One of the biggest misconceptions about cryptocurrencies is that they're anonymous. While it's true that there are some currencies, such as Monero, that do have built-in privacy features, that isn't the case for most of them. Bitcoin, Ethereum, and other similar tokens are pseudonymous, not truly anonymous. Proposals such as EIP-4337 do away with some of the challenges and issues of keys and seed phrases, making transactions more straightforward, but they don't address the on-chain issues that make transactions traceable.
Benefits of Privacy Pools and Zero-Knowledge Roll-Ups for Enhanced Data Privacy#
When transactions are completed on Ethereum's base layer, they're recorded on the blockchain for everyone to see. Anyone who wishes to look at the blockchain can follow a transaction to see what happens to the tokens. The average outside observer won't know who an address belongs to. Suppose your on-chain addresses become linked with your identity through a KYC exchange or when you buy something from a vendor that accepts cryptocurrencies. In that case, people may learn about your habits by examining the blockchain.
Privacy pools and zero-knowledge roll-ups can be combined to improve the privacy of transactions on Ethereum. They work by breaking the link between your deposit address and withdrawal address. If you've received funds to an address linked to your identity, perhaps by buying Ethereum from an exchange that follows Know Your Customer regulations, using a privacy pool can stop that exchange from tracking where the funds go next.
How Zero-Knowledge Proofs Work in Privacy Pools and Roll-Ups#
The idea of "mixing" currencies has been around for a long time, in the form of decentralized projects such as JoinMarket for Bitcoin and centralized pools such as the now-defunct Tornado Cash for Ethereum. There are nuances to how these projects work, but the basic idea is that several counterparties work together to 'swap' coins, breaking any links between the coins you put in and the ones you get out.
Zero-knowledge roll-ups serve as a way of scaling Ethereum and can help make privacy pools quicker and cheaper to interact with. ZK-rollups use Zero-Knowledge Proofs for a large number of transactions into one batch. They can process thousands of transactions at once, roll up those transactions into a much smaller piece of data, and feed that back to the Ethereum base data along with cryptographic proof in the form of a SNARK that shows the transactions are correct.
The Role of Cryptography in Protecting Privacy in Privacy Pools and Roll-Ups#
There are many different privacy solutions. Some operate on the base layer, some use optimistic roll-ups, and some take advantage of ZK-rollups. For example, Aztec offers privacy in layer 2 by using a combination of encrypted privacy circuits and zero-knowledge roll-ups. However, some exchanges view transactions conducted through such tools with suspicion. Privacypools.com also offers low-cost transactions, and since it's built on Optimism, it also provides some reassurance that the addresses involved are not linked to known addresses engaged in illegal activities.
Zero-knowledge roll-ups use cryptographic proofs to guarantee security. They can be used alongside transaction data encryption to make it even more difficult for third parties to trace transactions.
Use Cases for Privacy Pools and Zero-Knowledge Roll-Ups in DeFi Insurance#
Users of PrivacyPools.com have the option of depositing funds into the pool, then later withdrawing their funds to an unlinked address. Those users, and users of other similar pools, may want to insure the funds they contribute to those pools, and DeFi Insurance is an obvious solution to this issue.
The relationship between DeFi insurance and Privacy Pools is two-way. Traders who hold enough tokens to actively participate in the DeFi industry will likely want to protect their identities. DeFi platforms and insurers want to feel confident that the people they're trading with aren't known criminals or terrorists. Privacy Pools and Optimism's ZK-roll-ups are an excellent match for insurers.
The Future of Privacy Pools and Zero-Knowledge Roll-Ups in the World of Data Privacy#
The world of cryptocurrency is still evolving, and governments worldwide are considering ways to regulate the industry to prevent money laundering and fraud. Privacy-centric tools are viewed with suspicion by regulators. Many Ce-Fi platforms are reluctant to handle cryptocurrencies that their analysis tools have identified as having been through a mixing service.
Solutions such as Privacy Pools offer a way to normalize privacy, similar to WhatsApp adopting end-to-end encryption. Today, users who take advantage of privacy tools when transacting with cryptocurrencies are in the minority. If such tools were more common and operated in a legally compliant way, then privacy would become the standard, and private transactions would not stand out from the crowd. This would benefit everyone, whether they’re seeking privacy for personal reasons or simply don't want their transaction data shared with the world.
Key Challenges in Adopting Privacy Pools and Zero-Knowledge Roll-Ups: Addressing Scalability and Cost Concerns#
We still have a long way to go before ZK-roll-ups and Privacy Pools become mainstream. There are several barriers to adoption:
- Implementing ZK-roll-ups is more costly than implementing optimistic roll-ups because of the additional cryptographic proofs required.
- ZK-roll-ups still need widespread EVM support.
- Arbitrum and other popular scaling solutions have focused on optimistic roll-ups.
While it's true that optimistic roll-ups are cheaper and easier to implement, zero-knowledge roll-ups offer faster transaction verification times, which can be necessary in many cases. As EVM support improves and more developers adopt ZK-roll-ups, we may see enhanced compatibility, widespread rollouts, and improved performance.
Conclusion: Why Privacy Pools and Zero-Knowledge Roll-Ups Are Important for Data Privacy in the Digital Age#
For DeFi to see widespread adoption, it must:
- Support inexpensive and predictable transaction fees.
- Offer faster transactions.
- Offer a reasonable level of privacy by default.
In the current environment, where fees fluctuate based on the level of on-chain activity, transactions can take hours to complete. There are many privacy-related footguns to consider that are not suited to the average casual user. Privacy Pools and zero-knowledge roll-ups address many of those concerns, helping build a more robust ecosystem for users of all experience levels and technical literacy.
At Neptune Mutual, we offer parametric insurance on Ethereum layer 1 and Arbitrum, and we're always looking to innovate and incorporate new technologies into our cover pools. If you'd like to get involved with growing the Neptune ecosystem, check out our grants and bounty programs today.
