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Privacy Pools: Regulatory-Compliant Anonymity Powered by Zero Knowledge

Lincoln Murr

Summary: Blockchain's best and worst trait lies in its unparalleled transparency. While open transactions foster accountability and trust, they also strip away financial privacy, which many consider non-negotiable. At the same time, entirely anonymous transactions risk turning blockchain platforms into breeding grounds for illicit activity. Enter privacy pools: innovative smart contracts designed to maintain user privacy ...

Blockchain's best and worst trait lies in its unparalleled transparency. While open transactions foster accountability and trust, they also strip away financial privacy, which many consider non-negotiable. At the same time, entirely anonymous transactions risk turning blockchain platforms into breeding grounds for illicit activity. Enter privacy pools: innovative smart contracts designed to maintain user privacy while complying with regulatory standards. In this article, we delve into the mechanics of privacy pools and discuss their potential impact on the future of cryptocurrency transactions.

As demonstrated by Tornado Cash, regulatory compliance is paramount for private blockchain transactions. For those who are unaware, Tornado Cash was an Ethereum-based protocol that acted as a coin mixing service, where users could deposit ETH, have it mixed with other users’ deposits, and send it to an unassociated address. It was effective, so much so that high-profile hackers, including some that are believed to be associated with the North Korean government, used it to launder funds related to the Ronin Bridge hack. As a result, the U.S. government sanctioned the smart contracts and charged the co-founders with money laundering and other related crimes. This case was incredibly controversial since many argue that the founders merely wrote and published code - an activity protected under the First Amendment. Interestingly enough, the contracts are still on Ethereum and have some activity, and the government will never be able to fully take them down due to their immutable and distributed nature.

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The case of Tornado Cash highlights the need for privacy pools that can maintain user privacy while complying with regulatory standards. These pools aim to balance transparency and privacy, allowing users to conduct transactions without revealing their identities while preventing illicit activity. 

Fortunately, a solution has just been proposed. On September 6th, Ethereum co-founder Vitalik Buterin, alongside Ameen Soleimani, proposed a research paper for regulatory-compliant privacy pools titled “Blockchain Privacy and Regulatory Compliance: Towards a Practical Equilibrium.” The main idea is to create coin-mixing pools similar to Tornado Cash but allow users to create a zero-knowledge proof to prove that their funds did not originate from illegal sources, like a hack. Since the proofs utilize zero-knowledge technology to prove a fact without revealing its reasoning, privacy is still preserved. Since honest transactions can be mixed with other honest transactions, regulatory compliance can be guaranteed while preserving privacy. 

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Though this may seem of minor significance, it has vast consequences for cryptocurrency's long-term adoption and use. Until now, every blockchain-based transaction was required to be public or potentially noncompliant with U.S. regulations and subject to sanction enforcement. For the average person, neither of these solutions are ideal and are objectively worse than the traditional banking system’s privacy-oriented approach. With privacy pools, we get both regulatory compliance and an unparalleled level of privacy - not even banks or the government can read these transactions. They help facilitate employees who get paid in cryptocurrency and do not want their employer to see their account balance or transaction history, for example. Additionally, the support of Vitalik, one of the most influential names in the blockchain industry, will accelerate the adoption of this technology, and it could become an automated feature in the backend of many smart contracts and protocols. Adding privacy to a transaction could become as easy as toggling a switch.

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The first iteration of Privacy Pools is live on Optimism testnet and will likely be on mainnet in the coming months, if not sooner. Once live, the vision of Tornado Cash will again be achievable by all, and on-chain privacy will slowly become the norm.

By Lincoln Murr

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