There is a common misconception about Bitcoin that it is anonymous. Unfortunately, this is untrue. In fact, Bitcoin transactions are easily traceable. [1] [2] Though Bitcoin addresses are not directly tied to real world identities, it is almost impossible to remain anonymous on the Bitcoin network — especially if you have acquired Bitcoin through one of the many KYC/AML law-abiding on-ramps. Once you have attached your real world identity to a Bitcoin address, your transactions can be traced on the Bitcoin blockchain quite easily.

Traceability is a valuable property of blockchain technology if you are a data analytics company or a government. It is NOT such a valuable property if you a proponent of anonymity and privacy.

My theory is that this is actually the crux of the block size debate.

Privacy & Anonymity in the Digital Age

The debate boils down to one side wanting to push second-layer scaling solutions where users are afforded the opportunity to transact off the main chain in what are colloquially known as “sidechains.” These sidechains would enable faster transaction speeds and higher throughput while piggybacking on the security of the underlying Bitcoin network. In addition to scalability, there are many possible second-layer solutions that would enable anonymity and privacy.[3]

Much of the focus of this argument is centered around the risks of hard-forking, including loss of at least some participating nodes due to their failure to properly upgrade node software. A hard fork would require all network participants to download and run the latest version of Bitcoin’s software, rendering all previous version incompatible with the network. This would risk the existence of two separate, non-interacting networks, reducing Bitcoin’s network effect proportionally.

Instead, this side has lobbied for a soft fork update to the protocol called Segregated Witness [4]. A soft fork allows the protocol to be updated while remaining backwards compatible with previous software versions. Segregated Witness solves a known bug called “transaction malleability,” [5] which has made it difficult for any second-layer solutions to be considered “secure.”

A Visual Diagram of Sidechains

This side of the argument is made up of Bitcoin’s Core developers as well as a large amount of users (at least those who are vocal on Twitter). Among those developers are people like Adam Back, an early cypherpunk and current CEO of Bitcoin development company, Blockstream. To understand this side of the argument better, it is important to understand the principles of the cypherpunk movement.

From Bitcoin Documentary “Banking on Bitcoin”

From A Cypherpunk’s Manifesto, written by Eric Hughes in 1993:

Privacy is necessary for an open society in the electronic age. … We cannot expect governments, corporations, or other large, faceless organizations to grant us privacy … We must defend our own privacy if we expect to have any. … Cypherpunks write code. We know that someone has to write software to defend privacy, and … we’re going to write it. [6]

As you can see from the quote above, the cypherpunk goal is to achieve privacy and anonymity in the digital age through the use of cryptography and code. As you’ll come to see, though it was intended to be used as a form of digital money (which, in order to be deemed “money,” would arguably require anonymity and privacy as features), Bitcoin is far away from being private and anonymous.

The Biggest Data Set We’ve Ever Seen

On the other side of this debate are companies like Bitmain, a mining company located in China, Bitcoin-focused businesses like BitPay and Bloq, and Barry Silbert’s Digital Currency Group. These companies want to maintain on-chain traffic with various reasoning posited, including “maintaining the integrity of Satoshi’s vision.” By increasing the block size, miners can now fit more transactions into blocks directly on-chain. Users benefit from lower fees as the competition for block space dramatically reduces.

With more transactions fitting in a block, there are effectively more transactions to monitor. There are numerous companies that stand to benefit from the transparency the Bitcoin blockchain provides. Companies like Chainalysis, Elliptic, Numisight, and Skry are performing blockchain analytics to identify criminal actors who are involved in crypto-heists, ransomware attacks, and other nefarious activity.[7]

A Visual Diagram of Bitcoin Blockchain Analysis [8]

Furthermore, an even greater number of companies are performing blockchain analysis to assist in the KYC/AML process for institutions like banks and payment processors. The objective of companies like Coinfirm, Libra, and even major players like Deloitte, is to perform blockchain anlaysis and produce reports detailing relationships between Bitcoin addresses and the coins held in those addresses. This would serve to indicate to the banks and other financially regulated business that the customers with which they are doing business meet the requisite demands of the KYC and AML regulations. For example, if a cryptocurrency exchange wants to have a bank account, the financial institution would run KYC/AML analytics on the deposits held on the exchange to determine the extent to which those deposits are associated with illicit activity.

I saw this tweet from Matthew Roszack, Co-Founder of Bloq, during the announcement of their acquisition of blockchain analytics company, Skry.

The full quote is: “Blockchain networks will create the greatest data sets we’ve ever seen. Leveraging machine learning techniques will enable faster and enhanced decision making, while uncovering insights and massive opportunities along the way.” [9] This statement is more important than you would initially think upon first glance while scrolling through your Twitter feed. It is indicative of the direction companies like Bloq are headed.

Companies like Apple, Amazon, Google, and Facebook have ascended the market because they hold and monetize a massive amount of the valuable consumer data that exists on the Internet. They generate 80% of revenues from that data! So, you start to understand what companies like Bloq see as a potential future state for their balance sheets.

It’s also obvious, to me at least, that governments would want as much traffic on-chain as possible for the purpose of tracking digital crime like ransomware perpetrators, as well as other nefarious activity like dark net market transactions. Additionally, a government like China’s would be able to better police capital flight if they could find and punish those who are using Bitcoin to financially “flee the country.”

Governments could even begin blacklisting Bitcoin addresses and the coins residing in them that are associated with the aforementioned activity.[10] As I was writing this, I came across an article just published by Bitcoin-user Beautyon. The author makes the case that the intended outcome from governments could be an on-chain AML/KYC compliant coin that acts as a no-longer-permissionless financial network.[11] This fundamentally destroys Bitcoin’s value proposition as censorship-resistant money.

Bitcoin transactions related to acts classified as crimes in some jurisdictions.[12]

A definitional property of money is that it is fungible. That is, someone can exchange one unit of that currency for another without fear that the newly owned currency has lost any of its value relative to the previously-owned piece. Essentially, any two pieces of currency must be interchangeable for it to be deemed worthy of currency status.

If we begin blacklisting addresses and the coins associated with them because those addresses were deemed to be engaging in “nefarious activity,” Bitcoin begins to lose its fungibility property. Although it is likely we would see markets arise for coin-washing, like sending U.S. blacklisted coins to a different jurisdiction for clean coins, this outcome is not the preferred one if Bitcoin is going to have a seat at the “truly disruptive” table.

Questioning Bitcoin’s “Ideology”

The last thing I wanted to point to was Peter Rizun’s recent presentation at the Future of Bitcoin conference in the Netherlands. He is the Chief Scientist at Bitcoin Unlimited, which is a development team vying to unseat Bitcoin Core as the main reference implementation. Their goal is to change Bitcoin’s protocol via hard fork to remove the block size limit altogether.

Cryptocurrency is more theology than science. In science, we start with the null hypothesis and an attitude of skepticism, and then make observations on the reality around us. In theology, we start with scriptures we believe to be divine, then twist and contort our observations to make them appear unchallenged.

In the quote above, he is setting up his position that Bitcoin is composed of nothing more than ideological rules and that those ideologies should be challenged. He is subtly alluding to the ideology of the cypherpunks who are responsible for Bitcoin’s existence. He even mentions in passing that we should be malleable to new beliefs from new people entering the cryptocurrency space, including whether to remove the limit on how many Bitcoins will ever exist.

An example he gives is there being some known “nasty terrorist” that we know is holding Bitcoin in an identifiable address. Peter’s “ideology” would hold that, regardless of who owns those coins, there should not be an ability to confiscate them or diminish their value in anyway. Then he suggests that there could be a day that he is forced to question his beliefs about what Bitcoin should be based on what other people believe it should be.

I think it is a real possibility that Peter is subtly preparing his listeners to be open to a future where we should make changes to Bitcoin for “utilitarian” reasons like political emergency. The only way someone could confiscate coins owned by a terrorist is if those addresses and coins are visible to everyone. The only way THAT happens is if the majority of transactions remain on-chain.