Many people believe you can gain privacy by switching in and out of a privacy coin. They do this because they want to anonymize funds received from a friend or transferred in from an exchange.
The truth is, this really doesn’t work. When transacting through privacy coins on transparent blockchains, you’re leaking a large amount of data about yourself and you’re likely creating patterns between your transactions that make you easier to track.
Ian Sagstetter is the communications and community manager at Electric Coin Company, the creator of Zcash. He is also the founder of ZecHub, an education channel focused on the Zcash protocol.
Holding funds in a shielded asset, for an extended period, gives you a stronger anonymity set and provides more security when you need to perform private transactions.
Privacy coins are not mixers, and treating them as such will weaken your privacy set and will likely make you easier to trace.
Transparency keeps decentralized finance (DeFi) protocols honest and provides an easy path for auditability, and many users have reasons for wanting their transactions and holdings to be public.
But there are also instances where users need financial privacy. Crypto has been pretty bad at providing it, and the protocols that do provide privacy have been cast into a sub-category that delegitimizes their utility.
Pass-throughs result in maximum data leakage
User-privacy is protected by leaking the least amount of data possible. Shielding funds, through monetary protocols with Zero-Knowledge proofs, enables users to store value and transact with other users with higher privacy sets when compared to transparent protocols like Bitcoin.
The cryptography ensures that transaction data is encrypted, but can still be verified by the network. When a user moves funds into one of these protocols they gain a stronger level of financial privacy.
However, every time a user transacts, even when using a privacy-preserving payment protocol, they leak data about themselves. This is especially true if you use the protocol as a pass-through between addresses or counterparties.
This is a popular technique users deploy to obscure funds from their original source. People mainly use this technique to make sure their main wallet address is not connected to their public address. For example, when a big DeFi user needs to get some ether (ETH) to their wallet associated with their Ethereum Name Service (ENS) address, they might use a privacy tool as a pass-through to ensure that these addresses are never linked together.
The issue with this practice is that chain surveillance companies could pretty easily trace this transaction. Let’s say you move 1 ETH in and out of a Zcash wallet. A surveillance company could easily break down all transactions worth 1 ETH between the Zcash and Ethereum blockchains during a given period of time. Your transaction would likely appear in this search, associating your Ethereum address as a part of this user group.
If someone does this enough times, they’re consistently leaking data about themselves and making it easier for the surveillance companies to determine their identity.
Hodling is the best way to ensure privacy
Arguably the best way to gain privacy in crypto is to hold funds in a shielded asset. The longer you keep funds at rest, the stronger your anonymity set becomes.
This actually makes maintaining privacy relatively easy. Have a stash in a privacy-preserving crypto, add small amounts to it as desired, hold the stash to strengthen your privacy set and use it for payments when needed.
A potential problem with this could be when users only privatize funds to make a private transaction. See, private payments have long been touted as the killer use case for cryptocurrencies like zcash (ZEC) and monero (XMR). Need to send some money privately? Swap some bitcoin for a privacy coin and send the transaction.
See also: The Coming Privacy Wars | Opinion
But this action doesn’t give users the level of privacy they think it might. Imagine this scenario:You want to make a donation to an activist organization, but you don’t want the donation to be linked back to your identity because of safety concerns. The only permissionless asset you hold is bitcoin (BTC), and because you bought it through an exchange the transparent asset is tied to your identity.
You decide that you want to swap your BTC for ZEC, a shielded asset. You make the swap and then immediately send the donation. The recipient receives the donation and exchanges it for fiat the next day.
When a chain surveillance company is tasked with finding identities for people who sent donations via shielded assets to this organization, the ones who held their funds in the shielded asset for the least amount of time are the easiest to determine. Because the shielding of the BTC and the deshielding of ZEC happened within a short period of time, it’s not out of the realm of possibility that your identity could be tied to the activist organization’s exchange of ZEC to fiat.
So, instead of buying a shielded asset for one-off use cases, it’s better to store small amounts of value in a shielded asset consistently over time. By not creating irregular accumulation patterns and gaining a stronger anonymity set through holding, your future payments will be more private.
Think of shielded assets like cash
Shielded assets in the crypto space need to be compared to cash. As recently as 10 years ago if people needed to make a private payment they would use cash instead of Paypal.
If you needed to use cash, would you go to the ATM (where there’s likely surveillance cameras) and take out exactly what you need every time you need to spend something? Probably not.
The best thing to do for personal security would have been to take out a small amount of cash every week or two and hold it somewhere safe. By doing this you’d have a stash of liquid cash with a strong privacy set available when you needed to spend it.
Something we think a lot about in the Zcash ecosystem is the need for fungible, private cash in the crypto economy. Cryptocurrencies can provide permissionless financial access to those who may have previously gone without, but without a private cash-like asset, the ecosystem might not achieve the censorship-resistant qualities it hopes for.
By making assets like ZEC more accessible and available in decentralized financial markets, we're providing users an opportunity to gain financial privacy, should that be something they want to do.
This also ensures that decentralized applications are providing an avenue to truly permissionless usage, as privacy is needed for an asset to be completely permissionless and censorship-resistant.
The crypto economy falls short without privacy
In the future economy, we need to provide infrastructure and access to shielded assets to those who want and need financial privacy. Without this access, systems might be decentralized, but they certainly won’t be entirely permissionless.
Giving users the ability to store value in shielded assets will provide them more autonomy, freedom, and security. It also strengthens crypto’s censorship-resistant attributes.
Builders of decentralized protocols need to keep financial access to digital cash in mind when building out decentralized financial systems. The cryptoeconomy won’t survive without it.