In Part One of this treatise, we examined the fundamental relationship between Bitcoin and privacy by going back to the beginning with the whitepaper. In spite of some excellent privacy preserving options that have been available to users since those early days, we seem to have taken a few wrong turns. But to fix it, in order to make Bitcoin’s privacy “great again,” we must be able to distinguish between real privacy and red herrings that can only lead us further off the path.
Fiat Gateways Lead to Privacy Graveyards
Bitcoin is an effective system to transfer and store wealth, but that wealth has first to "enter" the system somehow, very often coming from fiat money. (Of course, you can also earn satoshis directly in exchange for goods and services you provide, instead of buying them with fiat.)
Fiat-enabled bitcoin on-ramps (often known as "cryptocurrency exchanges"), acting as liquidity bridges, created huge privacy problems in Bitcoin. In order to manage fiat, exchanges will have to use traditional bank accounts. In order to get those, they have to meekly accept all the rules, conditions and limitations banks require. Traditional fiat banks, in turn, will pass over the extremely complex and heavy "compliance" burden they received from governments and regulatory agencies, including that concentration of economic illiteracy called "KYC/AML regulation."
So, fiat-to-bitcoin bridges will almost always end up demanding a scary amount of personal information from their user, linking that information to a few deposit and withdrawal addresses (often incentivizing continuous reuse) and then even hiring "chain-analysis" companies in order to follow, trace, tail and stalk all the previous and following economic activity on-chain.
Why Chain Analysis?
The first and most important reason for doing so is because these on-ramps are scared to lose the privilege of having a fiat bank account. Bitcoin was, is and will always be considered a "borderline" reality by governments and government-sanctioned legal cartels like modern fiat banks. Thus, it's realistic to assume they would close down operative accounts to any exchange which couldn't guarantee the same level of financial surveillance that fiat banks routinely enact.
For this reason, fiat-enabled gateways not only keep promoting wrong and dangerous uses of the Bitcoin protocol, discouraging security best practices and hiring "chain-analysis" spy companies: They often even go to great lengths to publicly praise "KYC/AML" nonsense regulations and to push the narrative that "Bitcoin is completely traceable," marketing some probabilistic assumptions as "legal proofs" and ignoring even the existence of the fundamental privacy features of the protocol.
For a while now, these businesses have been freezing or confiscating users’ accounts because of what theoretical "chain-analysis" heuristics (dishonestly promoted as "facts") suggest these users may have been doing way before or way after their interaction with the exchange, basically trying to break fungibility in Bitcoin.
We often see this happening for activities that aren't even explicitly considered illegal in the specific jurisdiction under which they happened: online gaming, adult services, political campaigns, etc. Anything considered even remotely controversial has been depicted as forbidden, and any statistical guess about "on-chain" activity, based on common patterns and typical tools, has been depicted as "proven."
Of course, there's nothing really proven in "chain-analysis" heuristics, so the spy companies arbitrarily decide how many "on-chain hops" to look for, arbitrarily assuming who is doing what. Even assuming that such heuristics are correct (they have never been 100 percent reliable, and they are less and less so each day, while Bitcoin developers build better tools and Bitcoin users start employing best practices), this behavior is unacceptable. It is the digital equivalent of your physical bank sending private investigators to follow your every move for days after you withdraw cash at the ATM, and then freezing or confiscating your bank account entirely if that PI comes back with a report that says that "you may have," with some probability, engaged in controversial actions with that cash.
More recently, this shady behavior has extended beyond some generically controversial activities engaged by "somebody somehow connected with customers" to encompass even the very act of trying to use Bitcoin's security and privacy best practices!
Closing the Blinds
In January 2020, a company that operates a regulated exchange froze a customer’s account once they discovered possible hints that somebody, possibly the customer himself (but after some "hops" following the withdrawal transaction, that is, not even directly), was using a wallet enabling privacy best practices. Again, imagine your physical bank sending a private investigator to follow your steps for days after you withdraw some cash at the ATM, and then freezing or confiscating your bank account if that PI reports that says that "you may have," with some probability, closed your shutters at home, or pulled your shower curtains while naked, or put a lock on your personal journal, or used HTTPS within your web browser!
Furthermore, the specific message to the customer was tragically hilarious: It said that the business "can't condone activities such as peer-to-peer (sic!) mixing or gambling." All this while talking about Bitcoin, which is literally a peer-to-peer protocol whose transactions can natively work as mixers, and coming from a business that operates in cryptocurrency trading, which some consider not that different from gambling!
Don’t Fall for Red Herrings
There have been many reactions from Bitcoin users and analysts to these dodgy examples of behavior, many of which are based on logical fallacies or straight-on distortion of the facts. A classical example is the absurd notion that "Bitcoin users should not use privacy best practices, because that's dangerous."
Red Herring #1: “Being Private Will Get You Into Trouble”
The pseudo-argument goes something like this: Since some overzealous business may use unreliable heuristics to accuse you of adopting privacy and security best practices that they have arbitrarily defined as "unacceptable," possibly freezing or even confiscating your account, or flagging it as "suspicious," you should just stop using those security best practices and move to insecure alternatives instead. In other words, to use our physical bank example, since your bank might flag your account if the PI they sent after you comes back with a report that says that you may have, with some probability, used some privacy best practices a few days after a cash withdrawal, you should just stop closing your shutters while home, or pulling the shower curtains while naked, or putting a lock on your personal journal, or using HTTPS within your web browser.
This is nonsense, of course. If anything, it's not using privacy and security best practices that would turn out to be extremely dangerous — not just for your financial safety but also for your physical safety. Reminder: Bitcoin's privacy is all-or-nothing! Once a business is able to attach your physical identities, not just to an on-chain address but also to all the future and past history connected with it, all it takes is a little leak (by the business itself, by its spy-contractors or by one of the countless government agencies which will receive and pass along that information) to direct very dangerous enemies to your doorstep.
Incidentally, the pseudo-argument is flawed more fundamentally as well: Even if you were so reckless as to decide to trust this third party with a complete account of your future and past transactions, in spite of the risk to your physical security (and that of your loved ones), you may achieve the very same result just by sending it the cryptographic proofs of all the inputs you ever signed (either on-chain or on upper layers), allowing the meddling gateway to read through each of your CoinJoin or Lightning Network routing — all without giving up generic privacy best practices. You are still risking a leak, but at least you are not giving every random guy with an internet connection an easy way to deanonymize and stalk you (and others you interact with).
Red Herring #2: “If You’re Just Using Bitcoin to Invest, You Don’t Need to Worry About Privacy”
Usually this red herring comes with some distorted vision of Bitcoin's utility. "If users just want to invest in bitcoin as an uncorrelated financial asset with some disinflationary features," they say, "then they don't need privacy at all." This pseudo-argument is severely flawed.
Here's the bad news: Gold was, for many many centuries up until 1933, a typically "uncorrelated financial asset with some disinflationary features" that people in the United States and elsewhere could invest in. But then came Executive Order 6102. Gold was confiscated all across the nation, and all the investors who didn't protect their privacy (which was especially hard with "paper gold," kept in custody by trusted third parties eager to comply with the order, but also pretty hard with actual physical gold, difficult to hide in large amounts or to smuggle across a border) had to give it to the government.
A good general heuristic is this: If you are a privileged "first-world" investor, with a good KYC identity, and you are looking for some kind of investment that is politically uncontroversial now and likely to remain that way, then you will soon be able to access that type financial product from you favorite fiat bank. If that describes you, don't even concern yourself with complex stuff like private keys, blockchain fees, addresses: leave the real protocol to real users. Just call your good old bank over the phone and ask to buy some "bitcoin-flavored risk": certificates, futures, ETNs, ETFs, CFDs, etc.
If, on the other hand, you are not as privileged (like the majority of the world population today, which doesn't have a KYC-friendly identity), or if you think that the financial asset you seek is a bit controversial today already or likely to become so in the future, then you will eventually need some very strong privacy techniques to acquire it and to safely store it, since "legally compliant" exchanges, brokers and marketplaces will do everything they can to keep you out of it or take it from you.
Red Herring #3: “Just Use a Magical ‘Privacy Coin!’”
A second typical reaction, even more absurd, is to suggest "privacy altcoins" as a "solution" to this problem. A regulated exchange will flag your account if you use best practices such as CoinJoin, or Lightning Network, or address-reuse-avoidance. Then, instead of bitcoin, just use some illiquid bitcoin-clone whose design has been altered in such a way that it's said to offer "more fungibility,” right?
The superficial problem with this approach is that such "magic privacy coins" don't actually exist in the real world. On one hand, that's because most of the changes marketed as "privacy improvements" are either entirely fake or greatly exaggerated. They also tend to come with serious trade-offs which make these clones otherwise unusable at scale over the long run (usually including a completely centralized development process, trivial to compromise).
On the other hand, even if such a coin were to exist, from a technological point of view, it couldn't work in practice from an economical point of view. Remember: Privacy loves company. A huge chunk of the bitcoin economy and its users would have to move to the very same bitcoin-clone as you. Otherwise, your transactions will have a lower liquidity and a smaller anonymity set, regardless of how perfect and sci-fi-worthy the privacy tech you are using is.
More on These Magical Privacy Coins and Why They Are Useless
The Bitcoin + Privacy-Coin Combo Fallacy
There are variants of this red herring which are based on some kind of "bimetallic standard" idea: Those proponents will suggest that you use bitcoin as your fundamental store of value (which centralized illiquid clones can't be for obvious economic reasons), and then add a particular "privacy altcoin" for privacy in transactions.
Of course that can't work in most real-world scenarios. Assuming that the payer and the payee both use bitcoin as a long-term store of value, the payee would have to move satoshis from his personal storage solution to some kind of market (regulated or not, it doesn't really matter here) with the same privacy issues as any other bitcoin transaction; then exchange those satoshis for altcoins on some low-liquidity shared order book with very low privacy; and then move the altcoins over their native system with a low anonymity set to an address provided by the payee. Then the payee would have to repeat the same steps in reverse.
The privacy guarantees of the whole process would be, overall, way lower than a normal bitcoin transaction performed following the best practices. Of course, these guarantees can be increased if either the payee or the payer "batch" many transactions in one big altcoin reserve, exchanging satoshis only once, way before or way after the single individual transactions. But this would require the altcoin to be a reliable store of value for long periods of time — which illiquid and centralized bitcoin-clones (often crippled by unbalanced trade-off choices between privacy features and other very delicate aspects) can't be.
The deeper problem with this approach is that, even if feasible, it would become completely useless pretty quickly. The very same reasons that convinced some regulated exchanges to actively discourage or even prevent their customers from adopting privacy best practices on Bitcoin, would readily convince the very same exchanges to just delist any "privacy-focused" bitcoin-clone. The "smaller" the altcoin, the weaker the incentive to list it. The "bigger" the altcoin, the stronger the regulatory pressure to delist it. It's as simple as that.
The “Mandatory” Privacy vs “Opt-In” Privacy Fallacy
Some weak attempts at steel-manning this approach focus on the distinction between mandatory privacy and opt-in privacy. "With Bitcoin," the altcoin proponents say, "you are not forced to use the fungibility features at the protocol level, so it's easy for the exchange to ask you not to use them. But with my altcoin, you have no choice, so the regulated exchange will also have no choice but to allow you to use them."
Again, this is nonsense; it's not true that a privacy feature can ever be "mandatory at the protocol level."
As the history of Bitcoin teaches us, it's mostly about tools: Even when the base protocol includes strong fungibility capabilities, if the most widespread tools don't leverage them, then people will simply not use them. They’ll just resort to using whatever is easy and available, even if that mean adopting bad practices instead.
It doesn’t matter which protocol you use: If the tools are inadequate, so is your privacy. Just as you can have a bitcoin wallet that is incompatible with CoinJoin and that forces address reuse, you can also have a monero wallet that leaks confidential information about amounts and always constructs "ring-signatures" between every single user and himself. If such a wallet is widespread, spy companies can assume such behavior as common and build de-anonymization heuristics.
Of course, altcoin proponents may just build and market tools that actually use the privacy features already present in their clone at the protocol level. But then again they would need just as much time, money and effort that is required for building and marketing tools that actually use the privacy features already present in Bitcoin at the protocol level.
What Really Matters: Incentives
A more useful distinction to examine is the one between privacy features that are economically convenient to use and privacy features that are costly to use. The perfect (bad) example would be that of "shielded transactions" in the altcoin Zcash: Since they take way more space inside blocks, and way more computation time to be verified and signed (making this last action almost impossible on a light client), economic incentives push the already-few users of the coin to "unshielded" transactions, which are just an outdated version of the traditional bitcoin ones.
As a direct effect, many users will think they have "more privacy" when this process, in fact, makes tracking and deanonymizing far easier. An indirect effect will be that the very few users who do decide to pay the extra cost for "shielded" transactions will find themselves within an even smaller anonymity set, ending up exposed instead of protected.
An opposite example would be the Lightning Network on Bitcoin: Since block space is expensive, users often have strong economic incentives to switch to payment channels to save fees, reducing the "timechain footprint" to just opening and closing channels.
Same Old Story
Ultimately, it's not surprising at all that some of the most vocal proponents of the "CoinJoin is risky because your account will get flagged" narrative turn out to be also promoters of new, illiquid “privacy” altcoins, which they hope to push to profit from "pump-and-dump" schemes. Same old story: "Bitcoin's fees are too high: buy my low-fee altcoin!" or "Bitcoin signatures aren't quantum-proof: buy my quantum-ready altcoin!" or "Bitcoin's smart contracts aren't flexible enough: buy my Turing-complete altcoin!" or "Bitcoin is not fungible enough: buy my privacy altcoin!"
Solutions Are Coming
Are there real solutions and ways to mitigate the threat that regulated exchanges pose to the privacy and the security for Bitcoin users, beyond the red herrings? Yes: many.
The ultimate solution, albeit very slow, will eventually come from the evolution of the market. While more and more resources will leave the fiat world to enter Bitcoin over the years, more and more parts of the bitcoin economy will move from fiat gateways to satoshi-denominated trades among users. Gateways will still be important, but gradually less so, making their bargaining power lower and lower over time. Fiercer competition will also help: People will be happy to leave meddling PI-hiring banks who force them to keep shower curtains open if they have alternatives.
Another mitigation will come from the evolution of Bitcoin tools. While more and more modern wallets will make it harder to reuse addresses or merge inputs, and easier to coordinate CoinJoin rounds, regulated exchanges will have a harder time forcing their customers to use only old, outdated or inferior wallets instead.
Yet another mitigation will come from the adoption of the Lightning Network. Since block space in the base layer will become more expensive, users will be strongly incentivized to route transactions over payment channels instead. It will be harder for regulated exchanges to arbitrarily ban customers due to a probabilistic link between the satoshis they deposited or withdrew on the Lightning Network, especially when the latter will be ubiquitous, thanks to economic incentives.
Additional improvements may possibly come from the next protocol upgrades in Bitcoin, especially the one called "cross-input Schnorr signature aggregation." This upgrade will make coordinating with several different parties within CoinJoin rounds extremely convenient, from an economical perspective.
Another hope comes from the idea of decentralized exchanges (DEXes). So far, they suffer from liquidity limitations and their security remains tricky: While the Bitcoin "leg" of any trade can be easily trust-minimized, the fiat leg remains ultimately trust-based, making complex and expensive escrow mechanisms necessary. (In turn, escrow mechanisms tend to prove very difficult to decentralize effectively.)
Your privacy is in your hands — just keep calm and be diligent. Don't submit to dangerous privacy violations. Don't reuse addresses. Use CoinJoin. Close your shutters when you’re at home. Pull the shower curtains when you’re naked. Put a lock on your personal journal. Use HTTPS when surfing the web.
In the end, Bitcoin fixes this.
This is an op ed contribution by Giacomo Zucco. Views expressed are his own and do not necessarily reflect those of Bitcoin Magazine or BTC Inc.