While regulators are trying to restrict privacy in crypto, their efforts may be futile, according to privacy-centric protocol Monero’s maintainer, Riccardo “Fluffypony” Spagni.
“The U.S. Internal Revenue Service (IRS) wants the same level of insight [into monero] as they have over digital dollars in bank accounts; however, cryptographers and researchers are always going to be one step ahead on privacy,” Spagni told CoinDesk.
Launched in April 2014, monero (XMR) is a private, secure and untraceable cryptocurrency. The protocol allows transaction participants to obfuscate their identities and hide the amounts transferred from third parties, except for those they designate.
Protocols offering privacy have become the focal point of regulators and law enforcement agencies when the race among central banks to launch sovereign digital currencies is heating up.
The IRS recently hired blockchain firms Chainalysis and Integra FEC to develop transaction tracing tools for monero and layer 2 protocols. In June, Chainalysis added support for monitoring transactions for privacy coins dash (DASH) and zcash (ZEC).
Further, the U.S. Department of Justice (DOJ) published an extensive white paper, “Cryptocurrency: An Enforcement Framework“, on Oct. 8, citing the use of anonymity enhancing cryptocurrencies (AECs) that use non-public or private blockchains as a risk to anti-money laundering programs and controls put in place to combat terrorism-related finance.
According to Spagni, who was lead maintainer of Monero until he stepped down last year, regulators’ best bet is to apply controls at entry and exit points. “Payment service providers and merchant service providers are sorts of the points at which they can apply a degree of regulation. And that I think is feasible,” Spagni said.
For instance, a payment gateway facilitating monero or lightning transactions could ask users to verify location and charge sales tax. Similarly, if the user is dealing directly with a merchant service provider, the merchant would employ necessary checks before approving transactions.
Besides, even if regulators succeed in developing some traceability solutions, monero is likely to fix the bugs, retaining privacy over the long run, according to one analyst.
“Untraceable cryptocurrencies such as monero are here to stay,” Dr. Tom Robinson, co-founder and chief economist at blockchain firm Elliptic, told CoinDesk in an email. “In the short term, it may well be possible to find exploits in these systems and trace transactions to some degree, but these bugs will be fixed.”
Over the weekend, monero implemented an upgrade codenamed “Oxygen Orion,” which includes a new ring signatures feature called compact linkable spontaneous anonymous group (CLSAG). That is expected to reduce transaction sizes by 25%, improving transaction verification times by 10% and boost security.
Perfect solution unlikely
An ideal world solution that limits backdoor entry into privacy protocols for regulators and law enforcement looks out of reach.
“A system of controlled access would be fantastic; however, the thinking, though not bad, is just flawed,” Spagni said, adding that both well-meaning people and hackers could abuse the system.
Besides, regulators continue to struggle to establish controlled access in traditional finance, where paper money still offers some privacy. “Traditional financial institutions are already comfortable with untraceable payments in the form of physical cash,” Elliptic’s Robinson said.
In the days before the dot-com era, physical cash transactions dominated the global economic activity, and regulators and agencies relied heavily on active surveillance methods like monitoring behavior and actions to break cases. Currently, regulators and law enforcement agencies rely on passive surveillance like facial recognition systems, tracking bank accounts, and suspicious activity reports by financial systems.
Spagni said agencies need to step up their game and not rely on passive surveillance or influx of information, which “ultimately results in false positives.”
There could be a better middle ground between regulators and privacy cryptocurrencies that facilitate legitimate financial investigations but avoid surveillance.
“Our position is that financial privacy is important, and people should be able to pay for day-to-day expenses without having to fear hitting regulators’ radar and provide identity proofs,” David Jevans, CEO of blockchain forensics firm CipherTrace, told CoinDesk in a telephone interview.
Monero shrugs off regulatory concerns
Monero has charted an impressive rally over the past few weeks despite the increased regulatory scrutiny and dour expert forecasts.
The privacy coin rose to a two-year high of $135 last week, marking an over 90% rise from the lows near $75 observed in early September. The cryptocurrency is currently trading near $120, up 22.3% so far this month, the highest of any crypto asset valued above $1 billion, according to data site Messari. Monero’s price has increased 173% on a year-to-date basis while bitcoin has gained 60% over the same amount of time, according to CoinDesk 20.
CipherTrace’s Jevans believes monero has largely tracked bitcoin’s price, and the recent outperformance is mostly due to chart factors.
“Speculators, algorithmic traders look to have fueled the price rally,” Jevans told CoinDesk, adding that people who care about monero haven’t been involved.
That could be the case, as the broader market has remained bid since the March crash, and the majority of prominent cryptocurrencies, including ether (ETH) and the decentralized finance coins, have outshined bitcoin (BTC) by leaps and bounds.
“The overall sentiment of crypto as a whole has turned fairly bullish as of late with monero’s gains simply outpacing those of other coins breaking out past some technical resistance at $95 and $115,” Connor Abendschein, a crypto research analyst at Digital Assets Data, told CoinDesk.
Nevertheless, the price rally, regulatory inquiry, and potential traceability solutions could turn out to be net positives for monero. “It gets visibility in the market,” Jevans said.
That governments and regulatory authorities are trying to clamp down on monero transactions suggests there is strong demand for the privacy token.
Abendschein, however, maintains that the cryptocurrency would lose ground if Chainalysis succeeds in “consistently tracing” monero transactions, while Jevans foresees privacy coins falling to the backwaters of crypto markets if they fail to comply with regulatory requirements.
That said, the international law firm Perkins Coie published a regulatory white paper a month ago, detailing how regulated entities can comply with anti-money laundering obligations while supporting privacy coins.
“The AML [anti-money laundering] risks of privacy coins, while real, do not require specific, tailored regulations that may pose an unnecessary risk of stifling privacy coins’ growth. Rather, virtual assets service providers (VASPs) can adequately address those AML risks by maintaining an effective, risk-based program. Allowing VASPs to support privacy tokens undercurrent, tested AML regulations strike the appropriate policy balance between preventing money laundering and allowing beneficial, privacy-preserving technology to develop,” the white paper said.
Regulated exchanges are already developing ways to support privacy coins in a compliant way. “Crypto exchanges that support zcash [also a privacy coin] are using Elliptic’s products to assess risk on zcash transactions,” Elliptic’s Robinson told CoinDesk.