May 4, 2021
DeFi and Layer One Privacy
DeFi — the new goldrush — is making headlines as cryptocurrency enthusiasts and investors flock to the marketplace. This article (1 of 2) considers DeFi from a layer one (L1) privacy perspective, with the follow-up considering layer two (L2) solutions.
The umbrella term DeFi covers a range of projects all of which in theory are working towards a fairer, rule-backed monetary system. The dream is one in which the whims of central government and self-interested banking systems cannot interfere with a person’s money. You want to send someone money without it taking three days? Or perhaps you want to swap one form of cryptocurrency for another? You can do it, with DeFi. You want to preserve your purchasing power against deflation? You can deposit to a liquidity pool or stake your tokens, for inflation-busting returns (provided your token price holds against fiat!). You want to collateralise your crypto assets to borrow against them? DeFi.
Those three ideas: moving money, lending and borrowing, and earning interest on your cryptocurrency assets, are fundamental to understanding — and earning from — the DeFi revolution.
The earliest DeFi platform was LocalBitcoins, a 2012 marketplace that connected Bitcoin sellers with buyers who, for whatever reason, didn’t want to trust a centralised exchange (cex) with their personal data or money. This peer to peer (P2P) choice seemed vindicated in 2014 following the Mt. Gox exchange hack, in which each active user lost on average 3.9 Bitcoins. Today, those 3.9 Bitcoins would be worth in excess of $200,000, an expensive reminder that trusting a centralized authority always comes with risks.
Early DeFi applications such as Shapeshift and AtomicDex wallet allowed users to anonymize their funds in a transaction, or trade P2P remotely. The 2017 bull market was characterized by ICOs, many of which focussed on privacy protocols. It is important here to differentiate between platforms and privacy coins such as Monero, Z-Coin, and Pirate Coin. These coins provide native support for privacy, meaning P2P transactions can be conducted on-chain with optional or mandatory shielding of some form, rendering a layer of protection in the same way as a fiat transaction conducted in cash.
During the 2018 Bitcoin bear market, many projects continued to build and slowly attract a userbase. The “flash crash” in March 2020 was followed by an explosion in popularity for cryptocurrency in general, and DeFi specifically.
While DeFi platforms such as ETH and BSC have moved the focus of the crypto-sphere away from on-chain privacy, it is still a very important part of the crypto ecosystem. So how can the user of ETH or BSC benefit from L1 privacy protocols?
To consider how transactions can be tracked, consider the blockchain as a chain of transactions, one after the other, on the same chain or chain-to-chain, visible to anyone who wants to investigate. Imagine Alice wants to send Bob 1 BTC. The transaction can be visualised as below.
Alice buys 1 BTC with fiat at a KYC cex
Alice sends 1 BTC to Bob
Bob sells 1 BTC for fiat at a KYC cex
This method is possibly the easiest, however both exchanges have a record of Alice and Bob’s transaction, and the on-chain transaction (but not the identity of Alice and Bob) is public knowledge. This can be improved by the use of on-chain privacy protocols such as ZK-Snarks or Schnorr ring signatures as found in Z-Cash, Komodo, and Monero coins, visualised below.
Alice buys 1 BTC with fiat at a KYC cex
Alice exchanges 1 BTC for XMR at the KYC cex
Alice sends XMR from her cex XMR address to her XMR wallet — using on chain privacy protocol
Alice swaps XMR for 1 BTC via a dex such as AtomicDex
Alice sends 1 BTC to Bob
This method involves more work, but protects Alice’s privacy. The cex know that she has bought 1 BTC, but cannot trace it beyond knowing the date and time she transferred it off the exchange. The dex cannot know the origin of the XMR swapped for BTC, and so while the BTC on-chain transaction between Alice and Bob is public knowledge, Alice has protected her privacy.
This L1 method of securing privacy is not without risk, as Alice will pay extra trading fees and transaction fees. She also has to hope XMR (or whichever privacy coin she chooses) holds value against BTC until the chain of transactions is completed, and risks sending <1 BTC by the time she is ready to settle on-chain to Bob. For quicker and potentially cheaper methods of bringing privacy to DeFi platforms such as ETH and BSC, there are a number of L2 solutions considered in the next article.
This article does not constitute financial advice. Potential investors are encouraged to do their own due diligence and make an informed decision aware that value of investment may fall as well as rise. To the extent permissible by law the author declaims any and all liability arising from any losses incurred by investors.
