Why Aren’t Privacy Coins Gaining More Traction? (#121 - 8 October 2022)

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Are privacy coins doomed to fail? Do they have any legitimate use outside of bad actors? Is privacy in payments a topic that deserves more attention?

These are important questions that will try to address in today's issue of the newsletter.

First, what are privacy coins??

Privacy coins are cryptocurrencies that protect the privacy of their users by shielding their identity and the origin of their transactions, with popular examples including Monero and, to a lesser extent, Zcash and Dash.?

Unlike Bitcoin and most cryptocurrencies, privacy coins enable users to leverage blockchain technology and send each other transactions without tracing those transactions back to them.

Each privacy coin has its own technical mechanisms to enable this, with Monero using a three-prong approach to privacy using ring signatures, which hide the true output (sender), RingCT which hides the amounts, and stealth addresses, which hides the receiver.

Privacy coins have always been controversial not only in policy and regulatory circles but also in the broader crypto community.

For example, many argue that privacy coins need to be banned, the argument being that if the end-user is not traceable, then it can create a money laundering or terrorism financing risk. This is why many countries and exchanges ban the trading of privacy coins on crypto exchanges.?

Others believe that privacy coins are almost a fundamental right and in many cases are essential in certain countries where freedom of expression and freedom of speech are at risk and tracing the transactions could allow governments to clamp down on those who oppose them.

In addition, many argue that privacy coins provide the same level of privacy that users enjoy today when using cash, but also when using the banking system, at least when it comes to third parties.

But privacy coins have been back in the news recently.

The high-profile arrests of the New York couple accused of laundering funds connected to the 2016 Bitfinex hack, not to mention the gripping saga of The DAO that we discussed here, highlighted the key role that privacy coins play in facilitating illicit activities.

It was also reported that bad actors like North Korea have been shifting away from traceable coins like Bitcoin to privacy coins like Monero.

However, there is still a big segment of the crypto community that believes in the importance of privacy in payments and that privacy coins have a role to play.

And they (often rightly) argue that the majority of illicit transactions are taking place in some of the traceable cryptocurrencies like Bitcoin.?

For example even on darknet markets, like the shuttered Hydra platform that we discussed here in the past, recent data indicates that Bitcoin remains the crypto asset of choice to launder funds, which is ironic considering Bitcoin’s strong traceability features.

Source: RAND Corporation

Earlier this year, I read an opinion piece in CoinDesk penned by Haseeb Qureshi that talked about the future of privacy coins and that made me reflect.?

According to that article, there are various reasons to explain why privacy coins haven’t become more widely adopted.

• Lack of Demand

Whilst the concept of privacy is obviously highly prized amongst crypto enthusiasts, that doesn’t necessarily mean that traders and investors want to transact in privacy coins.?

That is probably because unlike Ethereum, Bitcoin, and stablecoins like USDT and USDC, privacy coins like Monero are still relatively user-unfriendly, with sometimes confusing wallet setups, poor on and off-ramps, and relatively low levels of liquidity.?

The Ethereum-based privacy system Tornado Cash, on the other hand, (at least up until the sanctions announced by the U.S. Treasury Department in August) managed to gain traction because they brought such privacy features to where people were actually transacting - on Ethereum’s smart contract blockchain - and via popular and widely-held crypto assets. The below chart on the level of activity of Tornado Cash is a good illustration.

Source: Dune Analytics

This is radically different from the Monero ecosystem, where wallets, fiat offramps, liquidity, and general user accessibility are still not very user friendly. This is not surprising as there is always a trade off between user convenience and security/privacy and where that middle ground sits is different for everyone.

• Privacy Is Difficult:?

As we’ve discussed in this newsletter in the past, HTTPS, or the method of encryption used to access virtually every website today, shows us that, in general, people only opt for privacy when privacy is easy to navigate.

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Comparison between HTTP and HTTPS; Source: The Book of Crypto, Henri Arslanian, Palgrave 2022.

Initially, HTTPS was limited to credit card processing purposes, as it was far too?slow to be applied to other sites. But they subsequently became cheap?enough to be expanded without burdening users.?

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Benefits of HTTPS and SSL; Source: The Book of Crypto, Henri Arslanian, Palgrave, 2022.

WhatsApp took a similar path, rolling out end-to-end encryption without ever consulting?its users.

Both cases were foundational for internet privacy, yet neither instance involved user?input or participation.?

Yet privacy coins like Monero and Zcash require relatively high levels of technical sophistication to master, a high burden to place on users concerned about privacy. If these coins are to gain traction, they will need to examine the reasons why HTTPS and WhatsApp became?so successful.

• Privacy Isn’t as Popular as We Think:?

This is controversial and something that would make any CSO roll their eyes.

We can learn a lot about why privacy coins haven’t properly taken off just by focusing on some of the most popular social media apps in existence today.?

Meta openly sells user data to third-party advertisers, and payments apps like Venmo broadcast user transactions for the world to see.

And rather than use encrypted messaging apps like WhatsApp, Telegram, and Signal, all of which are free, a lot of people continue to send and receive messages via SMS, including in advanced economies like the United States (where I never cease to be amazed by how much SMS has traction over messaging apps like WhatsApp or Signal).

The lesson of WhatsApp again provides us with an illustrative example of why privacy?coin adoption remains sluggish around the globe.

For instance, whilst WhatsApp?normalized encryption for its 2+ billion global user base, Monero, and its peers, continue to be primarily viewed through the lens of?suspicion and illicit activity.?

The underlying truth is that the steep learning curve and user-imposed frictions make the?concept of privacy significantly less appealing than most would probably care to admit.?

• Regulatory Clampdown:?

Over the past few years, several privacy coins have been delisted from centralised exchanges globally over money-laundering concerns.?

And whilst major crypto ecosystem assets like Bitcoin and Ethereum have become rapidly normalized thanks to increased demand from retail and institutional investors, those same traders, financial institutions, and corporates are unlikely to rush towards privacy coins, due to the regulatory, AML and broader reputational risks they pose.?

On the contrary, most regulated exchanges or funds actually make a legal undertaking that they will not transact in privacy coins.?

It is unlikely that this regulatory scrutiny around privacy coins will go away anytime soon, so we should not expect things to change here.

I am personally not a fan of privacy coins and believe that at this stage of the development of the digital assets ecosystem, they are causing more harm than good. However, and as I discuss in my last book, I think that ironically one of the flaws of the crypto ecosystem today is that it is too transparent. This is why for the broader long term development of the crypto ecosystem, the topic of privacy in payments in one that deserves attention.

For example, it can be argued that I have more privacy today by making a traditional fiat bank transfer to another bank account via the SWIFT network rather than a peer-to-peer Bitcoin transfer.?

And, inversely, using cash and the traditional banking system are probably safer options for any criminal organization compared to using digital assets. As I often say in my keynotes, if you are a criminal and looking at laundering funds, you should not use Bitcoin unless you want to get caught!

Over the long run, privacy in payments is essential. For example, if a business only operates in stablecoins, one could easily reverse engineer and have a rough idea of its financials. It would be like making your company's cash flow statement public for everyone to see.?

This is why we need to provide privacy in payments but via methods that are user-friendly whilst at the same time ensuring that bad actors are not able to easily use them.?

We covered this debate in a past issue of this newsletter and some of the solutions presented.

But the reality is that how this will happen remains to be seen.

Definitely a development to follow!

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Henri Arslanian

*Please note that this newsletter reflects Henri’s personal views and not those of any organisation he is involved with. This newsletter is for educational purposes only and none of its content should be construed as investment or financial advice of any kind.?