Privacy coins, cryptocurrencies that can't be tracked or traced, have always been a polarizing issue in the crypto industry. Despite concerns about how they might be used, privacy coins like Monero (XMR 1.71%) and Zcash (ZEC 3.39%) routinely rank within the top 50 on CoinMarketCap in terms of market value. There has always been demand for them because some people like to keep their online identities private and don't want their crypto transactions made available for all to see. 

On Aug. 8, though, the U.S. Treasury Department blacklisted a piece of computer code known as Tornado Cash that enables users to anonymize their crypto transactions. As a result, the U.S. Treasury blocked access to Tornado Cash and prohibited U.S. individuals from using Tornado Cash in the future.  While the U.S. government didn't punish privacy coins directly, it placed restrictions on the type of blockchain technology that makes them possible. This could be a disaster for privacy coins, especially because the U.S. government linked Tornado Cash to cybercrime and money laundering.  

What is Tornado Cash and why does it matter?

There's obviously a lot to unpack here. The U.S. Treasury Department acted via the Office of Foreign Assets Control (OFAC), which normally places restrictions and prohibitions on people, organizations, and other entities. And when it does impose penalties, it normally focuses on foreign nations such as Iran, North Korea and Russia that are in the headlines for the wrong reasons.  It doesn't, however, typically prohibit pieces of code on the blockchain. And yet that's exactly what it did in this case, because Tornado Cash is essentially just a bunch of smart contracts on the Ethereum (ETH -3.53%) blockchain. 

Frustrated computer user showing signs of stress and anxiety.

Image source: Getty Images.

Even lawyers are puzzled by this, because OFAC didn't go after the developers who created the code. As a result, the Tornado Cash site is down, and all code used to create the open-source mixing protocol is unavailable. If you try to use Tornado Cash now, you may face fines or even jail time. From the perspective of the U.S. government, trying to anonymize your crypto transactions online is now equivalent to violating sanctions against trading with the enemy.

The impact on privacy coins

The Tornado Cash episode is a warning for anyone thinking about investing in privacy coins. It's likely going to become more difficult for the casual investor to buy and sell them. Some cryptocurrency exchanges enable you to do so, but others do not. Obviously, cryptocurrency exchanges have always been concerned about the potential for privacy coins to be used for illicit purposes, and the Tornado Cash disaster isn't going to help matters. 

Yet what's really surprising is that privacy coins have held steady in the aftermath of the Tornado Cash incident. Monero is up 3.2% over the past seven days, while Zcash is up 14% over the same time period. Moreover, a number of high-profile people within the crypto world have spoken out in support of Tornado Cash. For example, Vitalik Buterin, the co-founder of Ethereum, says that he has used Tornado Cash in the past for completely legitimate purposes. When he donated money to Ukraine, he used Tornado Cash to "mix" his crypto so that the Russian government couldn't see his Ethereum moving from one crypto wallet to another. There are clearly some situations when it makes sense to keep your crypto transactions private.

The future of privacy coins

And that's why I'm so optimistic about the future of privacy coins. This new attack on "crypto mixers" reminds me a lot of the early days of Bitcoin (BTC -3.82%), when people were concerned that Bitcoin was being used only for nefarious purposes. Remember the days of the Silk Road and how Bitcoin had a very shady reputation with the government back then? Today, the U.S. government obviously has reasons to be concerned about "crypto mixers" and the potential for money laundering, just as it had reasons to be concerned about Bitcoin nearly a decade ago. 

It might be risky to invest in them right now, but privacy coins are not going away. They will likely go mainstream at some point, just as Bitcoin has. After all, privacy coins are just like any other crypto, just with an added layer of security and privacy. For now, though, it pays to keep a close eye on regulatory developments in Washington, D.C. Cryptocurrencies have always been subject to regulatory risk, and that is something that you should particularly keep in mind if you decide to invest in privacy coins.