Brought to you by the Liquid team to help you make sense of crypto.
Over the past decade, we’ve seen explosive and unprecedented growth in the cryptocurrency market. With this growth, many people have been discussing the importance of financial privacy.
Flying the flag for privacy are what we call privacy coins.
In this article, we'll learn all about what are privacy coins and why privacy is such a hot topic.
We will cover:
- Anonymity vs privacy in cryptocurrency
- What makes a cryptocurrency private?
- Use cases of private cryptocurrencies
As the cryptocurrency industry has progressed, projects and cryptocurrencies tailored to different purposes have been created. Some, like Monero (XMR), were created for one simple purpose:
private and fungible digital money.
Anonymity vs privacy in cryptocurrency
If you’ve kept up with Bitcoin’s rollercoaster history, you’re probably familiar with Silk Road, the infamous online black market that accepted Bitcoin as a form of payment.
Following Silk Road’s shutdown by the FBI, the word “Bitcoin” suddenly became synonymous with drug dealers, cybercrime and money laundering.
Shortly after, Bitcoin’s “high tech hacker and criminal money” stigma caused people to associate it with “private money” or “dark money”.
But Bitcoin was not designed with privacy in mind. In fact, Bitcoin’s ledger is 100% transparent – every single transaction, including details about its origin, destination, and value, is recorded on a publicly accessible blockchain for everyone in the world to see.
While Bitcoin doesn’t offer much in terms of financial privacy, it does offer a certain degree of anonymity or physical identity disassociation when used in the proper fashion.
A Bitcoin wallet address is a unique combination of 27-34 letters and numbers. At first glance, this random string of characters may seem private and anonymous, but that’s not the case at all.
So why isn’t Bitcoin private?
Bitcoin’s blockchain is 100% public. This means you can head over to Blockchain.info, a Bitcoin block explorer, and look up origin, destination and value details of every Bitcoin transaction since the birth of the network.
Wallet balances are also publicly displayed. For example, let’s use Blockchain.info to inspect this address: 3D2oetdNuZUqQHPJmcMDDHYoqkyNVsFk9r.
As you can see in the image above, this wallet address holds approximately 183,000 BTC and holds the first position on Bitcoin’s “Rich List”, at the time of the screenshot.
In the transactions section, the origin, destination, value and date of each transaction is clearly displayed. Since Bitcoin’s blockchain doesn’t obscure transaction details and wallet balances, we can definitively conclude one simple statement:
Bitcoin is not private.
Why is Bitcoin (sometimes) anonymous?
Depending on how it’s used, Bitcoin can offer anonymity – kind of. On a macro level, anonymity with Bitcoin can be achieved by disassociating your physical identity with your Bitcoin wallet address.
While this may sound simple on paper, it’s actually quite challenging to pull off in the real world - especially if you’re someone who’s interested in using the Bitcoin network to transact on a regular basis.
Consider the following examples.
- Alice pays 0.5 BTC to Bob in person. After this transaction, both parties become aware of each other’s wallet addresses and complete transaction histories.
- Charlie sends 1.5 BTC from his hardware wallet to his Coinbase account to exchange to USD. After sending the Bitcoins, Charlie’s hardware wallet address is now associated with his physical identity.
- David receives a portion of his monthly salary in Bitcoin. Since he had to give his Bitcoin address to his employer, the company’s accounting department is aware of David’s financial history on the Bitcoin network.
From the above examples, we can see the only way to remain anonymous is to avoid both direct and indirect links to one’s physical identity.
That's no easy task.
Maintaining anonymity with this level of security and discretion is exhausting and impractical for casual day-to-day transactions.
What makes a cryptocurrency private?
Now that we’ve established Bitcoin’s lack of privacy, let’s discuss four features of a truly private cryptocurrency:
A private cryptocurrency should make it a priority to conceal users’ wallet balances and transaction histories. Transaction details should only be visible when a user wants it to be.
Furthermore, it should be impossible to generate a “rich list”, a list of the richest wallet addresses on the network, with a private cryptocurrency.
A private cryptocurrency needs to be fungible, where two units of the cryptocurrency are always identical and interchangeable. In the physical world, two examples of fungible assets are USD1 and 1kg of gold:
a USD1 bill can always be substituted with another USD1 bill, and 1kg of gold can always be substituted with another 1kg of gold.
Bitcoin is not a fungible asset because its transparent blockchain enables blacklisting of coins and wallets based on their previous transaction history.
In other words, an entity can choose not to accept Bitcoins with a questionable or criminal transaction history, making those coins less valuable than ones with a clean transaction history which can be freely transacted on the Bitcoin network.
Bitcoin’s lack of fungibility isn’t just a theory. Back in March 2018, the USA’s OFAC stated they were considering:
...adding digital currency addresses to the SDN List to alert the public of specific digital currency identifiers associated with a blocked person.
Based on this, we can see the importance of fungibility and how it is a cornerstone principle of a truly private and useful cryptocurrency.
Private cryptocurrencies should be sufficiently decentralized to ensure a trust-less and safe environment for value transfer.
In an ideal scenario, a private cryptocurrency should have a few layers of decentralization including geographical locations of nodes, a proper consensus algorithm, mining hash power distribution and more.
This is a simple concept – is there a demand for the cryptocurrency? If no one is willing to accept it, then it can’t be used as private digital money.
Use cases of private cryptocurrencies
Now that we’ve discussed what makes a cryptocurrency private, let’s go over a few use cases of private cryptocurrencies.
Since a private cryptocurrency is fungible and cannot be individually discriminated against based on previous transaction history, it can be used as digital cash.
When you transact with a friend with Bitcoin, he or she will be able to see your whole transaction history and associated wallet addresses.
Personal wealth storage
Since a private cryptocurrency does not display wallet balances on the public blockchain, it can safely be used as personal wealth storage. When you open up a bank account, your balance doesn’t appear on a public website for the whole world to see.
The same privacy standards should apply to a “crypto bank account”, and this is most definitely not the case with Bitcoin.
Getting paid in cryptocurrency
Since a private cryptocurrency provides unlinkability between sender and receiver, it’s a great medium of financial exchange between employer and employee.
Currently, the majority of cryptocurrency-based compensation relies on Bitcoin, which has a completely transparent ledger. Unless you use a unique Bitcoin address just for interacting with your employer, they will be able to see your past transaction history on the network.
This could result in profiling based on your financial history.
This content is not financial advice and should not form the basis of any financial investment decisions nor be seen as a recommendation to buy or sell any good or product. Trading cryptocurrency is complex and comes with a high risk of losing money, particularly if you trade on leverage. You should carefully consider whether trading cryptocurrencies is right for you and take the time to learn how trading works and decide how much money you are prepared to lose.
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