Privacy Protection in Cryptocurrency Blockchains
“Congratulations, you are one of the active users who are lucky to get 0.5 BTC…” — spam of this kind, with fake giveaways that ask people to send their BTC or ETH and receive much more crypto coins back, is notorious for having deceived many crypto users. Only in a Twitter hack on 15 July 2020, hackers compromised one hundred thirty high-profile Twitter accounts to tweet out a bitcoin giveaway scam, having stolen more than $100,000 from many victims. According to CipherTrace analysts, fraud constituted 73% of a total crypto crime volume in 2020 (amounted to $1.9 billion). The data also shows that 2020’s hacks were smaller compared to the ones in the previous year. This fact indicates that crypto platforms tightened their security and control systems, and crypto users became more cautious about crypto scams. However, malicious actors may be very innovative when it comes to making someone send them crypto assets, and new forms of sophisticated fraud are regularly disseminated through social media. In this respect, users with unprotected data on their financial situation and identity are particularly vulnerable to cryptocurrency-related frauds. Scam letters can be designed for a specific individual-recipient based on his financial data, which makes it very difficult to spot their sender’s bad intentions.
Public, Traceable and Immutably Stored Transactions
A public blockchain stores permanently every single cryptocurrency transaction ever made, allowing everyone to view it. In ledgers of Bitcoin, Ethereum, Ripple, etc., without special permission, everyone can track all transactions of any public address, amounts of the transactions, their date and time, as well as to figure out a balance of a particular address (by adding up all the outputs connected to the address for UTXO-based blockchains).
What is unknown to the blockchain is the user’s real name. Instead, in the blockchain, each user appears under a public address (it is pseudonymous as represented by a string of letters and numbers), which is created individually by each user’s wallet and is not linked to any proper name. However, there are plenty of possibilities to identify a real person behind the public address. For example, when he or she transacts with someone who knows his identity (e.g., CEXs collect KYC), or when he uses apps processing his source IP address. [1]
Financial Privacy
Financial privacy is an element of privacy, a fundamental human right declared in many international treaties. Robert N. Mayer defines financial privacy “as the ability of an individual to control his or her personal financial information” and highlights two concerns related to this definition: data protection and freedom from intrusion. Data protection is about protecting an individual’s financial information from its misuse by third parties, like by banks or investment firms (data processors and data controllers), to whom an individual provides his data in order to commence or execute a business relationship. The right to privacy is designed to restrain the third parties’ actions in order to avoid abuses by introducing norms about fair and secure processing of client data. Within a blockchain, the information of your financial activities, previously shared with a few organizations, becomes available for everyone worldwide. Under certain conditions, an interested party can identify how much cryptocurrency you have, how you use it, and who your counterparties are, thus creating your complete profile. The exposed information attracts malefactors and opens crypto users up to risks of various criminal offenses. Blockchains’ transparency in relation to financial activities and, therefore personal interests, can also result in intrusion into the personal life of another by various entities/individuals advertising their products and services, offering to contribute or to invest.
Privacy-Enhancing Technical Solutions
Given shortages of a legal basis for data privacy in the crypto sector (except laws on data protection observed by custodians) and technological specificity of blockchains, users themselves need first and foremost to forestall the possible misuse of their data by self-protection: to transmit cautiously information to new counterparties, transact on trusted platforms, not to engage in ‘financial deals’ with unknown parties on social networks, etc.
Furthermore, during the past decade, many privacy-enhancing techniques have been introduced to address the privacy problem in public blockchains and help users take control of their privacy.
Cross-chain transactions on DEXs, where one coin (e.g., ETH) is swapped for another coin native to a different, separate blockchain (e.g., BNB), appear to obscure the connection between the addresses. However, some studies show that it is possible to identify the performed cross-chain transaction by searching blockchains where a transaction of the same value occurred within the timestamp.
There are also various online mixing services, aka crypto mixers and tumblers, available to crypto users to disguise their fund’s original source on the public blockchains. Some of them may turn out to be insecure due to the lack of a rigorous audit as well as the remaining possibility to re-establish the link between transactions. In addition, some countries closely monitor the activities of these services moving towards making them illegal. In 2020 a US resident, who ran a darknet-based mixing service Helix from 2014 to 2017, was charged for money laundering conspiracy and operating money transmitting business without a license. [2]
Another direction in the field of crypto anonymity is privacy cryptocurrencies. At the forefront of this movement, there are such anonymous PoW cryptocurrencies as Monero (‘ring confidential transactions’ and ‘stealth addresses’) and Zcash (‘a zero-knowledge proof’), which have developed mechanisms obfuscating the identities of senders, receivers, and transaction amounts. Another privacy-focused network, Blur, employs the same privacy features, maybe even trying to make a symbiosis of both that follows from current efforts of porting the Blur network to the Komodo ecosystem.
Dash was the first to introduce a mixing protocol based on PoS consensus, allowing their users to make their transactions anonymous by opting for ‘PrivateSend,’ an optional feature of Dash’s wallet. Later on, many coins with the same attribute were forked from Dash (like Pyrk or GoByte).
An increasing number of crypto projects are currently working on extending the scope of privacy in crypto activities, moving the focus from the privacy of transactions with a particular cryptocurrency to DeFi privacy. This idea encompasses the possibility to shield transparent cryptocurrencies, like BTC, USDT, BNB, within a ‘secret’ ecosystem where all transactions with it (swapping, providing liquidity, staking, etc.) are private and untraceable. Further, the shielded cryptocurrencies can be unshielded and sent back over bridges to their native public blockchains.
In this regard, the Secret Network, a protocol focused on privacy for DeFi, introduced a concept of privacy-preserving secret contracts’, which have encrypted inputs, outputs, and state. Having implemented this technology, the Secret Network launched SecretSwap, a cross-chain AMM for trading privacy tokens that represent native or off-chain assets. The SecretSwap excludes the possibility of front-running, as their mempool is encrypted and cannot be viewed by malicious actors.
Incognito is another privacy-protecting network. Their hallmarks are their own multi-currency wallet, a decentralized exchange pDEX, and mining through providing liquidity or running a validator node (they even provide an opportunity to buy a hardware one-click setup node). While the Secret Network has a bridge to Ethereum (a Secret-BSC bridge is under development now), pDEX now allows users to trade assets from a larger number of blockchains (Bitcoin, Ethereum, Dogecoin, Litecoin, etc.), as community members can create different bridges and provide bridge liquidity.
Related Problems
The use of anonymous technologies and the expansion of privacy-focused networks are inhibited by substantive shortcomings related to them.
First of all, at the technical level, they may be subject to vulnerabilities and flaws that are more difficult to detect (and they can stay undetected for years) in comparison to the popular cryptocurrencies where a larger number of people scrutinize their code. The full anonymity of some cryptocurrencies is also brought repeatedly into question.
Secondly, although privacy coins may have been initially designed for the right reasons, they are reported to be used for illicit activities such as money laundering, scams, ransomware attacks. Some cryptocurrencies’ untraceable nature makes them an effective instrument for criminals to cover their tracks and get away with committing crimes. The criminal misuse of cryptocurrencies provoked adverse reactions from regulatory bodies worldwide, which appear to restrain the circulation and use of privacy coins. Thus, Japan (from June 2018) and South Korea (from March 2021) imposed a ban on trading DASH, XMR, and ZEC on exchanges based on their jurisdictions. In other countries, due to regulatory pressure, many exchanges took the initiative to delist privacy cryptocurrencies (e.g., US Bittrex delisted DASH, XMR, and ZEC from January 2021, Swyftx (Australia) delisted DASH, XMR, ZEC, ZEN, KMD, XZC (FIRO), etc. from August 2020).
The decrease in the number of entities accepting privacy coins, their questionable ‘shady’ character, and scalability issues impact their trading liquidity and mass adoption among market participants, which are essential factors enhancing anonymity in many privacy systems. Besides, in some crypto wallets, such as Dash, Zcash, the shield technology is not set by default. According to the statistics by Insights, only 9% of Dash transactions and 14% of Zcash transactions, in one way or another, involve the private features, whereas the actual number of completely shielded transactions are far less (0.7% and 0.9%, respectively).
Low liquidity in the networks, where mixing is performed only between participants who want to mix, reduces the quality of mixing and increases the risk of sybil attacks. The higher the number of shielded transactions, the stronger the anonymity, and the more complicated it is to identify the user employing shielding of coins on the blockchain. In this regard, to tackle the insufficient engagement from users, Callisto came up with the idea to mix transactions from all traffic of the network by using smart contracts and sending these transactions in a new order (so-called Total Eclipse).
Rightful preservation of financial privacy and identity on the one side, and obfuscation of wrongdoings on the other, may be performed by the same methods on blockchains. In such a case, there is a question of whether everyone’s financial privacy could be sacrificed to eradicate public evils.
Derogation from the right to privacy and rampant data collection could have adverse effects on crypto users whose personal data becomes exposed to intruders, as well as it may constrain mass adoption by investors who prefer to keep their financial matters quiet.
According to a Ciphertrace research, a mere 0.5% of the yearly volume of Bitcoin in 2020 is attributed to illicit operations [3]. Whereas, as per a RAND report, Bitcoin, due to its high liquidity and convertibility to fiat, is dominant for illegal transactions on the darknet (Bitcoin made up 76% of the darknet operations in 2019), compared to privacy-focused cryptocurrencies, from which criminals seem to have turned off because of the liquidity issues and trading limitations caused by AML requirements worldwide. Besides, illicit crypto transactions are reported to be 39 times lower in jurisdictions with strong AML compliance. Therefore, at the current stage of the crypto community development, users’ anonymity should be balanced by disclosures entailing adequate security measures suppressing criminal activities. It may also be developed generally acceptable risk assessment tools applicable by virtual assets service providers to handle crypto assets originated from shielded addresses (if it is allowed within a jurisdiction). One of the practical concepts here is ‘optional transparency’ by implementing view keys — these keys can be shared by an address owner with third parties to view transaction details of that address (e.g., so far partial information is made available by the ‘read-only key’ in Incognito and ‘view key’ in Monero).
References
[1] For details, see: Eric Wall, Privacy and Cryptocurrency, Part I: How Private is Bitcoin?).
[2] Ohio Resident Charged with Operating Darknet-Based Bitcoin “Mixer,” which Laundered Over $300 Million, U.S. Department of Justice. // URL: https://www.justice.gov/opa/pr/ohio-resident-charged-operating-darknet-based-bitcoin-mixer-which-laundered-over-300-million
[3] Available statistics on Bitcoin usage for criminal purposes may vary from 0.5% to 44% as research results differ. // URL: https://www.rand.org/content/dam/rand/pubs/research_reports/RR4400/RR4418/RAND_RR4418.pdf