What Does Government Regulation Mean for Privacy-Focused Cryptocurrencies?

As the drumbeat of government regulation for cryptocurrencies becomes louder, what do current developments mean for coins that are focused on user privacy? 

In recent times, governments and regulators around the world have highlighted the utility value of bitcoin and cryptocurrencies to criminals. For example, Treasury Secretary Steven Mnuchin recently said he wants to make sure that cryptocurrencies do not fall into the hands of “bad guys.” (See also: Steven Mnuchin Doesn't Want Bitcoin To Become A 'Swiss Bank.') 

Their attention is expected to make cryptocurrencies transparent so that consumers and businesses are comfortable with using them. This may be good news for institutional and business investors, but they may be a setback for privacy-focused coins that have enhanced or, in some cases, doubled down on bitcoin’s privacy features.  (See also: The Rise Of Private Cryptocurrencies.) 

Does regulation and increasing transparency in the bitcoin ecosystem spell the death knell for privacy-focused coins? More specifically, should investors bother to invest in such coins given the prospect of regulations that might strip them of privacy features? 

To understand the future of privacy-focused cryptocurrencies, it is first important to understand the need for such coins. Although it claims to be anonymous, bitcoin is, in fact, a public currency. Bitcoin transactions are recorded on a public ledger. It may not be possible to trace bitcoin addresses back to their rightful owner, but it is definitely possible to know details of transactions, such as amounts and location of the cryptocurrency.

In addition, linking your real identity to a bitcoin address makes it possible for others to see details of your financial transactions without your permission. What’s more, bitcoin can also be stolen from an exchange that does not have adequate security measures. In sum, bitcoin is not as secure and private as its developers would like you to believe. 

Privacy-focused coins improve on bitcoin’s flaws to make transactions and identities untraceable. 

For example, Monero, which is the most well-known of all privacy coins, was developed using the CryptoNight Proof of Work protocol and uses “ring signatures” which “obfuscate” the public ledger, making it impossible to detect the source and endpoints of a transaction.

Among other things, in practical terms, this means that it is not possible to know the consolidated total of Monero coins held by a particular node. Not surprisingly, the WannaCry ransomware hackers chose to convert their stash into Monero to evade detection by authorities. (See also: An Introduction To Monero.) 

More evidence of Monero’s robust privacy measures became evident during the U.S. government’s seizure of AlphaBay, the dark net’s most popular marketplace. Even after they closed it down, authorities said they were unable to estimate the amount of Monero, which was the most popular cryptocurrency used for transactions there, floating around in the marketplace.     

Another example of a cryptocurrency that incorporates privacy features is Dash, which is competing with the likes of Litecoin and bitcoin to become a cryptocurrency for daily use. Its privacy feature is called PrivateSend and uses the “CoinJoin” technique of mixing up transactions that makes it difficult to identify the owner and recipient of coins for certain transactions on its blockchain. 

At first glance, the protocols and examples provided above might make it seem that criminal activities and actors are the primary use cases and users for privacy-focused coins. But when one considers current regulations for commercial transactions, utility of privacy features dramatically expands.

A new class of coins, which bridge the gap between the anonymous world of cryptocurrencies and the real world of business applications and commercial transactions, has emerged to take advantage of this space. For example, Ripple and ZCash have included functionality that enables disclosing of transaction data and identity metrics to comply with regulatory agencies. (See also: 'Zero Knowledge Proofs' Could Boost Blockchain Adoption On Wall Street.) 

Dash’s PrivateSend feature is optional. This means it can be utilized for transactions that users of the cryptocurrency would like to keep hidden from the public blockchain. As an example, rent payments and salary information can be hidden from other users.

“Privacy is important for many practical reasons including user safety, so we believe it is an important aspect to incorporate into our solutions,” said Ryan Taylor, CEO of Dash. “It is also a safety issue for users that could be targeted by criminals that become aware of a user’s holdings by tracing their transactions.” (See also: Dash Races To Build Payment Systems Network For Tomorrow.)  

Noted cryptocurrency investor Barry Silbert expressed the same view at a cryptocurrency conference recently. “Around the world, people will want money that is not accessible to others,” he said. Silbert is an investor in ZCash, a coin that is being tested by Wall Street banks for transactions.   

Rob Viglione, co-founder of ZenCash - a cryptocurrency focused on privacy and security - said such coins also empower individuals in repressive political regimes. For example, Venezuela and Zimbabwe have reportedly witnessed a surge in the use of cryptocurrencies as their economies deteriorate. In fact, users in these countries are willing to pay a premium to own bitcoin. 

“Competitive pressures and market demand will likely push most cryptocurrency projects to adopt strong privacy primitives,” said Viglione, adding that high-encryption techniques that enable masking of user and transaction identity will “likely be pervasive across future money.”

Government regulation is mostly focused on making virtual currencies accountable and transparent in their transactions. But it could also have an adverse effect on cryptocurrency valuations. (See also: SEC Chair Testified About Cryptocurrency Regulation Before Congress.)

“Increased scrutiny may make them (cryptocurrencies) a riskier investment for more traditional traders/investors,” said Sheffield Clark, CEO of Coinsource, an operator of bitcoin ATMs. But he said privacy-focused coins will always have use cases in places with restrictions on personal freedom and for individuals interested in transferring funds to family and friends “or engaging in commerce without state scrutiny.” 

The market size for such use cases is still unknown, but there is a good chance that privacy might become a key selling point for cryptocurrencies in the future. 

“Competitive pressures and market demand will likely push most cryptocurrency projects to adopt strong privacy primitives,” explained ZenCash’s Viglione. “Just as https has slowly replaced http across the Internet, zk-SNARKS (a zero-knowledge cryptography protocol used in ZCash) or other high-encryption techniques will likely be pervasive across future money.” 

Investing in cryptocurrencies and other Initial Coin Offerings ("ICOs") is highly risky and speculative, and this article is not a recommendation by Investopedia or the writer to invest in cryptocurrencies or other ICOs. Since each individual's situation is unique, a qualified professional should always be consulted before making any financial decisions. Investopedia makes no representations or warranties as to the accuracy or timeliness of the information contained herein. As of the date this article was written, the author owns small amounts of bitcoin.