While many assume that major blockchains are private, they are of course anything but. Every action on a public blockchain is openly recorded and accessible to anyone, posing challenges for integrating blockchain into traditional finance, where the privacy of personal and transactional information is paramount.
The issue is particularly pertinent to Ethereum, which aims to revolutionize the global financial sector and is currently the primary blockchain for Decentralized Finance (DeFi).
Many have tried to fix privacy on Ethereum, and Tornado Cash has been the most successful to date. Essentially a mixer, the project blends user deposits with others in a pool, effectively masking the connection between sender and recipient addresses.
The solution rapidly garnered attention on launch. Yet, beyond its legitimate users, various hacker groups exploited it to launder stolen crypto. Consequently, the U.S. Treasury's Office of Foreign Asset Control (OFAC) sanctioned the protocol, leading to the arrest of the developers behind the project.
The Tornado Cash fiasco further reinforced the prevailing notion that privacy and regulatory compliance are incompatible. Yet, in his recent paper, Vitalik Buterin counters this perspective.
Together with several co-authors, Vitalik introduced the concept of Privacy Pools. While they function similarly to the Tornado Cash mixer, they address the problem of bad actors exploiting them.
A fundamental problem with Tornado Cash was that genuine users struggled to separate themselves from the illicit actors exploiting the protocol. Privacy Pools only lets users access certain pools if they can show that their transactions come from honest sources.
Each Privacy Pool is linked to a specific transactional association set. If a user's address meets the criteria of a particular set (e.g. deposits from Coinbase and Binance are allowed, but deposits from Tornado Cash are not), they can use the mixer effectively; if not, they can't.
Privacy Pools are also highly flexible. With specific association sets, the protocol can adapt to many different use cases. A group of commercial banks could establish an association set exclusive to their customers' deposits. Different jurisdictions may have their own association sets, depending on the local laws. The authors also propose Association Set Providers (ASPs) - special intermediaries that can construct association sets on behalf of the users.
In fact, usage of association sets can go far beyond privacy mixers. By using zk-proofs, users can easily prove that their transactions belong to a certain association set, without actually revealing their address and transaction history. This could be particularly applicable to KYC and AML use cases.
While the solution might sound easy, the paper reveals several potential problems with the actual implementation of Privacy Pools. For example, in cases where there is no global consensus on whether funds are perceived as “good” or “bad”, it could come down to the societal perspective or jurisdiction. The authors do not exclude distinct rule sets for association sets in each jurisdiction.
Although the demand for privacy within Ethereum is evident, it remains to be seen whether this new protocol concept will be adopted by developers in the ecosystem.
As articulated by the authors of the paper, it “should be seen as a humble contribution towards a potential future, in which financial privacy and regulation can co-exist.”
We will Observe whether any team attempts to bring this concept to life.
