What Are Privacy Coins And How To Investigate Them?

Cryptocurrencies have drawn the attention of illicit actors throughout the years. They have been a target of illicit use in low and high profile malicious activities. As investigators trace and combat these activities to enforce the law and maintain financial integrity, they may find an ally in Bitcoin and other coins that display better transparency than traditional currencies, not privacy coins, however.

Designed to improve user anonymity and confidence, these digital currencies present interesting benefits. Nonetheless, they bring valid questions regarding general financial transparency, regulatory compliance, and misuse. The argument over privacy coins emphasizes a basic conflict between the need for security and transparency and the want for privacy

Today we dissect this debate and inform investigators to better tackle privacy coins in their cases. 

What Are Privacy Coins?

Privacy coins are a subset of cryptocurrencies, they aren’t much like Bitcoin and Ethereum, though. Bitcoin runs on a public ledger known as the Bitcoin blockchain. Everyone can thus view transaction history, sender, receiver, and amount being transferred. Although user identities are not explicitly disclosed, this degree of transparency usually helps detectives in their search for transaction back-off to possibly identify individuals.

Unlike Bitcoin, privacy coins use different cryptographic techniques to obscure transaction information and offer higher levels of anonymity. These techniques can be implemented on public blockchains, rather than necessarily relying on private blockchains. 

For investigators to oversee privacy coins, it’s important to understand how transactions within privacy coins work. First, let’s get familiar with the most prominent privacy coins.

The Most Prominent Privacy Coins

Good examples of privacy coins include Monero (XMR), Zcash (ZEC), and Dash (DASH). Each of these coins employs different methods to achieve privacy. Some privacy coins further allow users to switch up the transaction type between public and private.

Here’s a list of the top in market capitalization privacy coins at the time of writing.

How Do Privacy Coins Work?

Privacy coins use various cryptographic techniques to obfuscate transaction data.    They shield sender and receiver addresses using temporary addresses generated for each transaction. Privacy coins often break down and mix transactions with others before processing takes place, further obscuring the origin and destination of the funds.

Let’s take Monero for instance.

Imagine Bitcoin transactions are like sending a postcard. You write on it how much money you’re sending and where it’s going, then sign it with your own fancy stamp (your digital signature). Anyone can pick up this postcard and see who sent it, where it’s going, and how much is being sent. Not super private.

Monero is more like sending a secret message. You whisper the amount you want to send to a bunch of friends, and they all whisper it to each other in a circle. One of them then shouts out the final amount anonymously. No one listening in knows who actually started the message, or who the final recipient is. That’s how Monero uses ring signatures to hide the sender and receiver.

Regular signatures, like on the Bitcoin postcard, prove you have the money and are allowed to spend it. Ring signatures are like a secret handshake that says “someone here has the okay to spend this money,” but without revealing who it is. 

Monero leverages additional obscuring techniques to further anonymize transactions:

• RingCT (Ring Confidential Transactions): Instead of revealing the transaction amount, RingCT uses cryptography to provide evidence of the legitimacy of the transaction. It mathematically shows that the total amount sent out equals the total amount received, without revealing the exact numbers.
• Stealth Addresses: Every transaction uses a unique one-time address for the recipient. This eliminates the possibility of linking transactions to a single user address over time.

Other examples of privacy coins like Zcash offer optional privacy through zk-SNARKs (zero-knowledge proofs.)

Why Privacy Coins?

Undoubtedly, privacy coins sever the link between a user’s identity and their financial activity more effectively than regular cryptocurrencies. With the senders, receivers, and transaction amounts all obscured, risks of financial data breaches, identity theft, and general surveillance are minimal.

Businesses are equally interested in achieving this elevated level of privacy, with financial confidentiality serving as the cornerstone of their approach. They could obscure transaction details from competitors, regulators, and other inquisitive third parties. 

Privacy coins also enable users to circumvent censorship in footprints with restrictive financial regulations or oppressive regimes. 

If you are not wondering yet, the same advantages have brought forward a foundation of suspicion. 

Risks and Concerns around Privacy Coins

While privacy coins offer compelling benefits to individuals and businesses, such unusual levels of anonymity raise concerns about potential misuse for illegal activities. On this point, regulatory bodies around the globe expressed their concerns about the financial risks accompanying privacy coins differently. 

One of the most significant criticisms of privacy coins is their potential to facilitate age old crimes like money laundering, drug trafficking, and other illicit transactions. Acting on this, many big nations outright banned the use of privacy coins

• China: Completely banned cryptocurrency transactions and offerings in 2017, including privacy coins.
• South Korea: Banned privacy coins on domestic exchanges in 2021. While not technically illegal to hold them, using them is severely limited.
• Japan: Banned privacy coin usage on exchanges in 2018 due to concerns about money laundering.
• Dubai: Recently joined the list in 2023, restricting privacy coin usage due to AML/KYC challenges.

While some countries have restricted privacy coins, others are taking a more nuanced approach. The United States, the European Union, and Singapore, for example, haven’t explicitly outlawed them. However, they’ve implemented robust Know Your Customer (KYC) and Anti-Money Laundering (AML) regulations for cryptocurrency exchanges.

KYC/AML forces exchanges to verify user identities and monitor transactions for suspicious activity. This can help investigators in a few ways:

• Identifying Suspects: If a crime involves cryptocurrency exchanged through a regulated platform, KYC data can help identify the involved parties. This makes investigations faster and more targeted.
• On-chain tracing: Transactions, even with privacy coins used on regulated platforms, still leave a digital footprint on the blockchain. Investigators with specialized tools can analyze these trails to track the flow of funds and potentially connect them to criminal activity.

Privacy coins undoubtedly resemble a significant advancement in the financial ecosystem, with offers of enhanced privacy and security to users. However, their potential for misuse and the challenges they pose to regulatory frameworks erodes the trust they are given by governments and financial institutions. 

A balance that guarantees financial security and protects their privacy is essential for these coins to thrive.

Learn more about cryptocurrency investigation at blockchaingroup.io