How does Zcash balance privacy and transparency in blockchain?

Zcash, a cryptocurrency launched just last week, promises a new kind of transaction privacy on public blockchains that could make distributed ledger technology more attractive to financial institutions, but regulators may not be so happy.

Peter Van Valkenburgh, director of research at Coin Center, said:

“With a public blockchain, if you’re JPMorgan, you can see all of Credit Suisse’s books, so neither JPMorgan nor Credit Suisse are comfortable with that level of transparency.”

With Zcash, software developer and Zcash founder Zooko Wilcox has provided a solution to this problem. If the technology works as envisioned, it could not only make blockchains more bankable, but also help resolve long-standing tensions between banks and anti-money laundering regulations. It remains to be seen how governments view a system where transactions can be audited to reveal who is in control.

Starting with the same basic framework as Bitcoin, Wilcox added a recent cryptographic innovation to the blockchain: zero-knowledge proofs.

The Zcash system allows users to conduct private transactions while maintaining the integrity of the blockchain that supports the transactions. With Bitcoin, users are identified by anonymous transaction addresses. Those alphanumeric strings alone do not guarantee privacy, as the movement of funds can be tracked through the blockchain and addresses controlled by the same users can therefore be linked.

For Zcash, it features two types of addresses, ‘transparent’ and ‘shielded’. With transparent addresses, the amounts sent back and forth can appear on the blockchain like Bitcoin. But if a user chooses to use a shielded address, the transaction will be obscured from the public ledger. If both the sender and receiver of funds choose to use a shielded address, the amount sent will also be encrypted.

Zcash founder Zooko Wilcox

Eventually, the Zcash development team will add ‘view keys’ that users can share with third parties to reveal their transactions – without anyone else seeing them.

Wilcox said:

"We call this 'selective disclosure,' and it comes with an encrypted memo field that allows institutions to attach sensitive information to transactions that only authorized institutions can see."

The potential of zero-knowledge proofs, Van Valkenburgh said, is that they "allow you to prove something about a data structure without revealing the data inside that data structure."

Wilcox said at American Banker’s Blockchain + Cryptocurrency Conference:

“You can actually get many or most of the properties of transparency, privacy and data security at the same time with encryption. You can add encrypted data to the blockchain in such a way that only authorized parties can decrypt it, not everyone.”

But it retains the important properties of blockchain.

He also said:

“Zcash is like any other blockchain, in that the information you provide to different people for a transaction cannot be different, and you cannot change your information.”

After pausing work on zero-knowledge proofs to ensure Zcash can be released on time and securely, the company is now moving toward pursuing research on both projects in parallel.

Wilcox said in an email on Monday:

“Our code is being tested by the internet community.”

An obvious question is whether the privacy features of the Zcash currency (ZEC) will make it more difficult for financial institutions — such as digital currency exchanges and wallet services or other banking providers — to comply with anti-money laundering laws.

On the one hand, Zcash’s ‘selective disclosure’ capability, combined with pressure on intermediaries to comply with anti-money laundering rules, will ensure that most transactions are traceable.

The collection of basic transaction data for AML purposes will likely be performed by third parties such as wallets and exchanges.

To comply with money services business rules, or because they need to satisfy banking partners, these companies (wallets or exchanges) will have to obtain data and other information about the participants in the transaction to ensure that they can flag suspicious transactions.

Pratin Vallabhaneni, an associate researcher at the law firm Arnold & Porter, said:

“All of the same compliance infrastructure still needs to be in place. If you’re a Zcash user and think ‘Oh, I can do more anonymous transactions.’ That’s not correct because if you don’t disclose basic identity information, you’re not going to be able to access the rest of the [financial] ecosystem.”