In an anonymous system, a person’s identity is always hidden. In contrast, Coinmarketrate.com tells us that the Bitcoin system is pseudonymous. And this means that, although no information should be disclosed, a third party can find the identity behind the address.
Bitcoin works on the basis of a verifiable and public database containing all transactions, which is called blockchain. The name comes from the fact that transactions are stored in blocks that are organized in such a way that they form a chain.
Transactions store information about how many BTC and which addresses are involved, so anyone can determine how many Bitcoins are stored at a particular address.
Each address is not associated with any information, be it a phone number, email address, name or other data linking a real person to it.
Therefore, the BTC address and the Bitcoin network are pseudonymous, which is very different from anonymity. Although the information is not in the database itself, it can be linked to external information and the necessary tools.
However, pseudo-anonymity allows Bitcoin users to maintain a certain degree of privacy if they use the cryptocurrency in the right way.
The user can use Bitcoin privately as long as he does not disclose certain information about himself. For example, at the moment when he buys a product that should be sent to his email address or place of residence, there is a chance that someone will link this data and violate the privacy of the person.
Having these two pieces of information (identity and address), someone can begin to see all the movements of this user’s funds in the blockchain, to some extent knowing how much money he received, from whom and even what things he could buy. Not that this information is accurate, but it may be a violation of privacy.
For many, it would be ideal if the system were completely anonymous, but if this happened, it would be very difficult to make sure that no more coins were created than should have been, or that there is a double spending of funds.
How Bitcoin Affects Our Privacy
Although there is a certain anonymity in Bitcoin, blockchain analysis companies and governments are constantly working to reduce the privacy of users on the blockchain.
In principle, there are two issues that facilitate the work of these two groups:
- Know Your Customer (KYC) and Anti-Money Laundering (AML) Law
In many countries, bitcoin services such as exchanges, brokers and custodians are required to collect and verify their customers’ personal information.
They keep the information in case the authorities need it in the future. It is also true that when we work with these services, they keep a copy of the address associated with this information.
As soon as the authorities gain access to this personal information, as well as to Bitcoin addresses, the pseudonymous nature of this cryptocurrency disappears, and with it privacy.
Now this third party, who has the information at their disposal, can see what we have done, to one degree or another, with our funds. He can trace the route to other known addresses and confirm that we have bought certain goods or just find out how many BTC we own.
To make matters worse, some of these services share this information with blockchain analysis companies. This allows them to track information about customers, starting from the moment they receive Bitcoins and ending with where they go when they withdraw them from the platform.
Moreover, all this creates an additional risk that the data may be compromised by someone with even more malicious intentions. It can be used to our detriment.
- Blockchain Analysis
Blockchain analysis companies use heuristic methods such as the shared entry ownership heuristic and the round sum heuristic to try to track BTC ownership across all transactions.
Since each Bitcoin transaction can be sent from multiple inputs to multiple outputs, the analysis should determine which Bitcoin was sent to which address.
For example, if we want to send 1 BTC to a friend and we have two UTXOs of 0.6 BTC and 0.8 BTC, we can create a transaction with these two inputs, plus an output to another person and another with an exchange address.
- 0,6 BTC
- 0,8 BTC
- 1 BTC (friend)
- 0.4 BTC (our exchange or wallet)
This example has several privacy issues, even though the outgoing addresses are new and unrelated to the incoming addresses.
A transaction observer who knows that the input addresses are ours can determine that the exchange address is also ours.
To do this, he will have to apply heuristics and a bit of simple logic:
- Round amounts: Since one of the addresses has an exact amount of 1 BTC, it is most likely that this is a payment that we are making. We can almost certainly say that this is not our address.
- Exchange amounts: If 0.4 BTC were a payment, it is unlikely that we would use two inputs to create a transaction. We will be charged more fees because it is a more difficult operation. Otherwise, we would use only one input, for example, 0.6 BTC.
In order for blockchain analysis to be useful, it is necessary to have certain reliable input information, for example, who owns UTXOs or addresses.
The provider of such information may be services that are required to comply with laws on the knowledge of their customers and the fight against money laundering.
If the ownership of one of the UTXOs is known, then when spending this UTXO, the analyst can try to determine whether it was sent to someone else or the owner sent it to himself.
On the other hand, these are very simple examples, but there are also more advanced techniques that give greater strength to such privacy violation mechanisms.
How can Bitcoin Privacy be Restored
We have already considered in detail the two main reasons that prevent us from achieving greater privacy when using Bitcoin. All of these methods are successful because they focus on the interchangeability of BTC.
However, there are many tools that we can use to improve privacy. This, together with the work of developers, is looking for ways to make the heuristics used in chain analysis obsolete.
Thus, the pseudonymous nature of Bitcoin remains intact, as does the privacy with which it was created.
One of the developments that are being worked on to solve this problem are the Lightning Network and Liquid Network protocols, which allow transactions to be carried out without the need for publication in the Bitcoin blockchain.
But if we consider the improvements of the Bitcoin blockchain and its privacy, then it is impossible not to recall its latest update – Taproot. But this is a completely separate conversation.