Bitcoin: privacy vs. anonymity

Today we will deal with a somewhat controversial topic, namely blockchain anonymity, expecially that of bitcoin. In the blockchain world, we have two main ways in which transactions are handled: the UTXO model (which ensures that no one is able to spend money that they do not have or spend twice) and the "account model" (which simply stores the balance of our address and it is very easy to track). The first one used in bitcoin has the potential for privacy.

On the other hand, the second model, which is used in Ethereum, is characterized by an absolute lack of anonymity and privacy. At the beginning, I will explain how bitcoin works by referring to a real example. Then I will try to debunk a few myths and refer to the claim that bitcoin is for terrorists and other non-factual beliefs that I have heard a lot at meetings and conferences.

First, I would like to explain what anonymity and privacy are, as these terms are often used interchangeably, which is a mistake. Let us assume that for a given transaction to take place in an anonymous manner, at least three conditions must be met:

• Maintaining privacy - the content of addresses may not be disclosed to third parties, no traceability by third parties
• Security - all transactions must be cryptographically encrypted
• Decentralization - every node is equal

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Anonymity and privacy

Many people who have nothing to do with blockchain technology think that Bitcoin is internet money that is anonymous. The word "anonymous" usually has a negative meaning here, meaning that it is a technology for buying drugs, financing terrorism and all evil that we can encounter in everyday life. 

I would like to make it clear at this point that anonymity should not be confused with privacy. The bitcoin system is anonymous, but it is very far from privacy, i.e. the inability to track specific people. The US justice system, with the help of specialized companies such as Chainalysis, has demonstrated at least a few times high efficiency in analyzing the digital distributed ledger (blockchain) and then finding a specific person who committed illegal transactions that were embedded in the bitcoin network. It should be clarified that distributed ledger systems fall into two main groups:

• public - all transactions are public (anyone with access to the Internet can view and analyze them), anyone can verify the system as well as become a participant
• private - transactions are verifiable only for selected persons or institutions and only they can verify the system

Bitcoin in the context of privacy

In this part of the course, we will focus specifically on the bitcoin system that is public. In practice, this means that every person with the help of special software with open source code can become a participant of this protocol (sometimes we define a decentralized system with the word "protocol" as a set of strictly defined rules written in the form of a computer source code), and using public websites to browse transactions that are concluded on an ongoing basis.

Due to the fact that the data on each transaction concluded in the bitcoin network is public, we must realize that the cost of obtaining this data is close to zero and this implies a great incentive for the creation of analytical companies (or any other institutions, for example the tax office).

In order to implement the business model, these companies need data (the cost of which is close to zero), so they will spend almost all their financial and human capital on working on specialized algorithms that search for embezzlement. The presented model of costs and incentives is really unattractive for people who want to break the law using the bitcoin network.

I emphasize once again that the transfers that we make every day in traditional banking can be analyzed currently by the tax office, bank or all authorized state institutions, but not by anyone in the world or any company with appropriate competences and specialized personal data collections, this is a huge difference that should be emphasized and realized. 

Considering the fact that creating an address on the bitcoin network (or more precisely, a public key and a private key) is free and very easy, we can get the impression that the bitcoin system is anonymous. 

However, the practice is that currently all bitcoin-supporting institutions are forced to implement AML - KYC regulations (anti-money laundering regulations), which in practice make it impossible to withdraw funds from an anonymous bitcoin address, which results in linking our personal data to a specific address on a public network.

Misconceptions about bitcoin privacy

Sometimes I engage in polemics or I am asked directly what I think about the anonymity of the bitcoin network, and I hear opinions of people who associate networks such as bitcoin with terrorists and drug purchases. 

I always answer this polemic that if for any reason I was forced to act illegally, I would not try to use the bitcoin protocol. The main reason for this answer is the fact that I am aware that such activity remains in the scattered register forever, additionally secured with enormous computing power, which in practice makes it impossible to obliterate illegal activity, and a simple, accidental error, at any time in the future, may cause the discovery of my personal data. The law is not keeping up with technology, but I expect that in the next decade there will be a law saying that any illegal activity discovered in the protocols will automatically result in a given sentence because the computational power behind these protocols makes it difficult to enter into any polemics with them. 

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About the anonymity of systems such as bitcoin, I suggest that all illegal activity is traceable, and the main factor determining the resources involved in searching for a given person is the size of the abuse, which, given the appropriate size, turns into the question “when will a given person be disclosed?" and not “whether they will be revealed”.

Taproot update in the context of privacy

In the previous paragraphs, I showed that the bitcoin network currently has little to do with privacy (in a practical sense, and not in theoretical, far-from-reality considerations and wishful thinking). 

However, we must realize that bitcoin is a software and a working protocol that is constantly being updated and patched to improve its operation. One example of such an update is the Taproot patch, which was activated on the bitcoin chain on November 17, 2021, giving a much wider range of possibilities for bitcoin to technically be able to handle much more private transactions than it is today. 

The Taproot update introduces a lot of changes, but one of the more interesting in terms of privacy is that it will be much more difficult to track transactions. Still, let's be aware that every transaction leaves a mark and to say that bitcoin is private and anonymous with the Taproot patch is a far-reaching abuse.

Scalability of bitcoin, or Lightning Network (for the inquisitive)

Current transaction systems process a total of millions of transactions per second, while the bitcoin network allows you to handle about seven transactions per second. However, the so-called the second layer, i.e. the Lighting Network,allows for a significant increase in the capacity of the scale of operation of this distributed system. 

The Lightning Network allows you to build smaller networks within which theoretically an infinite number of transactions can take place. In practice, scalability is determined by the number of nodes supporting the LN network and connections between them (open channels), and this has been growing in recent years. 2021 was a breakthrough in this respect. I think that the accelerating growth of newly created nodes (around one hundred thousand globally) and channels may be due to the release of a very user-friendly Umbrel solution (https://getumbrel.com/).

The Lighting Network is actually a separate network, but closely integrated with the bitcoin network, so we call the main bitcoin chain transactions "on-chain", while the LN transactions are called "off-chain". Thus, the scalability of the system as a whole (the bitcoin network with the coexisting Lighting Network) is limited by the scalability of the Lighting Network, which in the medium term has a high chance of exceeding the capabilities of the traditional financial system. 

Trying to use an analogy, we can imagine a situation where an employee of a corporation opens a transactional channel with the payroll department and is able to receive a payment not once a month as before, for example for each completed task while maintaining the privacy of transactions and a very low cost of settlements aiming at zero . In the case of mass adoption of architecture based on the Lightning Network, companies have a chance to completely change the way employees pay, significantly reducing the costs of private billing.

Today, each of us can watch high-definition YouTube videos or play games with friends. The main reason why the Internet has been able to scale is the fact that it has been divided into smaller subnets within which Internet traffic takes place. Keeping to the analogy of playing games, probably many of us have played games over the network with friends, we must be aware that the traffic generated by our playing with a neighbor does not burden the main network hubs, which in the case of Europe are located in Frankfurt. 

If you think about it, it makes sense, because why burden the part of the system that does not need to know that two neighbors are playing the game in a smaller town - this traffic is handled by the local subnet. 

At the same time, if we want to play the same game with a friend from the USA, of course the Internet gives such an opportunity and only then our traffic will flow through the main network hubs. 

However, due to the fact that the traffic will be transferred through the largest network hubs, this will be at the expense of the connection speed, which in practice is not very important. The game movement with a neighbor will be very fast, while with a friend from the USA the delays will be slightly longer. 

And exactly the same mental pattern is used when scaling the bitcoin network, where on-chain transactions are slow (analogous to internet hubs), while the Lighting Network gives you the ability to create subnets that result in scalability to infinity. After all, we can have very many neighbors playing a game with each other.

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‍Bitcoin as a waste of electricity

I think all of us have heard the statement that maintaining a bitcoin network is a waste of electricity. I think this is a myth, because if we compare the costs (never calculated) of the current financial system (millions of servers around the world, millions of jobs) with the cost of mining bitcoin, it will turn out in the future that a decentralized system where the source code works is about hundreds of percent more effective and cheaper. 

It is worth mentioning that with the appreciation of the bitcoin exchange rate, the economic incentive to use renewable energy sources increases, which results in a natural, gradual process of "greening" the mining process, dictated not by ecological ideas, but by a hard and ruthless economic calculation. 

It is also worth mentioning the newer (I'm not saying better) generation of blockchain solutions, which instead of consuming large amounts of electricity, uses frozen capital to maintain the network and the production of blocks with transactions.

The future of bitcoin privacy

I feel obligated to mention clearly that any statistics I am showing are data collected from nodes that are not hiding behind the Tor network (special software designed to hide Internet activity). 

These are public data that can be verified by anyone with appropriate technical knowledge. The truth is, however, that a significant percentage (it's hard to judge exactly what) of nodes works in the Tor network, which basically makes it impossible to take such nodes into account, so the conclusion is that the presented data is understated, and the question we can ask ourselves is "about how much ”and not“ if ”. 

As a summary of the anonymity and privacy of the bitcoin network, I would like to emphasize the fact that these are issues on which developers are currently working a lot, because in today's form, bitcoin is a transparent protocol.