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What you need to know about stablecoins’ privacy

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Cryptocurrencies are often associated with anonymity. But stablecoins are a different kettle of fish. Today we will talk about why they can’t be as confidential as cryptocurrencies. We will tell you in what ways centralized stablecoins differ from decentralized ones, what are the problems with privacy and how these problems are solved if at all.

Stablecoins and privacy

State regulation of cryptocurrencies is a complex task that developed countries are trying to solve. To develop and implement bills, they often turn to analytical companies working with the blockchain. One of such companies is Chainalysis, which monitors cryptocurrency transactions.

Chainalysis works with internal agencies in the United States and Europe, such as the Federal Bureau of investigations (FBI) and Europol. Tracking of up to 90% of all transactions in cryptocurrency helps in the fight against corruption, fraud and terrorist financing. According to the Chainalysis’ report, more than $1 trillion worth of cryptocurrency transactions were made in 2019, and 1.1% of them were illegal.

In fact, the work of blockchain analysis services is to identify the connection of specific individuals with specific transactions in the network. Thanks to the Chainalysis services, the Internal revenue service of the United States tracks the actions of bitcoin holders and monitors the payment of taxes. Therefore, even Bitcoin transactions cannot be considered completely anonymous.

For stablecoins, the cost of which is pegged to the exchange rate of a fiat currency, the issue of confidentiality is even more complicated. Problems arise from the goals that users follow:

  1. To minimize the risks associated with the volatility of cryptocurrency.

The problem in this case is to simplify the algorithms of stablecoins. This makes it easier for monitoring networks such as Chainalysis to work. Reducing privacy may have negative consequences in countries where the cryptocurrency market is not yet regulated.

  1. To protect themselves from inflation in the real economy.

In this case, the holder of a stablecoin is at risk, as it acts in opposition to the economic policy of the state. There may be clash of interests not only on the ideological level, but also on the regulatory level. With the devaluation of the national currency, the anti-crisis measures include control over the movement of capital. Such a case occurred in Argentina in 2019, when the government forced citizens to keep a currency that was rapidly losing its value.

  1. To use in Decentralized Finance (DeFi). 

Due to the lack of transparency of cryptocurrencies, the traditional financial market cannot fully integrate them. Stablecoins allow you to create an alternative to existing financial systems based on the blockchain.

All these problems are solved in different ways, since the privacy parameters of any cryptocurrency depend on the principle of its operation. Stablecoins can be divided into two groups — centralized and decentralized.

Centralized stablecoins

Centralized stablecoins are backed up in a 1:1 ratio by currencies that are stored in bank accounts. They are created and managed by a single organization and store data only on their own servers. At the same time, the stablecoin of a single company can exist in several different blockchains. For example, UDST runs on the Omni, Ethereum, EOS, Tron, and Liquid platforms.

Examples: USD Tether (UDST), Paxos Standard (PAX), Binance USD (BUSD). 

The non-profit organization Human Rights Foundation in 2019 presented a report that provides an analysis of the privacy of stablecoins. HRF identified five main evaluation parameters:

  1. The ability to monitor transactions using Chainanalysis;
  2. Open source contracts;
  3. Basic privacy tools;
  4. The ability to freeze accounts;
  5. Monthly certifications.
The result of HRF's report about atablecoins
Table of different stablecoins characteristics. Source: Human Rights Foundation

Of the above, only USDT on the Liquid blockchain supports any privacy tool. That is Confidential Transactions, which hides the asset type and amount of each transaction.

It is important to consider not only the technical capabilities of organizations, but also how they use these leverage. According to HRF, Tether has only frozen USDT at 16 different addresses.

Decentralized stablecoins

Decentralized stablecoins do not have a central regulator. They are backed by cryptocurrency collaterals and are managed by the users themselves.

Examples: DAI, EOSDT, USDJ. 

The DAI decentralized stablecoin, like USDT, is pegged to the US dollar. The difference is that to get it, users block a certain amount of their ETH.

The main problem with privacy is that it is easy for monitoring networks like Chainalysis to identify users. This is because the Ethereum blockchain encourages the reuse of addresses. By default, most users make all their transactions using the same address. This allows monitoring companies to identify the relationship of specific individuals with specific transfers. However, it is still technically impossible to block funds in DAI by the decision of the regulatory body.

On October 12, 2020, the Aztec 2.0 platform for the Ethereum blockchain was announced. The startup provides tools for sending tokens with a high level of anonymity. The zkSNARK Protocol hides the sender’s and recipient’s data, as well as the volume of transactions, which makes them private.

Summary

The very purpose of using stablecoins causes a number of privacy issues. Centralized and decentralized projects try to approach the solution from different angles. However, HRF analysts conclude that the privacy of stablecoins still «leaves much to be desired».

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