Stablecoins: Privacy or Panopticon?

Since the launch of Tether in 2015, the stablecoin sector has gone through quite a transformation. In this five-year window, the industry evolved from nothing to the multi-billion-dollar behemoth it is today. The principles behind a stablecoin are simple: launch a token on a ledger and use whatever means necessary to keep the token price stable. In a market hallmarked by volatility, it is no surprise that stability is much sought after.

Though stablecoins are booming, they inherently suffer from a major drawback native to most blockchain-based systems: complete transparency. A digital alternative to cash that is devoid of privacy only serves to empower the surveillance state. Before discussing potential solutions, let’s look at the different types of stablecoins.

Taxonomy of stablecoins

There are four main types of stablecoins (not counting those backed by precious metals or other physical goods, which some consider to be stablecoins).

Fiat-Collateralized

The simplest, yet centralized, approach to stablecoins is fiat-collateralization. This revolves around an entity holding at least 1:1 fiat in off-chain reserves compared to the outstanding stablecoin supply issued on-chain. The most famous and oft-cited example of such a stablecoin is Tether (USDT). However, as it turns out, Tether has not always been backed 1:1 in cash or cash-equivalents, and may not be still.¹ The peg appears to have held regardless, for now. A more trustworthy example would be USDC, which undergoes frequent audits for its collateral.²

Cryptocurrency-Collateralized

Cryptocurrency-collateralized stablecoins can function in a more decentralized manner, through a collateralized debt position, or CDP. A CDP allows users to mint their own stablecoins. This is done by depositing collateral into a smart contract. The collateral must be of greater value than the debt (denominated in the stablecoin) they are withdrawing. A price oracle is then used to track the value of collateral. A liquidation mechanism will then close any underwater positions automatically. Dai by MakerDAO is the largest such stablecoin (see Zero Knowledge Podcast episode on MakerDAO and DAI here). Another example is sUSD, a synthetic dollar token issued on Synthetix.

Algorithmic stablecoins

Algorithmic stablecoins are not backed by any underlying asset. Instead, they rely on an expanding and contracting token supply to meet a target price point. This supply is governed by an algorithm that is usually based on price and market conditions. In practice, this means that these coins are not very stable and can lose their functionality if there is no liquidity.³ Hybrid stablecoins — a mix between algorithmic and collateralized stablecoins — often suffer from the same problem, but to a lesser degree.

CDBCs

Finally, there are central bank digital currencies (CDBCs) which also take on the form of stablecoins. Over 80% of central banks have begun researching CBDCs. The CBDC project by the People’s Bank of China (PBC) is already at an advanced stage, with pilot testing underway in several cities. Figure 1 shows the high-level design.

Figure 1 Design of the PBC CBDC

The future of CBDCs

The goal of a CBDC is to be a digital cash equivalent. This means that some form of privacy for the public is necessary to achieve cash-like functionality. Even though combating terrorist financing and anti-money laundering are not core central bank objectives, CBDCs will still need to conform to regulations within their jurisdictions.

A key question is how central banks will handle payment data from a CBDC. If there is an underlying ledger recording all transactions, then who can access this data, and when? What are the consequences of a data leak in such a system? While combating illegal activity is important, finding an answer to these questions that does not trample upon civil liberties is even more pressing.⁴

Considering this, how will central banks manage the balancing act of respecting user privacy while ensuring regulatory enforcement? If we look at privacy in other types of stablecoins, it paints a grim picture. By default, stablecoin transaction data on Ethereum is all public. This is because behind the veil of pseudonymity lies a complete map of all accounts and their interactions. But there may be a glimmer of hope.

Zero-knowledge proofs: balancing privacy and transparency

Users of Ethereum may know that there are in fact a couple of methods to add privacy to their (by default, public) stablecoin transactions. Tornado.cash is the most popular solution. It allows users to deposit several stablecoins into a smart contract. The coins can then be sent to another Ethereum externally-owned account without directly linking the user’s own account to the transaction. For more details, see the Zero Knowledge Podcast episode on Tornado Cash.

Even though Tornado.cash transactions are anonymous, other network participants can still verify that they have been sent by valid accounts using a cryptographic technique known as zero-knowledge proofs (ZKPs). Rather than publishing the exact details of a transaction, a ZKP allows you to post a proof that certain rules have been followed. For example, you can hide the amounts included in a transaction while proving that no counterfeiting took place, as is done in Aztec. The combination of ZKPs and blockchain technology introduces an interesting new paradigm, where transparency and privacy can both be achieved simultaneously. See Zero Knowledge Podcast episode on Aztec for more details.

A CBDC could use ZKPs to prove all kinds of data, without having to reveal all of its transaction contents. This could range from proving that only users who have completed know your customer are accessing specific services, to providing financial privacy for the end-user. Cases may arise where more details than just a proof are necessary. Still, ZKPs allow us to build a solid foundation for an inclusive and privacy-preserving financial system.⁵

The need for a privacy-centric approach

The unforeseen exponential growth in stablecoins has led us to a crossroads. Stablecoin usage and adoption are skyrocketing, with over $20B stablecoin tokens in circulation. The upcoming launch of many CBDCs shows that there is no end in sight.

A 2017 study shows that cryptocurrency users will forego privacy due to a lack of knowledge and simple user interface problems.⁶ Since it launched over a year ago, there have been less than a thousand individual stablecoin deposits into Tornado.cash. Aztec has faced a similar lack of adoption, with their v1 only having been interacted with 441 times since launch.⁷ At current usage levels, the privacy guarantees are quickly eroded.⁸ This makes it clear that while users have to become more aware of the impact their choices have on their privacy, builders and educators need to better guide them along the way. Aztec’s v2 is a big step in this direction, which promises cheaper gas costs per private tx than a regular Ethereum transaction.

If the proposed rules from FinCEN(the USA’s Financial Crimes Enforcement Network) are anything to go by, we have every right to worry about our current trajectory. There will be databases built on an unprecedented scale with the sole purpose of tying one’s real identity to a ledger address. Once lost, the permanent nature of blockchains means that there is no way to regain this privacy. In such a world, transacting with stablecoins equates to subjecting oneself to mass surveillance.⁹

As a community we must take responsibility. The systems that enable us to achieve meaningful privacy are actively being built. As users we need to educate ourselves and remain wary of regulatory overreach. As developers we must avoid UX hurdles that exclude people from achieving privacy. Central banks should make privacy an integral part of any CBDC. By embracing ZKPs, we can enjoy the open nature of blockchains while keeping our privacy intact. Without them, using stablecoins will take us one step closer to a financial panopticon.

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[1]: Tether’s U.S. Dollar Peg Is No Longer Credible https://www.forbes.com/sites/francescoppola/2019/03/14/tethers-u-s-dollar-peg-is-no-longer-credible/?sh=1af1b63e451b

[2]: USDC transparency reports https://www.centre.io/usdc-transparency

[3]: Dynamic Set Dollar faces ‘massive test’ as stablecoin falls as low as $0.27 https://cointelegraph.com/news/dynamic-set-dollar-faces-massive-test-as-stablecoin-falls-as-low-as-27

[4]: Rise of the central bank digital currencies: drivers, approaches and technologies https://www.bis.org/publ/work880.pdf, Central bank digital currencies: foundational principles and core features https://www.bis.org/publ/othp33.pdf

[5]: Design choices for Central Bank Digital Currency https://www.brookings.edu/wp-content/uploads/2020/07/Design-Choices-for-CBDC_Final-for-web.pdf

[6]: The Digital Privacy Paradox: Small Money, Small Costs, Small Talk https://www.ftc.gov/system/files/documents/public_comments/2017/09/00010-141392.pdf

[7]: Aztec analytics https://explore.duneanalytics.com/dashboard/aztec-v1_1

[8]: Blockchain is Watching You: Profiling and Deanonymizing Ethereum Users https://arxiv.org/pdf/2005.14051.pdf

[9]: Requirements for Certain Transactions Involving Convertible Virtual Currency or Digital Assets https://public-inspection.federalregister.gov/2020-28437.pdf