EU Report Flags Layer 2 Crypto Solutions as Risks

A recent report from the EU Innovation Hub for Internal Security has raised concerns over Bitcoin’s Lightning Network and other layer 2 technologies, labeling them as potential tools for criminal activities due to their data obfuscation capabilities.

This First Report on Encryption from the EU body, which coordinates innovation labs across EU member states, identifies these technologies alongside others such as Mimblewimble, zero-knowledge proofs, coin mixers, and privacy coins like Monero and Zcash as susceptible to misuse.

The report specifically points out that the Lightning Network’s method of handling transactions—where only the opening and closing of payment channels are recorded on the blockchain—presents challenges for law enforcement investigations. It suggests that this and similar layer 2 solutions could obstruct efforts to trace the origins of potentially illicit cryptocurrency transactions.

Additionally, the report critiques technologies such as Tornado Cash and various privacy coins, noting their use of zero-knowledge proofs and other mechanisms that significantly hinder the tracing of transaction origins. These features, while designed for user privacy, are seen as complicating factors for detecting and investigating illegal activities.

The use of the cryptographic protocol Mimblewimble, utilized by cryptocurrencies like Grin, Beam, and even Litecoin, is also cited in the report as problematic, although it acknowledges that encounters with transactions using Mimblewimble are relatively rare.

Regulatory pressure on privacy-enhancing cryptocurrencies has been intensifying globally. The impending EU’s Markets in Crypto Assets (MiCA) framework, set to be enforced by the end of 2024, will place strict regulations on crypto-asset service providers’ interactions with privacy coins. This has led major crypto exchanges, including Binance, to delist such coins.

Moreover, the crackdown extends to crypto mixers, with notable actions such as the conviction of Tornado Cash developer Alexey Pertsev for money laundering by a Dutch court and the arrest of the founders of Bitcoin mixer Samourai Wallet by U.S. authorities for conspiracy to commit money laundering. These legal actions have sent ripples through the crypto community, causing several coin mixing services to cease operations in the U.S. following the Samourai Wallet arrests.

While layer 2 solutions and privacy coins offer significant benefits for user privacy and efficiency, they also pose notable challenges for law enforcement and regulatory bodies, prompting a need for balanced solutions that address both privacy rights and anti-crime measures.