Every action has a reaction, and the world of government regulation is no different. Recently, the regulatory chatter has picked up around Bitcoin and it appears to be focused on two major mandates as perceived by the financial regulators.

Number one is the attempt to apply invasive technology-specific money transmitter regulation to a technology that doesn’t seem to fit into any of their other regulatory boxes. Licenses are being crafted to ensure the same level of AML (Anti-Money Laundering) and KYC (Know Your Customer) guidelines for bitcoin companies as for other types of existing financial institutions.

Number two is protecting us “from ourselves” under the standard guise of consumer protection and fraudulent operators. In an interview on The Bitcoin Group, Andreas Antonopoulos describes a self-regulating method where the consumer protection holes can be solved by free market-enforced exchange solvency and implemented cryptography solutions.

New York-Style Licensing

Regarding technology-specific regulation at the state level, New York has put forth a bad idea with an unfortunate name, mostly because it sounds like an innovative Silicon Valley startup which it definitely is not.

It is, however, a grand attempt from a local regulator to overlay an inappropriate technology-specific regulation within the confines of the great state of New York.

Unfortunately, this will cause greater hardship for New Yorkers than it will for the bitcoin businesses that will most likely seek out other favorable jurisdictions. If New York wanted to drive new growth businesses away from the state, then this would be the way to do it. These antics are not predicted to be emulated.

Markets perceive regulation as ‘damage’ and route around it. This is true with Internet-related damage and it is equally true with Bitcoin-related damage.

For example, artificial damage to bitcoin’s semi-anonymous properties could be inflicted by tracking specific bitcoin addresses at the exchange endpoint level and beyond. Perhaps mandated by law in the near future, this type of regulatory action would be akin to to registering bank note serial numbers during a routine cash withdrawal.

Most people would reel in horror at the prospect of this because they naturally believe that they have a right to use their cash as they see fit without serial number tracking.

Surveillance techniques

Coin tracking and coin validation schemes are new types of surveillance techniques that Bitcoin’s public transaction ledger enables. Interestingly, either the free market or the law could spawn these invasive techniques as a business model.

In the case of an exchange seeking to bolster its compliance reputation, it might turn to an independent service provider that analyzes bitcoin address data and associated traffic patterns known to be involved in crimes.

Of course, the major underlying and still unresolved problem here is that subjective judgement must be exercised in data analysis of this type which could unduly harm the downstream owners of fungible bitcoin. That is, if anyone held title in bitcoin to begin with.

Markets provide solutions to these cases of bitcoin privacy ‘damage’ and this is where it becomes tricky for regulators. They are practically in a no-win situation because regulators must use their tools to regulate, but the more they do, the more they inadvertently encourage market-based responses.

Fortuitously, Bitcoin comes with built-in plausible deniability due to the many ‘mixing’ hops that can be traversed both on-block chain and off-block chain. Unless the user’s private key is seized, no one can prove with absolute certainty that a particular amount of bitcoin is owned by an individual without their consent. In financial privacy terms, this is referred to as “knowledge of balance” privacy and it is a key element of overall financial privacy.

Mixing services

As cited in ‘The Politics of Bitcoin Mixing Services’, mixing services for bitcoin may emerge as the next frontier in the battle for financial privacy. Coin mixing services for cryptocurrencies do not violate any laws and they merely attempt to re-balance natural deficiencies in the protocol.

According to CNBC, Ben Lawsky and New York’s Department of Financial Services are “still wrestling with whether to ban or restrict the use of ‘tumblers,’ which obscure the record and source of virtual currencies.” Lawsky said tumblers are a concern to law enforcement although they might have legitimate uses.

[post-quote]

Is it even possible for New York to ban tumblers that exist on the global Internet? How will the cryptographic free market respond to encroaching regulation into the market for Bitcoin?

Zerocoin and CoinJoin represent two attempts to restore the balance in making digital cash as private as physical cash today. They operate in a decentralized manner without requiring trust in a third party.

Originating from Johns Hopkins University, the first Zerocoin plan was a proposed extension to the Bitcoin payment network that added anonymity to Bitcoin payments and used provably secure cryptographic techniques to ensure that Bitcoins cannot be traced.

After refusing to gain traction among the bitcoin user and developer communities, creators Matthew Green and Ian Miers decided to launch Zerocoin as its own independent cryptocurrency complete with separate block chain and reward incentive system. The Economist refers to Zerocoin as “washing virtual money”.

CoinJoin, first described by Gregory Maxwell as a method of increased coin privacy for the real world, is an urgently needed improvement, because:

“Bitcoin is often promoted as a tool for privacy but the only privacy that exists in Bitcoin comes from pseudonymous addresses which are fragile and easily compromised through reuse, ‘taint’ analysis, tracking payments, IP address monitoring nodes, web-spidering, and many other mechanisms. Once broken this privacy is difficult and sometimes costly to recover.”

Involving no changes to the Bitcoin protocol but requiring specific wallet implementations, CoinJoin operates as a unique transaction style for Bitcoin users to dramatically improve their privacy.

Both efforts succeed where the original Bitcoin protocol stopped short. In direct response to increasing and potentially onerous regulations, Zerocoin and CoinJoin stand as pillars of financial privacy in a world where surveillance has run amok.

Ultimately, society can have hope that if privacy becomes disrespected, the market can and will provide cryptographic solutions to restore the balance. If Bitcoin is to succeed, that is the real challenge for the talented individuals and leading companies in the Bitcoin ecosystem.

Disclaimer: The views expressed in this article are those of the author and do not necessarily represent the views of, and should not be attributed to, CoinDesk.

Follow author on Twitter.

Surveillance and tightrope images via Shutterstock