Abstract：There is no central authority needed to facilitate and authorise transactions - instead it is the technology itself and its consensus mechanism that reaches agreement on the accuracy of transactions and to provide finality of settlement.
The tension between transparency & privacy
How crypto anonymity intersects with you real world identity
How blockchain analytics is big business
Some valuable Part of blockchains is that they are permissionless. There is no central authority needed to facilitate and authorise transactions - instead it is the technology itself and its consensus mechanism that reaches agreement on the accuracy of transactions and to provide finality of settlement.
Additional critical aspect of blockchains is transparency. Anyone with an internet connection can access crypto transactions Many mistakenly believe that cryptocurrencies enable completely anonymous transactions, but this isnt the case. Knowing just how crypto visibility works is a crucial part of the learning process. In so many ways, transactions processed on a blockchain are much more visible and therefore more open to scrutiny and analysis than traditional financial systems.
There is a clear tension between transparency and privacy, which is an on-going battle in crypto. As the industry is maturing, it is increasingly emerging as a competitor to traditional centralised financial systems. Many encourage this as a way of tackling crime and creating a fairer, more accessible financial system. Others argue that without safeguarding privacy now, the transparency that blockchains promote may be weaponised against users.
Putting Crypto Traceability Into Context
Recall that we have explored the anatomy of a bitcoin transaction and how easily the flow of funds can be accessed and analysed in our last article. Now we are going to put this information into context. It is essential to understand that the absence of personal information doesnt make users invisible. We can begin to explain the big business of blockchain analysis, how the crypto industry is working with regulatory authorities and the rise of privacy coins.
Also, it is important to stress that the industry is new and dynamic. Innovations are occurring all the time, and we are only just beginning to work out how blockchain technology will impact our lives.
The absence of personal information doesnt make you invisible
Initially, it is essential to understand that the absence of personal information on blockchain transactions does not result in anonymity. For example, Bitcoin transactions move funds between addresses which are alphanumeric strings (containing no personal information) simply pointing to a location on the Bitcoin blockchain ledger. These addresses are recorded on-chain and are therefore visible to the public via any free explorer service such as Blockchain Explorer.
The absence of personal information on blockchain transactions does not result in anonymity.
Because addresses are publicly visible, they can be recorded, analysed and most importantly annotated - in other words other associated information can be assigned to them. For example, it is easy to build a directory of businesses tied to the deposit addresses they openly share. If that business is regulated - such as a centralised exchange - then the anonymous transaction can now be connected to your identity (via the proof of identity you submitted during registration) and the traditional financial system via the banking details you associate with your exchange account.
Therefore any authority that follows an anonymous transaction to a point that connects to your real-world identity will then have full visibility. Cryptocurrencies arent anonymous they are pseudonymous. Pseudonymity provides a level of privacy whilst still maintaining a level of accountability.
Transactions don't include personal information, but as soon as they intersect with a regulated institution, your details become known by association. This level of visibility has given rise to the blockchain analysis industry.
The Business of Blockchain Analysis
Blockchain analysis companies apply data science techniques to publicly available blockchain data. They do this to discover useful information about transactions; the process involves identifying, clustering and modelling data. This data can then be visually represented and access sold in commercial packages using a familiar SaaS (software as a service) model.
The most obvious commercial uses include:
Finding missing coins
Analysing spending & holding patterns
Detecting fraud & money laundering
Tracing the proceeds of crime
Tracing nation level hacking & sanctions evasion
Combating the trade of online illegal goods & services.
These analysis companies' customers range from crypto startups to governments, and they conduct big business with key players in the industry, having raised over $80 million in funding to date.
The most popular companies include Chainalysis, Elliptic and Whitestream. According to 82 records of federal procurement contracts reviewed by CoinDesk federal agencies have spent at least $10 million in American tax dollars on Chainalysis tools, services and training since Chainalysis was founded in 2015. The agencies include the FBI and ICE so it is clear that blockchain analysis is lucrative and has broad applications.
Crypto analytics firms are effective at promoting the value in their services by publishing reports about crypto crime and significant successes. The perpetrators of the highly publicised Twitter hack in 2020 were quickly traced thanks to blockchain analytics. Regrettably the vast amount of data that can be harvested from public blockchains won't necessarily be used to fight crime. Given the huge controversy around the exploitative nature of the data practices of big data firms - notably Facebook & Cambridge Analytica - we should expect blockchain data to be weaponised in a similar way.
Cryptocurrency & Regulatory Authorities
Crypto analytics providers help bridge the gap between the crypto industry and regulatory bodies. Naturally, it makes sense to consider crypto as a challenge to regulatory and tax authorities due to the permissionless nature of blockchains. Some countries have certainly taken this view, with nations such as China, Russia and india at various time threatening to ban cryptocurrencies altogether.
Nevertheless, this isnt the case for every country. In Europe and the US regulatory authorities have been more embracing of blockchain technology. For example, the IRS has begun considering cryptocurrencies property and has issued tax guidance accordingly.
In 2020 the EU signed into law its 5th Anti-money Laundering Directive, including regulatory scrutiny of cryptocurrency and crypto-assets. As the usage of cryptocurrency grows, tax responsibilities are becoming increasingly relevant. For example, in the US, cryptocurrencies are currently treated as property and subject to capital gains/losses laws and taxes. Employees and employers are responsible for converting their earned/paid cryptocurrencies to fiat currencies and declaring it.
As governments groan under mountains of growing debt accumulated to mitigate the Covid19 pandemic they are likely to want to maximise tax receipts, so could conceivably rely on private or in-house crypto analytics to work out who is avoiding tax on their crypto. The visibility of cryptocurrencies that we have described means that crypto companies may be able to work productively with regulatory authorities to build a more transparent system as we advance, it really depends on how much of a threat governments perceive.
The recent moves by the outgoing Trump administration were seen as very aggressive, specifically what has been termed the Crypto Travel Rule issued by the Financial Action Task Force, with 37 member countries, and applies to the information virtual asset service providers (VASPs) - like exchanges - send to each other. As reported by Coindesk, the detail required is a clear challenge to the anonymity of crypto.
“Obtain and hold required and accurate originator [sender] information and required beneficiary [recipient] information and submit the information to beneficiary institutions … if any. Further, countries should ensure that beneficiary institutions … obtain and hold required (not necessarily accurate) originator information and required and accurate beneficiary information …”
Privacy Coins & Transparency, Anonymity or Pseudonymity？
Privacy coins are the crypto industries response to blockchain analysis, and government attempts at regulation. Those who promote them see transparency as a threat to privacy and security. Privacy coins are designed to give users complete anonymity when conducting transactions.
Unlike with BTC or ETH, these cryptocurrencies use stealth addresses and ring signatures to hide senders and receivers identities. They also offer tumbling services that can obfuscate the tracing methods used by blockchain analysis companies to identify and analyse transactions. Famous examples include Monero, Zcash and Dash. Monero alone is currently worth over $1 billion and is by far the most proven and trusted privacy coin on the market today.
Privacy coin proponents argue that big technology companies such as Google, Facebook and Amazon have exploited user data. The only way to prevent this - they claim - is to provide users with absolute anonymity. Whilst this is a strong argument, it remains to be seen whether it is realistic or not. Indeed, no one wants globally visible public records of all transactions. Financial privacy is essential for human dignity, personal safety and the efficient operation of the free market.
No one wants their neighbours knowing how much they earn, and what they spend it on. Nobody wants thieves to access your identity, and a free market cannot run if every actor can track all costs and sales. However, equally, nobody wants to live in a world free of accountability that total anonymity risks providing. The law is there for a reason and to be in favour of absolute anonymity risks empowering those who want to break it.
Comparison with offshore in tradfi & gaming
In many ways the development of this tension between transparency and privacy in crypto mirrors what has happened in traditional finance and gambling. Both have onshore regulation controlled by central bodies with rules that apply within and across major nations in relation to conduct, AML and taxation.
In both cases a shadow framework has emerged offshore, competing with the onshore version in terms of levels of taxation or scrutiny. Despite tough talk, there isn't the political will or even a practical solution to harmonise on and offshore. Most of the world's biggest private companies happily play the system, and leaks such as the Panama Papers or FinCen show the extent of wealth hidden offshore. That tension is replicated in crypto, and as more institutional money flows into the sector, there will be a growing demand for both sides of the virtual coin - transparency and privacy.
In relation to open, permissionless blockchains, the most likely conclusion is a compromise between these two positions. This compromise is called pseudonymity. Pseudonymity places data back in the users hands, granting a level of privacy whilst maintaining a level of accountability needed for society to function.
CBDCs - Government Crypto
Open permissionless blockchains aren't, however, the only show in town. Governments are starting to recognise that some of the elements of transparency provided by blockchains might actually enable them to exert more control over central bank issued money. This is leading to the rapid development of Central Bank Digital Currencies (CBDCs).
No wonder that some of the most authoritarian governments are leading the way in developing digital versions of their analogue currencies as they will have much greater control of the money supply of the national currency, visibility of who owns it and most importantly, what they do with it. It might be that both types of blockchains, and the money they support, can exist side by side but equally CBDCs may start competing with each other, given the ease with which crypto can flow across borders, which will certainly mean less transparency and more scrutiny of what you do with your money.
Enough privacy is necessary for digital currencies - government and private - to be valuable, but adequate visibility is also required for society to be held accountable. Getting this balance right will prove a huge challenge to authorities and as the crypto industry matures and becomes more relevant, this tension will play out and become increasingly important to our lives.