One of the most intrinsic things about blockchain is its transparency, with all transactions recorded on a public ledger, where they can be viewed and verified by anyone. This transparency is critical to the design of blockchains, as it’s what fosters trust and enables peer-to-peer interactions without the need for any middleman.
Yet, it’s also problematic, making it difficult to reconcile blockchain with existing data privacy regulations, and it can also expose users to a number of risks, such as front-running attacks, financial surveillance, and the possibility of being targeted by criminals.
In response to these challenges, numerous privacy-focused blockchains and decentralized finance protocols have emerged, offering innovative solutions to confidentiality that aim to protect users and their data while maintaining enough transparency for users to transact securely. They’re based on an assortment of clever techniques, including zero-knowledge proofs, ring signatures, stealth addresses, privacy coins, and more.
The problems of blockchain transparency
Although blockchain is often praised for its transaction security, it’s also something of a paradox in that it often sits at the opposing end of the technological spectrum in terms of privacy. The decentralized nature of blockchain is only possible because of its transparent and public architecture and is what makes the technology so secure. But it’s also detrimental for user’s privacy, leaving their transactions exposed to anyone who cares to look at them.
The lack of privacy in blockchain transactions is problematic with regards to compliance with data privacy regulations such as Europe’s General Data Protection Regulation. Known as GDPR, this landmark legislation was enacted by the EU in 2018 and decrees that individuals should be able to exercise significant control over their data. For instance, companies must obtain users’ explicit consent to be able to process their data, and those users must also be able to access and rectify any personal information or records kept by those companies. In addition, GDPR also stipulates a right to be forgotten, where users can request to have certain publicly available information erased completely.
That explains why it’s challenging for blockchains, which are known for being immutable, to comply with the GDPR. On networks such as Bitcoin or Ethereum, once data is recorded, it cannot be altered or erased, which seems to clash with the ideas of data erasure or rectification under the GDPR. Moreover, it’s also not possible to identify a “controller” of blockchain data, as these networks are operated by a network of independent nodes.
Lack of transaction privacy can also create problems specifically for users. The transparent nature of blockchain makes it relatively easy for criminals to identify and potentially target wealthy individuals. While blockchain wallets are essentially anonymous, in that they’re merely a number, with a bit of determination, it’s possible to link certain wallets to individuals. For instance, if someone posts an NFT on their social media profile, it might be possible to identify that user’s crypto wallet, and if that happens, it’s a trivial matter to establish how much funds they possess.
The dangers of this became all too clear earlier this year with a spate of kidnappings of crypto executives and their family members in France. In June, authorities arrested and charged 25 individuals over a series of abductions of prominent crypto figures in that country. In several instances, the kidnappers reportedly demanded significant ransom payments in exchange for the release of their victims.
There are other risks, too. For instance, rival traders can take advantage of blockchain’s transparency to surveil the investment strategies of crypto whales and other institutions, while those trading large volumes of cryptocurrencies are often subject to “front-running attacks”, where automated bots insert their transactions ahead of large buy and sell orders to profit from the price impact of such trades.
How Has The Industry Responded?
Still, these challenges do not necessarily mean that blockchain is incompatible with privacy requirements. Rather, they have invited yet more innovation in the crypto industry, with numerous projects attempting to create novel solutions that respect users’ privacy rights while maintaining decentralization and transparency. One popular technique is the “hashing” of personal data, which involves masking information with a numerical value to protect users’ identities. In addition, some developers are working on “off-chain” storage solutions or permissioned blockchains that are only visible to eligible users. Such innovations demonstrate how data privacy headaches can stimulate innovation instead of holding it back.
Some of the earliest solutions for blockchain privacy were privacy coins like Monero, Zcash, and Firo, which mask their ledgers using cryptographic techniques and make transactions untraceable. Monero utilizes ring signatures, which merge chunks of blockchain data to make it impossible to link a specific transaction with an individual wallet, while Zcash uses a different technology known as “zk-SNARKS. In this case, it allows users to verify transactions by proving they know the amounts sent and the addresses involved, but without publicly disclosing those details. As for Firo, it uses a different cryptographic protocol called Lelantus that achieves the same thing.
These privacy coins provide clear advantages in terms of user privacy and anonymity, but they have also faced considerable scrutiny and attracted a reputation as favorites for cybercriminals, as they can be used to mask illicit activities such as money laundering and ransom payments.
This has led to a focus on more balanced privacy solutions that attempt to be more palatable in terms of regulations. Aleo is a privacy-focused blockchain network that employs Zero-Knowledge Proofs to secure transactions and smart contracts and give users control over their financial data, while simultaneously catering to regulatory bodies that demand transparency and accountability to prevent fraud and other illicit financial activities.
Aleo incorporates a trio of features designed to ensure it can meet compliance obligations without forsaking privacy. For instance, it supports the “selective disclosure” of certain pieces of data, so users can prove they are in compliance with regulations without revealing personal information. It means they can demonstrate their financial dealings are legitimate by proving the origin of their funds and showing they comply with tax obligations while maintaining privacy.
Additinally, Aleo also supports auditability under certain circumstances. For instance, it can disclose specific transaction details with the approval of the parties involved, or when governments go through the correct legal channels while ensuring that no unauthorized parties will ever be privy to such information. Aleo also offers compliance tooling for developers, such as the ability to embed regulatory checks into smart contracts.
Secret Network is an alternative to blockchain privacy that leverages “secure enclaves” to process transactions in hardware-protected environments. This ensures data can be processed with full confidentiality, so data remains hidden from unauthorized access. The network is further fortified by its consensus mechanism, which encrypts transaction details during transmission and storage.
This may seem like Secret Network contravenes most compliance requirements, but it gets around this through its native SCRT token, which serves as the backbone of its network and adheres to various evolving global regulatory frameworks. Because Secret Network utilizes mechanisms such as staking and transaction fees, it promotes accountability and transparency, helping it to function within various compliance layers while guaranteeing user anonymity and data privacy.
Another innovative approach is employed by Railgun, a privacy-focused protocol that uses ZK-proofs to mask smart contract actions, so users can interact with DeFi in a private and secure way. Alongside ZK-proofs, it implements a mechanism known as Proof-of-Innocence, through which users can verify that they did not interact with any blacklisted crypto wallets or suspicious addresses linked to illicit activities. It provides cryptographic proof of non-interaction for users to show they are not a hacker or bad actor.
A Catalyst For Privacy Innovation
The transparency of blockchain is rightly hailed as one of the most significant technological breakthroughs this century, paving the way for trustless financial systems with unprecedented user security. Yet, the focus on transparency paradoxically encroaches on users’ privacy and safety from another angle, creating the need to strike a delicate balance between disclosure and discretion.
However, rather than create an impasse, this tension has helped to catalyze the development of pioneering new approaches to privacy, illustrating how such difficulties tend to increase innovation instead of stifling it. With the emergence of privacy-focused blockchains such as Aleo and Railgun, blockchain users can remain safe and secure with full anonymity, without falling foul of regulatory concerns.
Disclaimer: This article is provided for informational purposes only. It is not offered or intended to be used as legal, tax, investment, financial, or other advice.
