, it's highly likely the information is genuine—even though the receiver never learns the content. This is the basis of "zero-knowledge proofs."
Zcash is a cryptocurrency that uses this method to create a private blockchain. As of this writing, it is the second-largest privacy coin by market cap, valued at $405 million.
On Zcash, users can choose to send private or transparent transactions.
Privacy Methods: Combined Technologies
Monero uses multiple privacy techniques
The largest privacy coin by market cap is Monero, with a valuation of $2.48 billion. It uses three different privacy technologies:
Stealth Addresses: This technology hides the receiver of funds by creating a "stealth address" for each recipient and each transaction.
Ring Signatures: This type of signature mixes multiple senders' signatures in each transaction, making it impossible to identify the actual sender.
Ring Confidential Transactions: This component uses cryptography to hide the amount of currency transferred in each transaction.
The combination of these three techniques provides users with a high degree of privacy. On Monero, all transactions are hidden by default using these methods.
Other Privacy Methods
Top 10 privacy coins on CoinMarketCap
Other privacy technologies in the industry include coin mixing and Mimblewimble.
Currently, over 70 networks use the techniques mentioned above, or combinations of them, to provide privacy.
As of this writing, the total market capitalization for this sector is $5.3 billion.
The image in this section shows the top 10 privacy coins listed on CoinMarketCap.
Risks of Privacy Coins
A common risk often pointed out is that the transparency of traditional blockchains makes them easy to audit. This helps reveal potential errors or flaws that can then be fixed. However, if privacy coins hide some or all information, it becomes impossible to audit their design, functionality, money supply, and other key metrics.
For individual users, these blockchains provide privacy at the blockchain level. But counterparties might still disclose transaction data to competitors, authorities, or any other third party.
For these reasons, a conventional wisdom has formed in the industry: privacy should be a feature built at higher layers of the technology stack, not at the base blockchain level.
Frequently Asked Questions
What is the main purpose of privacy coins?
Privacy coins are designed to enhance financial privacy by hiding transaction details, such as sender, receiver, and amount, which are typically public on standard blockchains.
Are privacy coins illegal?
No, privacy coins themselves are not illegal. However, some jurisdictions have regulations regarding their use due to concerns about money laundering and illicit activities. Always check local laws.
How do privacy coins differ from Bitcoin?
While Bitcoin offers pseudonymity, privacy coins use advanced cryptographic techniques to provide stronger anonymity by concealing transaction details.
Can privacy coins be traced?
Some privacy coins offer stronger untraceability than others. For example, Monero is designed to be highly private, but no system is entirely immune to advanced analysis techniques.
Why are some exchanges delisting privacy coins?
Some exchanges delist privacy coins to comply with regulatory requirements aimed at preventing financial crimes, as these coins can be harder to monitor.
Should I use privacy coins?
It depends on your privacy needs and risk tolerance. While they offer enhanced privacy, they also come with potential regulatory scrutiny and technical complexities. Explore more strategies for managing your cryptocurrency investments wisely.
Thank you for reading this article!