How one’s focus can shift in just two weeks! While today everybody in the Bitcoin space seems more concerned with price fluctuations in response to the global financial panic (understandably so), it’s important to remember perennial issues that never go away, like the importance of maintaining your privacy when you transact in Bitcoin. Throughout this month especially, we’ve been hearing reports of KYC/AML-compliant exchanges freezing user accounts due to suspected use of CoinJoin software (more on that later), followed by yet another case of a famous and respected early Bitcoin proponent promoting his new illiquid altcoin as something that “will replace Bitcoin, which isn’t private enough!”
If you want to take a short break from global pandemics, financial meltdowns and price volatility, here’s an attempt at analyzing claims, facts and context of this latest “Bitcoin drama.” To begin with, in Part 1 of this two-part series, we’ll start by looking at the fundamental relationship between Bitcoin and privacy by going back to the beginning with the whitepaper. Then, in Part 2, we’ll focus on some the ways that Bitcoin privacy is being maintained and improved upon — and strike down a few “red herrings.”
Money Needs Privacy
Bitcoin is designed to perform monetary functions, and money needs a strong separation of personal identity from specific monetary units and transactions in order to work sustainably at scale. There are at least two fundamental components to this separation.
We could call the first component “deniability.” This describes the possibility for an individual using a monetary tool to credibly deny any connection with it later on.
The reason for this is that money has been developed to facilitate individual saving and voluntary exchange among people. But the positive-sum game of voluntary exchange is not the only way to increase one’s wealth: The other way is the negative-sum game of violent confiscation. As the sociologist and political economist Franz Oppenheimer brilliantly put it, there are two different paradigms for wealth acquisition within societies:
“These are work and robbery: one’s own labor and the forcible appropriation of the labor of others. I propose in the following discussion to call one’s own labor and the equivalent exchange of one’s own labor for the labor of others, the economic means for the satisfaction of needs, while the unrequited appropriation of the labor of others will be called the political means.”
While the temptation to resort to political means is always present in extended social contexts, it becomes particularly strong when money is involved: The same features that make money an especially good tool for exchange and for storing economically acquired wealth make it also particularly interesting as a target of confiscation — and as a way to store politically acquired wealth.
Individuals exchanging and storing money are more easily and more often targeted by political rent-seekers, since it’s most efficient to rob them than to rob participants in simple barter or insulated hermits who don’t exchange at all. Quite often political organizations prefer to present confiscation as conditional upon the specific type of exchange engaged in by the victim: taxes, imposts, tolls, tariffs, tributes, fines, bribes, penalties, excise duties, protection money, etc.
Privacy in communication is important, and economic exchanges are among the most important, sensitive, private and potentially dangerous forms of communication in adversarial environments. Money talks. Somebody whose financial and commercial life is completely exposed runs a higher risk of suffering robbery, blackmail, kidnapping or political expropriation.
For all these reasons, it becomes paramount for economic agents to be able to detach their own public identity from the specific monetary transactions they have taken part in and, thus, to be able to deny such connection.
The second component is called “fungibility.” By this, we mean the possibility for an individual receiving a monetary tool to safely ignore any connection between that tool and any particular individual or use case it interacted with in the past.
Fungibility is more an economical category than a political one: It basically means that any random amount of money is practically indistinguishable from any other, thus making the validation cost for a money receiver way lower. One $50 bill is as good as any other, and you don’t need to know who has used it in the past in order to accept or use it as payment today. Indeed, if a receiver had to evaluate the history of every individual unit before being able to assess its value, verification costs would increase exponentially.
Ironically, one of the relatively recent trends of “Know Your Customer” regulations around the world is, indeed, that money was mostly adopted as a way for merchants to avoid…