Over the past few months, private crypto assets, commonly known as privacy coins, have been under pressure due to recent AML regulations recommended by the FATF (Financial Action Task Force). In this article, we explain why preserving the privacy of monetary systems is important, and why it should matter to its stakeholders. Furthermore, we will outline how privacy coins can continue to be compatible with the new FATF Recommendations. Before getting into the impact of regulations on privacy coins, let’s go over how privacy coins introduce a new layer of security to databases, how they differ from Bitcoin and what their regulatory implications are.
Privacy coins are digital assets designed for private payment transactions. A transaction can be defined as private if no third-party is able to reveal the amount of payment being sent, the sender and the receiver of that transaction. You may be asking if that is already the case with Bitcoin. Bitcoin is actually neither private nor anonymous but is pseudonymous. That means if you don’t have information about who is behind a specific Bitcoin address, you will only see the amounts of bitcoin sent through the network. However, if an entity has further details about various bitcoin addresses, like an exchange, that entity can detect monetary flows between institutions and their customers.
With privacy coins, this information is concealed due to the utilization of different cryptographic systems. These systems allow a decentralized network to check whether transactions are valid, but don’t reveal other details. The fundamental concept in which many privacy coins are built on is called zero-knowledge proof. Let’s look into the problems that could arise when entities are required to reveal monetary flows containing sensitive information.
The Importance of Maintaining Privacy in Digital Assets
Preserving Individual Privacy
Imagine you are a regular user of a digital asset like bitcoin, and you, your co-workers and friends all receive salaries in bitcoin. The Bitcoin blockchain would contain pseudonymous information about your salary, your standard expenses and all transactions completed by your friends and the third parties involved. Note that we are only talking about legal transactions and not money laundering activities. It’s fair to assume that most of these transactions will flow through a handful of payment providers. What happens in the event that a payment provider gets hacked, and the data linked to certain Bitcoin addresses is leaked? All of your financial activities become visible and accessible to the public. Engineers can also utilize machine learning tools to track exactly where the funds have come from. Now you might say, “I’m not involved in any illegal activities.” If that’s the case, and there’s nothing to hide about your financial life, then why not make your bank account or PayPal records public?
This is because privacy doesn’t only concern the proliferation of illegal activities, but is also about providing users the assurance that they are not being monitored without permission. If you think about it, there are several aspects of your digital identity you want to keep private: your email inbox, your WhatsApp and Telegram messages, your YouTube history, etc., along with your bank account transactions.
Keeping a Competitive Advantage
Let’s look at a scenario where a business accepts Bitcoin payments. It could either accept bitcoin from a wallet-to-wallet transfer, or more likely, it would use a payment provider to process its transactions. As with the example above, let’s assume that the payment provider gets hacked or the data is stolen. It would be unfortunate if a corporation like PayPal got hacked and transaction details were leaked, but with a blockchain-based system like Bitcoin’s, the aftermath would be even worse — it could result in a situation where not only your revenue as a business becomes visible to competitors, but your suppliers, business expenses and all sales deals would be exposed to the public. Most businesses are intent on keeping their affairs private to maintain a competitive advantage over rival businesses.
Last, but not the least in importance, what about governments? No government would want other governments or entities to access their transaction histories. We live in a world where there are ongoing conflicts and political tension between different countries. It is crucial that these transactions, whether they come from partnerships, aid or donations, remain private.
The Decentralization Aspect
Considering the case for privacy, one could argue that Bitcoin isn’t an effective solution for facilitating sensitive transactions. Governments would have to create digital currencies and make their blockchains private. However, one of the main drivers for Bitcoin’s popularity is its decentralized qualities. Having central authorities create their own digital currencies would result in the same issues we have with today’s central banks. The situation would be different if governments enlisted independent institutions to manage their currencies, but at least for the foreseeable future, that seems unlikely. A private and decentralized solution fulfills the requirements for a secure monetary future.
How Can Governments Prevent Money Laundering With Privacy Coins?
Though preventing money laundering is a governmental priority, the current challenge is determining how governments can enforce AML policies if private, digital assets are being exchanged across decentralized networks. To address this, they relied on an inter-governmental body established in 1989, the Financial Action Task Force, or FATF, which is a “policy-making body” set up to combat money laundering, terrorist financing and other similar threats.
Given the real and perceived complications of the use of cryptocurrencies in the areas described above, the FATF made recommendations regarding the use and types of cryptocurrencies, which are defined as “virtual assets” (VAs).
A similar category of assets called “virtual asset service providers” (VASPs) are the entities involved in the transfer, safekeeping or administration of virtual assets. From the definition above, an exchange or bank holding digital assets for a customer would be classified as a VASP. It’s not certain whether cryptocurrency wallets and nodes that process crypto transactions like Bitcoin miners would be classified as VASPs. What is clear is that VASPs and their underlying platforms will have to be compatible with the new FATF Recommendations. That applies not only to transparent protocols like Bitcoin, but also to private ones.