Privacy coins are cryptocurrencies designed to protect user anonymity. Some popular examples are Monero and ZCash.
Unlike Bitcoin, where transaction details (sender, receiver, and amounts) are visible on a public ledger, a blockchain, privacy coins obscure this information.
In simple terms, privacy coins allow you to send crypto without anyone knowing who you are or the destination of your funds.
How do Privacy Coins work?
Let’s see two examples:
Monero:
Generates ring signatures which allow a user to sign on behalf of a group without revealing which member of the group initiated the transaction.
Each transaction generates a unique address, also known as stealth address, making it difficult to link payments to the sender or the recipient.
Implements confidential transactions (RingCT), a feature which hide the amounts being transferred.
ZCash:
Offers two options: transparent addresses (visible like Bitcoin) or shielded addresses (completely hidden using cryptographic methods).
These features make it nearly impossible to trace the parties of transactions, which is why privacy coins appeal to users who value privacy—and unfortunately, they can also attract bad actors also.
How Privacy Coins are Used in Money Laundering
Money launderers and overall criminals usually aim to obscure their identities including the illegal origin and destination of funds. Privacy coins, due to their unique features offer exactly what they want - complete privacy - which make them a perfect tool for money laundering.
Here's how a money laundering scheme may work:
Funds are obtained through illegal activities, such as drug trafficking, fraud, or others.
The illicit funds are converted into cryptocurrency. This often involves using exchanges that may not have stringent Know Your Customer (KYC) rules (non-compliant exchanges) to purchase known cryptocurrencies.
The cryptocurrencies are converted into privacy coins.
To further obfuscate the origin of the funds, criminals may use mixing services (also known as tumblers).
The launderers may conduct numerous transactions between multiple wallets they control.
Money launderers may employ advanced techniques like chain hopping or decentralised swap platforms to convert privacy coins into other cryptocurrencies, making it difficult to track the flow of illicit funds.
Finally, at some point the bad actor exchanges the privacy coins for fiat currency or other cryptocurrencies, bringing the funds slowly into a regulated exchange and then into the real world.
What are regulated exchanges doing to mitigate the risks associated with privacy coins?
To address these risks, many regulated exchanges do not offer exchange or trading in privacy coins. Additionally, in some countries, privacy coins are banned or restricted.
Conclusion
Privacy coins are not inherently illegal. They can offer individuals financial privacy, which is a fundamental right in many jurisdictions. The desire to keep personal financial activities private is not unlawful.
However, as with many products and services, the very features that protect privacy can also attract misuse. This duality challenges AML professionals to differentiate between legitimate privacy seekers and those exploiting these tools for illegal purposes.
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