Privacy coins have been controversial ever since they were created. This is primarily because of their association with illicit activity and their alleged inability to be compliant with financial regulations. However, as regulators look to force KYC on every crypto wallet, the importance of privacy coins is becoming ever more apparent and a forgotten report found that they can be both moral and compliant. Today I’m going to break down one of the most important crypto reports ever written and tell you what it means for the future of privacy coins and financial freedom.
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About The Report
Now that I’ve set the record straight, let’s see what this crypto report says and why it’s so damn great. The crypto report I’ll be covering today is called ‘Anti-money laundering regulation of privacy enabling cryptocurrencies’. And before you yawn, this report is more important than you think.
For starters, it was written by Perkins Coie, an international law firm that has been around for more than a hundred years, brings in over one billion dollars in revenue every year, has served as council to presidential candidates during their campaigns, and has represented some of the largest companies in the world.
Perkins Coie’s corporate client list includes crypto companies, most notably crypto VC firms and recent Horowitz and union square ventures, which collaborated with the law firm in 2018 to try to gain regulatory clarity about the crypto industry in the United States.
As far as I can tell, Perkins Coie’s privacy coin report is a part of this ongoing initiative, and I suspect that it was sponsored by crypto VCs and institutional investors. This is primarily because institutions seem to be itching to invest in privacy coins, and this was put on full display in January of last year when Greyscale revealed it had filed for a Monero trust.
The fact that greyscale did this despite the regulatory concerns around XMR suggests that it believes it has a possibility of getting approved, though it’s been over a year and it still hasn’t happened, at least not yet.
Crypto VCS have poured hundreds of millions of dollars into other privacy-focused cryptocurrencies like Secret Network. Digital Currency Group CEO Barry Silbert recently tweeted that:
Those who don’t know, the Digital Currency Group actually owns Grayscale and also has large stakes in other crypto companies like Coinbase, which has reportedly been trying to list XMR for years and has only held off because of regulatory uncertainty.
Another reason why Perkins Coie’s privacy coin report is so significant is that it’s been pinned to Monero’s twitter account since it was published in September 2020. The fact that it’s still there means its findings remain as relevant as ever.
As to why the report was published in September 2020, my best guess is that it was a fact-based response to all the bad press about Monero being used in illicit activity, namely malware and terrorist financing.
What Are Privacy Coins?
Perkins Coie’s privacy coin report begins with a brief introduction where the authors explain what privacy coins are. Simply put, privacy coins are cryptocurrencies whose transactions are partially or wholly invisible on their publicly viewable blockchains.
This is in contrast to other cryptocurrencies like Bitcoin and Ethereum, whose transaction details can be easily seen and analyzed using a blockchain explorer or other such tools. Whereas Bitcoin and Ethereum transactions are easy to track, privacy coin transactions are next to impossible to track and this begs the question of whether they can be in compliance with existing financial regulations.
According to the authors, the short answer is ‘yes’ and they claim privacy coins even fall within the existing regulatory framework for finance, meaning no additional regulations are required. The report aims to argue these two points and it’s been broken down into four parts.
- the importance of privacy in finance
- how privacy coins work
- an analysis of existing financial regulations in major jurisdictions
- how privacy coins can be compliant with these regulations.
The introduction ends with a footnote that specifies that ‘Perkins Coie LLC represents clients with interests in privacy coins’, which is another reason why I suspect the report was sponsored by crypto VCS and institutional investors.
Importance Of Financial Privacy
As I just mentioned, the first part of the report is about the importance of privacy in finance and the authors start with an interesting observation, which is that Bitcoin sacrificed a substantial degree of financial privacy in exchange for the transparency required for its initial adoption.
The authors then explain that governments around the world have extensive laws in place that protect privacy and give two examples of just how severe the sanctions can be when these privacy laws are broken. Now, if you ask me, these were more examples of how unsafe it is to keep sensitive data with a centralized entity but that’s neither here nor there next.
The authors point out that individuals and institutions rely on and expect financial privacy primarily because they could be exploited or coerced if all their transactions were public. The authors give an example of an individual donating to a charitable cause or political party that could be seen as controversial or an institution using the publicly available financial information of a competitor to disrupt their operations.
The authors conclude that the absence of financial privacy therefore harms both society and the overall economy and note that the absence of financial privacy disproportionately impacts minorities and small businesses.
After giving a brief history of cryptocurrency, the authors explain that although bitcoin transactions were initially pseudonymous since nobody knew who was behind each wallet address, this is starting to change because of KYC requirements at centralized exchanges. Completing KYC on a centralized exchange means that it’s easy to figure out which crypto addresses belong to whom. This is one of the main ways that blockchain analytics companies track crypto transactions.
Anyways, the authors then make another interesting observation, and that’s that privacy coins ‘combine the benefits that the traditional financial system and initial crypto currencies like Bitcoin offer’. This statement might sound a bit odd, but what the authors are basically saying is that Bitcoin no longer offers any meaningful degree of privacy because of all the KYC at crypto exchanges, whereas privacy coins combine the best of both worlds: KYC compliance at exchanges yet transactions are still private to underscore their point.
The authors draw parallels between privacy coins and other popular privacy-preserving technologies such as hypertext transfer protocol secure, or https, the technology that’s used to secure data when browsing the web by making it invisible to third parties. The authors note that when these privacy preserving technologies were initially introduced to the Internet in the 90s, regulators tried to crack down on them too, with the US government initially classifying them as munitions akin to military-grade weapons.
Eventually, the regulators lost the so-called crypto wars and today most websites use https encryption with no government backdoors, or so they say. The authors believe that it’s going to be the same story with privacy coins, and that’s simply because the benefits of privacy outweigh the risks associated with their privacy-preserving features.
Privacy Coin Technology
In the second part of the report, the authors talk about how a few popular privacy coins work and they divide this crypto niche into two categories:
- privacy by default coins
- privacy as an option coins.
The most popular privacy by default coin is, of course, Monero, which has been around since April 2014 and recently celebrated 8 years of existence. Bravo Monero.
The authors then explain Monero’s three privacy technologies in depth:
- stealth addresses,
- ring signatures,
- confidential transactions.
Don’t worry, I’ll keep it simple. Stealth addresses are crypto wallet addresses that are only used once. On Monero a new stealth address is created for every single XMR transaction.
Each XMR transaction is signed using a ring signature, which is where multiple wallets sign the same transaction in a way that makes it impossible to tell which wallet the transaction was sent from.
With confidential transactions, the result is a cryptocurrency whose transactions can’t be traced.
The authors also talk about the fact that each Monero wallet comes with two private keys used to sign transactions and two public keys used to generate wallet addresses. This dual key design can be used to reveal information about XMR transactions for compliance purposes.
Litecoin is currently in the process of implementing grin’s privacy protocol. As far as privacy as an option coins go, the authors start with Zcash, and this might have something to do with the fact that Zcash has been a favorite amongst institutional investors, with Greyscale’s Zcash trust holding over 50 million dollars worth of ZEC. In any case Zcash has been around since 2016. It’s essentially a fork of Bitcoin with privacy preserving technologies. Unlike Monero, ZEC transactions are not private and can be sent as unshielded, i.e. public, or shielded, i.e. private. This results in four different transaction types, which you can see here.
- The first transaction type is public.
- The second is shielding, meaning from public to private.
- The third is de-shielding, meaning from private to public.
- The fourth is private.
To make this privacy possible, Zcash uses zero knowledge proofs, hence the Z without getting too technical. Like Monero, zero-knowledge proofs make it possible to prove that a computation is valid without revealing the components of the computation. Private Zcash transactions have the option of including additional data that can be used for compliance purposes.
The authors then take some time to talk about Dash, which technically isn’t a privacy coin. This is because Dash uses the coin join mixing protocol for its private transactions and this is a technology that can be applied to just about any cryptocurrency, including Bitcoin. Luckily, the authors acknowledge this, and I say luckily because Dash has consistently found itself lumped in with other privacy coins by both regulators and compliance-obsessed exchanges.
Privacy Coin Regulations
Part three of the report is all about compliance, and the authors start off this section by giving a quick overview of what regulators in the United States, Japan, and the UK have said about privacy coins as well as the financial action task force or FATF in the United States.
The regulator that’s concerned itself the most with privacy coins is the financial crimes and enforcement network, or FinCEN, which revealed its first crypto regulations in 2013. Back then, FinCEN defined three possible characters in a crypto transaction as:
- regular crypto holders,
- crypto exchanges,
- administrators such as stablecoin issuers like Circle and Tether.
Obviously, they didn’t exist back then, but you get the point. As you might have guessed, FinCEN only really cares about the latter two. In 2019 FinCEN actually specified that exchanges and administrators dealing in privacy coins are subject to the exact same regulations as those dealing with other cryptocurrencies. This is a big deal because it means that there aren’t any regulatory grounds for banning or restricting the use or listing of privacy coins in the United States, at least according to FinCEN’s own criteria.
FinCEN also said that people developing privacy-preserving technologies are not subject to any regulations, though anyone who offers these privacy-preserving technologies will be subject to regulations, which explains the recent announcements from select crypto mixing services.
Interestingly, FinCEN also specified that adherence to the infamous travel rule, which requires financial institutions to report every transaction above a certain amount, does not have to be enforced at the blockchain level, meaning the private blockchains of privacy coins aren’t a problem.
The authors then examine another infamous element, and that’s the BitLicensed issued by the New York department of financial services, which is notorious for being extremely difficult to get due to the high regulatory threshold. The authors point out that BitLicensed’s own rules state that holders of the license can still deal with privacy coins and that some exchanges with the license have been able to list Zcash with no issues.
More importantly, the BitLicensed’s own rules state that information sharing at the exchange level is sufficient to be in compliance with the travel rule and other financial reporting requirements, which again means that the private blockchains of privacy coins aren’t a problem
As for Japan, some of you may be aware that its financial services agency effectively banned privacy coins in 2019 on the grounds that they are primarily used for illicit activity, despite the fact that this was not and still is not the case.
As for the UK country’s financial conduct authority ‘expressly stated that unregulated tokens can be privacy coins’, meaning that they’re subject to the same regulations as regular cryptocurrencies by their own rules. As for the FATF, they don’t call for the outright ban of privacy coins, rather they simply plan on designating any country or company that allows privacy coins in their region or platform as high risk and therefore undeserving of access to the global financial system. If you think that’s crazy, take a moment to consider that the FATF considers transfers to and from self-custodial crypto wallets as another high-risk activity which warrants sanctions in the long term.
How They Can Be Compliant
Anyhow, the fourth and final part of the report lays out how privacy coins can comfortably fit within existing regulatory frameworks for financial services. The authors start by saying that the focus of all financial regulations is the middleman, be it a cryptocurrency exchange or bank. As such, this is the only place where regulations should be applied, and this means that the assets involved are irrelevant, be they privacy coins or otherwise.
The authors also highlight the fact that even though the FATF labels privacy coin related services as higher risk activities, the presence of privacy coins isn’t the only factor in their risk analysis, nor is it the most important. Other elements like the location of the crypto service, the composition of its clientele, and the degree of due diligence, the research it conducts on said clientele is far more crucial. If you ask me, that’s a not so subtle way of saying it’s okay for institutions to invest in these technologies but not plebs like us. Recent headlines certainly suggest that this is the direction in which the wind is blowing.
The authors then attack the premise that privacy coins carry an inherently higher risk given that they have the same or similar qualities as cash, prepaid credit cards, and other payment methods that are also anonymous and can easily move across borders. Even though privacy coins theoretically have an edge on both fronts, in practice, this edge is blunted by the fact that privacy coins don’t count as legal tender and almost always require a regulated intermediary to buy and sell. As a result, the authors argue that ‘privacy coins and other cryptocurrencies do not present structurally higher or lower AML risks under these factors as compared to traditional payment types’.
Even so, the authors concede that privacy coins come with their own unique set of regulatory risks, which can be addressed in the following ways.
- They first collect additional information about any users looking to buy or sell privacy coins on cryptocurrency exchanges.
- Factor in regional differences and poor privacy coin use cases when making a risk assessment.
- Pay extra attention to deposits and withdrawals involving privacy coins and consider requiring additional information for any suspicious transactions.
The authors emphasize that crypto compliance is fundamentally no different for privacy coins given that they’re also bought and sold using regulated centralized exchanges. The authors also reiterate that the privacy of privacy coin blockchains doesn’t mean that compliance is impossible because most regulatory authorities specify that compliance doesn’t occur at the blockchain level. As for the infamous travel rule, the authors say there shouldn’t be any issues there either because the travel rule is only applied when money is moving between regulated middlemen and popular privacy coins like Monero and Zcash offer ways to communicate the information required for this compliance. Given this fact ‘the availability of multiple alternative compliance solutions to the travel rule logically eliminates any need for an outright ban or limiting regulation’.
The authors then say something spicy, and that’s that cryptocurrency regulations should be limited to exchanges and the like, since regulating peer-to-peer transactions of any kind would likely necessitate major changes to underlying AML legislation in order to withstand judicial scrutiny. In plain English, if you over regulate crypto, we will sue you.
The authors conclude that ‘absent evidence that existing AML regulations cannot adequately address the risks posed by privacy coins and there is no reason to impose new and overbroad AML requirements that specifically target privacy coins’.
What It Means For Privacy Coins?
This brings me to the big question: what does all this mean for the future of privacy coins and financial freedom itself? At this point, it’s clear there’s a huge demand for financial privacy in the crypto industry, both from individuals and institutions. However, it’s not entirely clear what this financial privacy will look like when all is said and done. It looks like regulators are quite comfortable with privacy coins that don’t have privacy as their default setting, such as Zcash.
Conversely, privacy coins with privacy by default, like Monero, continue to be controversial and this seems to be almost exclusively because of their association with illicit activity, a status that’s been mostly manufactured by anti-crypto media pundits and politicians. This is similar to how regulators seem to be ignoring their own regulatory guidelines when it comes to privacy coins, and I suppose that’s not entirely unexpected; they’re centralized institutions, after all, and that means their rules are relative and are not hard-coded like the laws of crypto.
What’s really concerning is that some countries and jurisdictions have been working hard to do away with as much crypto privacy as possible, notably the European Union with its recent bill to apply the travel rule to every single crypto transaction. In this sense, we might be on the brink of another crypto war, except this time the war involves crypto privacy and not internet privacy.
Make no mistake, but this is a war that must be won because without financial privacy there is no financial freedom and if you’re confused, consider this: you could be a crypto billionaire. At that point, if your identity is connected to all your crypto wallets and you find yourself on the wrong side of the status quo, your wealth will be worth nothing. That’s because it will be impossible to cash out and any peer-to-peer transactions will be refused or sent back because the counterparties won’t be able to cash out either. At that point, your only option would be to move to a crypto-friendly country where your wealth will be
[This article is a transcription of a video made by Coin Bureau]
Original video: https://youtu.be/EIwsMidCk0w ]