During the early days of Bitcoin (BTC -1.33%), an estimated 25% of wallet users utilized the digital currency for illicit activities such as buying narcotics or illegal firearms, or as payment for human trafficking. It was impossible to catch the criminal syndicates behind the transactions back then. After all, cryptocurrency exchanges were once not legally required to verify customers' identities -- leading to widespread money laundering from crypto back to fiat currencies. 

All of that changed with the rise of cryptocurrency companies such as Chainalysis. Every Bitcoin transaction since inception is available on the public ledger, so analytic companies can easily track the flow of funds from suspected wallet addresses used for illicit activities and flag them. Problems arise when criminals sell "tainted" Bitcoins on exchanges to new investors, or send them to legitimate merchants. The new recipients could then face questions from law enforcement despite being oblivious to the whole ordeal. This fundamental flaw has led to the rise of privacy coins. 

A person on a laptop working on crypto mining.

Image source: Getty Images.

How do privacy coins work?

Privacy coins are equal and fungible by default. Despite using a public blockchain network, they obscure the participants' identity and transaction amounts. Fund transfers therefore become untraceable -- ensuring that no coin could become "tainted" due to its history. What's more, privacy coins are far more cost-efficient, take less time, and are more eco-friendly than Bitcoin. 

The most popular privacy coin right now is Monero (XMR -2.44%), with a market cap of $4.2 billion. To accomplish its main goal, the Monero network employs ring signatures. That is, it broadcasts decoy wallet addresses with every transaction, confusing the outside observer. In addition, the network assigns a one-time, unique wallet address/key to the sender and buyer to make sure the transaction goes through. On top of that, Monero wallet users have stealth addresses on top of a public address, so it's impossible to look up the transaction amount with the former.

In May, Monero developers launched the Atomic Swap feature. This allows Monero users to convert their holdings into Bitcoin without an intermediary -- with no carryover of previous Monero transactions for the public to see on the Bitcoin network. The slight downside to Monero is that its inflationary, with a long-term coin dilution rate of 1% to entice miners. 

The next most popular privacy coin is Dash (DASH -0.81%), with a diluted market cap of $2.9 billion. Unlike Monero, there is a maximum supply cap of 18 million coins, with about 11 million already mined -- making it deflationary. It's also optional to send money via the public network. Meanwhile, the private network breaks down each transaction into multiple smaller denominations and then shuffles wallet addresses with other users (who also have had their transactions broken down) to shield them from the public eye.

The third most popular privacy coin is Zcash (ZEC -2.08%), with a diluted market cap of $2.2 billion. Similar to Dash, Zcash allows users to choose between sending private and public transactions. It does this by using a cryptography mechanism known as zk-SNARK, a type of zero-knowledge proof. In this setup, a user sends money to another just as they would with any cryptocurrency, but the network transactions data are obscured/hashed and are proved to the recipient to shield them from the public eye. The coin has a maximum supply of 21 million, with about 12 million in circulation.  

The verdict

Even after the brutal sell-off from the ongoing bear market, Monero, Dash, and Zcash are all up over 100% from last January. Due to limited supply, cryptocurrency prices tend to rise with growing network adoption -- which I believe will be the case for privacy coins as Bitcoin faces increasing fungibility concerns. Their ability to stay equal and fungible against the backdrop of increased regulatory and third-party scrutiny into crypto public ledgers on the whole is a major value proposition for investors. Hence, now is an excellent time to buy the dip on any of them.