Consensus 2021: Can Privacy Coins, Exchanges and Regulators Coexist?

The careful dance between global financial regulators and cryptocurrency exchanges saw a particularly big shift in January when the Bittrex exchange removed privacy coins monero and zcash as well as dash from its offerings. The self-custody exchange ShapeShift has also delisted the three coins, which was especially notable given ShapeShift’s hyper-libertarian founding ethos. (Representatives of the organization behind dash argued the coin was delisted based on a misunderstanding of its privacy features.)

Privacy coins are still available on major regulated exchanges including Kraken and Coinbase, but the delistings point to the inherent tension between exchanges and privacy coins. Financial regulators lean hard on centralized exchanges to monitor their users (one reason serious cryptocurrency users aren’t fans of the exchanges). Privacy coins, in principle, conceal information about where they’re sent, making such monitoring more difficult. Selling them may also draw added scrutiny from regulators simply out of distrust about their uses.

But that suspicion is likely misplaced. “There’s sort of been this insinuation that because you’re using digital currency that has additional privacy-preserving features that it’s inherently bad or you’re using it for improper reasons,” Grayscale VP Craig Salm told CoinDesk’s Colin Harper late Wednesday at the Consensus 2021 conference. "And that's not true." (Grayscale is a CoinDesk sister company.) At least according to existing analyses, a much lower proportion of cryptocurrency transactions are tied to criminal activity than is seen with U.S. dollar transactions.

Regulators may understandably regard privacy tokens and related technologies as ripe for abuse by money launderers and bad actors. But Wednesday’s panelists argued that restricting their use would be both legally misguided and bad for society. Salm argued, for instance, that exchanges restricting coins that have been “mixed” for anonymity was misguided: “At the end of the day, the technology shouldn’t be what’s being regulated, it should be the uses of the technology."

“A cashless society is a surveillance society, and anonymity is absolutely necessary for civil liberties,” said Marta Belcher, who serves as general counsel of Protocol Labs and also works with the Electronic Frontier Foundation. Many other observers, including the policy group CoinCenter, regard anonymous digital transactions as crucial for the preservation of civil liberties in the 21st century.

For now, restrictions are coming slowly, and there are options for those who want to hold or use privacy coins. According to Salm, self-hosted software or hardware wallets such as Ledger should remain safe from scrutiny by agencies like the U.S. Treasury Department's FinCEN. That's because the coins are legally similar to cash, which generally isn’t subject to search or seizure without a warrant. (By contrast, according to Belcher, exchanges regularly turn over user data to governments without warrants.) The rising popularity and effectiveness of decentralized exchanges, or DEXs, poses an even more complex regulatory challenge.

The best solution to blunting regulatory overreach may be to offer regulators a form of oversight that doesn’t involve mass surveillance.

“The more you’re able to become surgical in understanding account behavior, the less you need to surveil all activity,” Solidus Labs COO Chen Arad told the panel. “That doesn’t necessarily mean having access to all this information, it’s about using more advanced data analytics [and] machine learning in order to connect various dots.”

Solidus Labs offers “crypto-native” compliance software that uses machine learning to evaluate risk. Arad thinks that may offer not just a workable compromise on privacy coins but a more nuanced vision of financial compliance in general.

“The more we’re able to work with regulators and give them the comfort ... that there are ways to point out actually malicious activity without revealing everyone’s information,” Arad said, “the less we’ll see very aggressive action coming from regulators.”