The EU Innovation Hub vs Crypto mixers: How privacy coins and crypto mixers complicate regulation?

What's going on?

In the summer of 2024, the EU Innovation Hub for Internal Security published its first report on encryption which explained how crypto mixers and privacy coins have made it harder for regulators to develop a crypto framework.  

Interested in how traceable crypto is? Check out this article to learn more: 'Your crypto footprint'.

The 2024 report examined the dual use of cryptographic technologies. In other words, the reliance on cryptocurrencies and non-fungible tokens (NFTs) on public-private cryptography for the purposes of transfers, mining, and storage can be used by perpetrators to avoid law enforcement as well. 

Data encryption demonstrated its effectiveness multiple times, especially to maintain a fair balance between security and privacy. On the other hand, crypto-mixing protocols function differently. 

Specifically, the EU Innovation Hub identified certain cryptocurrencies such as Monero (XMR), Grin (GRIN), Dash (DASH), and Zcash (ZEC) as well as some Layer 2 initiatives, crypto mixing services, zero-knowledge proofs, and non-compliant crypto exchanges as tools used by bad actors. 

Mixers and privacy coins have been complicating tracing for many years. However, zero-knowledge proofs are relatively new developments that can obscure the visibility of cryptocurrency addresses, transactions, and balances.

The EU Innovation Hub told law enforcement agencies they need to be prepared to encounter these types of tools in their investigations to deal with crimes such as money laundering.

What is the EU Innovation Hub?

The EU Innovation Hub for Internal Security refers to a collaborative network of innovation labs that provide updates regarding new technological advancements and efficient solutions to support the work of law enforcement authorities across EU Member States. 

It is hosted at Europel; the Hub Team consists of staff from divergent EU agencies and Member States and representatives from EU institutions. 

The European Union's Innovation Hub serves as a joint platform for providing innovative technological solutions, consulting on innovation projects, identifying research initiatives and potential regulatory overlaps, and providing policy advice to EU stakeholders and internal security organizations.

What are crypto mixers?

Crypto mixers keep crypto transactions private by mixing potentially identifiable cryptocurrency funds with broad amounts of other funds. Crypto mixing services are used to keep private transfers and don’t require KYC checks. 

However, criminals utilise crypto mixers for money laundering or hiding earnings. And that’s the main problem with crypto mixers.  

For example, there are two types of Bitcoin mixers, centralised and decentralised. Centralised Bitcoin mixers are companies that receive Bitcoins and send back different Bitcoins for a fee, and decentralised mixers utilise protocols to hide transactions typically using a peer-to-peer (P2P) strategy.  

The mixing protocols enable a broad group of users to pool their Bitcoins and then funds are redistributed back to them. The outcome is that no one knows who received what and where the funds come from. 

There are also other types of crypto or coin mixes that can be either obfuscation-based or zero-knowledge-based. The first category also goes by the name decoy-based mixers and implements ways to hide the user’s transaction graph, while the second category relies on zero-knowledge proofs to entirely erase the graph. 

What are privacy coins?

Privacy coins refer to cryptocurrencies designed to prioritise the anonymity of users. Popular privacy coins are Monero, Zcash, and Dash.  

Even though crypto transactions don’t include any personal information or IP addresses, their pseudonymous nature means that information about the sender or recipient can be inferred from examining transaction data and spotting patterns.

For example, a Bitcoin transaction records several pieces of information on the blockchain such as the transaction hash, sender and recipient address, the unix timestamp, and the amount of Bitcoin sent. 

So, anonymity isn’t a default trait of blockchain-based transactions. To obtain anonymity, privacy coins have been created. In other words, they utilise certain design features to hide or remove transaction data. These features are, for example, ring signatures, confidential transactions, stealth addresses, and coin mixing protocols.

What does the report on encryption say?

In its first report on encryption, the EU Innovation Hub for Internal Security examined how privacy coins and mixing protocols complicate regulatory efforts.

The report pointed out that encryption technologies present many challenges yet also opportunities for crime-fighting agencies. It stated that crypto assets have been widely used for criminal activities and some concerns tracing funds will become more complicated with the expansion of Layer 2 solutions and zero-knowledge proofs. 

The same conclusion has been reached in the matter of quantum computing; while quantum computing can be a friend of law enforcement and used for breaking cryptographic protocols, it can be also used by bad actors. 

Vitalik Buterin, Ethereum's co-founder, examined how to deal with quantum attacks in the future. To find out more, why not read this article: 'How to survive a quantum attack? Vitalik Buterin's new plan'.

The EU Innovation Hub announced that the main future research areas relevant for authorities in the areas of justice and law enforcement shall be the use of user-controlled encryption, the development of quantum computing, and the use of encrypted data for machine learning advancements. 

Let’s get to the part where the report examines crypto mixers and privacy coins- it states that most crypto transactions and their features are publicly visible on the blockchain, but some coins can obscure this visibility. These are privacy coins. 

The report lays down Monero as its first example- the most used privacy coin was introduced in 2014 and has been delisted by many exchanges because the origins of funds couldn’t be determined. Interestingly, the report mentioned that, despite its privacy features, Monero didn’t manage to overtake Bitcoin in popularity among malicious actors and that this is probably because of Bitcoin’s higher liquidity.  

The report mentioned Dash as the second example. This is a type of cryptocurrency where enhanced encryption is an option; in other words, it is possible to enable a private sending function which is like mixing protocols.  

As the third example, the EU Innovation Hub’s report mentioned Mimblewimble, a cryptographic blockchain protocol used for private transactions that relies on elliptic-curve cryptography. It adds further that Litecoin implements Mimblewimble as its optional feature while coins such as Grin use it for all transactions. 

As for zero-knowledge proofs, the report states that they enable transactions to take place without showing the data publicly. For example, the Tornado cash crypto mixer has been using zero-knowledge proofs to allow users to withdraw funds from the mixer without revealing the original deposit amount. 

Finally, the report moves to Layer 2 solutions and mentions Bitcoin's Lightning Network and two-party multi-signature payment channels that don’t broadcast all transactions to the blockchain. The report added that Layer 2 solutions are being developed on many other blockchains and that they might cause problems for law enforcement investigations. 

These reports can sometimes be hard to understand without basic knowledge of crypto and blockchain terms. To learn more about the crypto space, take a look at our Learn Crypto Academy.