Bitcoin’s privacy problem – and what Cypherpunks is doing to solve it
by James · August 12, 2022
As the US government ramps up its crypto-regulatory efforts, it is targeting privacy-protecting projects like never before. The crypto community is worried – especially the cypherpunks – and users are currently grappling with the implications of the Tornado Cash ban and how it might be enforced in practice.
But behind the scenes, Bitcoin developers have been working for years now to preserve privacy when trading crypto.
“The targeting of an open source protocol (as opposed to an individual) is clearly an escalation in the effort to make cryptocurrencies ‘fit’ into what the US considers its financial control framework.” Craig Raw, developer of Bitcoin Sparrow Wallet, told Decrypt. “This is where the importance of keeping funds without KYC links are becoming clear, and the battle for financial privacy is escalating again,” he said.
Bitcoin was long thought to be private, but that is not correct. In the early days, many Bitcoin users didn’t know any better and would trade the cryptocurrency online without thinking about the consequences – including on illegal darknet marketplaces.
These days, authorities can easily match Bitcoin transactions with real people, because off-ramps like cryptocurrency exchanges collect personally identifiable information about their customers. In fact, law enforcement agencies even have so they prefer it when criminals use the asset because it is so easily traceable. Bitcoin can be pseudonymous – no one’s identity is registered on it blockchain– but every single transaction is.
“We’ve already put so much of our lives online, and this trend will undoubtedly continue,” Bitcoin Design contributor Christoph Ono told Decrypt. “After decades of the internet, it’s also clear that the urge to collect/analyze/hack/sell data is too strong for many private companies, governments and other groups.”
He added that “data is being used against us” and that the added layer of financial data on public infrastructure could make things “much worse.”
This is why developers are currently building tools that will make transactions on the Bitcoin blockchain nearly untraceable. Here’s what they’re working on.
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One way to make Bitcoin more private is to use certain wallets. In particular, wallets that use CoinJoin – a technology that groups Bitcoin transactions to hide their origin. There are several projects right now that use mixed protocols to promise more privacy and near-anonymous transactions. CoinJoin is one of them.
Fed eyes mix protocols: this week Treasury Department shut out Tornado Cash, a coin mixing app that allows users to send Ethereum anonymously in an unprecedented move.
US citizens are now not allowed to use the tool or interact with addresses that use it. Crypto developers and users are currently struggling with the implications of this ban and how it can be enforced in practice. But for now, the development of similar tools used for Bitcoin transactions continues. “Time will tell where the outcome of this fight lies, but at the end of the day, there’s no middle ground,” said Sparrow Wallet’s Raw. “Either we have tools where anyone can have privacy, or we have no privacy in it at all.”
Wasabi Wallet is a project that uses the Tor network to encrypt communications. Tor is software that allows users to anonymize their internet traffic by sending it through a network of servers run by volunteers. Wasabi, a desktop wallet, connects users to random Bitcoin peer-to-peer nodes, and hides transactions so that it is very difficult to know where the money goes. In June, it released its latest wallet, Wasabi 2.0.
The team said so Decrypt that the latest release was the best option for privacy because it will make “privacy the default for everyone” with a fast and cheap UX. “What difference does it make [from other wallets] is the user experience,” said Adam Fiscor, co-founder of zkSNACKs, the software company behind Wasabi Wallet. He added that privacy should be “frictionless and effortless” and that Wasabi does this; even a non-Bitcoiner would be able to wrap his head around to use it.
Why would anyone use Wasabi? “Good user experiences with privacy products are necessary as we move towards a world where everything is online,” Fiscor said.
Rafe, a longtime Wasabi contributor, shared Decrypt that Wasabi uses a new CoinJoin mechanism that hides more transactions than before, meaning more people can benefit from the app’s privacy feature.
Craig Raw said his Sparrow Wallet could make Bitcoin almost as private as Monerowhich is the largest privacy coin, with a market cap of $2.8 billion, and currently the best option for privacy.
Monero uses ring signatures – cryptographic digital signatures that cannot be identified – making it very difficult to track transactions.
Bitcoin’s transactions are traceable as everything is stored on a public blockchain. But Raw says Sparrow can achieve a similar level of privacy, if a user wants it. “It is possible, with care, to achieve a level of privacy similar to Monero,” he said Decrypt. “In practice, the answer lies in asking ‘how big is my anonymity set’ with every transaction you make.
“Using the tools in Sparrow, it is possible to make this sufficiently large that the probability of tracking ownership of funds is low enough to make this effectively impossible.”
The lightning network
A perhaps lesser-known way to stay private while using Bitcoin is via Lightning network. A “second-tier solution”, it was created to solve Bitcoin’s scalability problem – or in other words, to allow more transactions to be processed. It does this by looping the main Bitcoin blockchain.
But it also has privacy benefits because each transaction is not permanently stored in the blockchain. Instead, various transactions are grouped together, and then recorded as one large transaction. This is not only useful for microtransactions (like buy a coffee in El Salvador), but keeps payments anonymous.
Evan Kaloudis, the developer behind Zeus, a non-custodial Lightning wallet, said Decrypt that while using Lightning, it’s “virtually impossible” to figure out who paid what.
“Today, Lightning has great privacy for senders,” he said. “Your employer should not be able to see where you spend your paycheck. The convenience store where you make a small purchase should not be able to see how much money you have, or where else you shop.”
But there are still privacy issues on Bitcoin’s network, Rafe added, and it’s in our interest to fix them. Why? Because government surveillance can increase with digital money, which central bank digital currencies (CBDCs)—centralized, digital versions of fiat money (ie US dollars). CBDCs can in theory be used by large entities to monitor what we do.
Governments around the world are in various stages of building or researching such assets, with a number of Caribbean countries having already released one. But perhaps the biggest concern for the crypto community – or anyone concerned about privacy – is a CBDC being used by an authoritarian regime, which China’sto monitor people’s everyday lives.
“The scary thing is that governments are tightening their oversight of traditional finance as well CO2 points on credit cardsthe removal of cash, CBDCs and social credit points,” said Rafe. “I don’t think they will allow monetary competition or another system with other rules and freedoms.”
“If we want an alternative, we should build it quickly,” he said.
