Bitcoin Needs To Be More Private For Adoption

Bitcoin Needs To Be More Private For Adoption thumbnail

Aneta Karbowiak has been writing articles about Bitcoin and cryptocurrency since 2018.

When Satoshi Nakamoto wrote the Bitcoin white paper, he thought of a permissionless system to exchange electronic cash trustlessly. Today, Bitcoin has become a symbol of freedom, and as Edward Snowden says, “Liberty is freedom from permission.” By building a transparent, verifiable ledger, Satoshi introduced trust into the system, though. Trust can cause Bitcoin privacy and fungibility to be destroyed, and that’s not a good thing.

What Is Fungibility?

Fungibility means interchangeability for another good of the same kind and indistinguishability of individual units. Gold is fungible. One unit of gold can be used interchangeably with another. One gram will always equal one gram, regardless of whether it is ingots, bullion coins, or nuggets. One dollar will always be one dollar, regardless of whether it has been touched by criminals or famous people. It’s impossible to sell $1 for $2 as no one would buy it. No one cares about where the dollars came from or how many people passed them before they were yours. People want to know that the dollar they receive will not suddenly lose its value and that they won’t have to search for a place to exchange it for something at a lower cost.

A teacher who is paid for his work with a non-fungible asset such as a porcelain vase must go out and find a place to exchange it for something else. If a doctor is paid in grain, he will need someone to buy grain from him to pay his rent. Because everyone will be wasting their time trading things they don’t need in exchange for something they want, no one will work anymore. This phenomenon is called a double coincidence of wants. Production decreases when there is a restriction in the selling and buying of goods and services.

If the economy is to become efficient and active, it must have fungible assets that act as a unifying force. To ensure economic freedom and free trade, individual inputs should be freely exchanged. To have fungibility and sound currency, it is important to ignore the history and origin of inputs.

What Is Sound Money?

Sound money is money that won the marketability race and is the most used because it has properties like portability, homogeneity, divisibility, durability, acceptability, fungibility and scarcity.

Economist Ludwig von Mises described money as “the most marketable commodity” because it, spontaneously and through competition, becomes the most common medium of exchange. Money that is sound has naturally embedded protection against arbitrary actions by sovereigns to depreciate the purchasing power of a currency through the interventions of their monetary policy. The dollar stopped being sound money when Abraham Lincoln created the Legal Tender Act in 1862 to fund the Civil War and print greenbacks, and it continued its descent with the creation of the Federal Reserve system, gold confiscation by executive order, the abrogation of the gold clause contracts, and collection of unconstitutional income tax. This has led to a 97% dollar loss in purchasing power.

Bitcoin As Sound Money

Bitcoin possesses all seven properties of sound money. Some of these properties are better than gold, while others are less. Bitcoin is portable because you only need to remember a seed phrase in order to access your coins. It cannot be stopped by border controls. It doesn’t require secure transport or protection to move it from one place into another. It is more easily divided and may be even more durable than the code it covers. But, one thing could prevent bitcoin from being sound money, without government intervention or subsequent destruction: It’s the transparency and lack of privacy that undermining fungibility.

Exchanges’ Attack On Bitcoin Fungibility

All bitcoin balances are open to public scrutiny. This allows for surveillance of the ledger as well as controls by other entities, such centralized exchanges and law enforcement agencies. It also permits the creation of blacklisted addresses, transaction filtering and censorship. Bitcoin transactions can’t be censored if they are on the ledger or outside of centralized exchanges. However, transaction history of Bitcoin UXOs is permanent. This means that certain criteria can be used to tag or taint them.

If a UTXO is linked to a criminal activity, such as hacking, or if it has been connected to a black market transaction it could be immediately blocked if the bitcoin gets on an exchange. This may seem legal and reasonable.

Exchanges may verify UTXOs up to six hops, which means that if there is no suspicious activity in the six previous transactions, then this UTXO of bitcoin is deemed “clean.” If someone received “dirty” bitcoin from someone else, then this transaction would get blocked, and the person would need to give an explanation or worse, they could be associated with a crime and face criminal charges.

Users reporting transaction rejection and account bans are always more frequent. Following guidelines issued by the Financial Action Task Force (FATF) and recommendations to enhance recordkeeping by virtual asset service providers (VASPs), exchanges started considering interaction with “unhosted” wallets as high risk. These guidelines recommend labeling peer-to–peer transactions between “unhosted” wallets and keeping them records.

Who’s At Risk Of Being Blocked Or Flagged

Anyone selling products or services for bitcoin or receiving transactions or participating in peer-to-peer trades is exposed to the risk of getting “dirty” bitcoin. This is something that most people don’t know about. If their identity is linked to the transaction, they could be in trouble with law enforcement.

People with bitcoin with rigged transaction histories will try to trade it for a discount, as they won’t be able to sell it on centralized exchanges. This can cause problems with fungibility as it may not be convertable to another bitcoin with a clean transaction history.

To escape the stigma of a UTXO attached to identity or stained by criminal history, people often use tumblers or other kinds of privacy-enhancing tools like CoinJoin. Exchanges started flagging addresses receiving funds from these anonymizers. Although privacy-enhancing tools are not indicative of criminal transaction history, exchanges block transactions and ask for proof of origin. It is not known how far a surveillance firm like Elliptic, Chainalysis or Crystal can delve into transaction history to find suspicious transactions.

In an interconnected world like we have today, where every person is linked to another person by six degrees of separation, it means that potentially, everyone will be linked to a dark bitcoin and could be placed under surveillance or be charged with a crime at a convenient time. While this issue is only of concern to a few people, it will be ignored. However, when surveillance becomes widespread, people will begin to view it as tyranny. The risk of having a dark bitcoin increases with its value. This is a problem for hedge funds. One or two tainted bitcoins could affect the entire investment pool and reduce its market value through association.

Bitcoin is being sought as freedom money, without censorship, and can be used to fight oppression. However, the use of bitcoin in the trucker protests in Canada, for funding WikiLeaks, or as support for Ukrainians in their war against Russia could be used and, in some instances, was already used, against people who donated. On the other hand, Coinbase blacklisted 25,000 Bitcoin addresses just because they belonged to Russians whose country was sanctioned.

For a counterexample, bitcoin with no history at all, the one coming from the miners, is traded at premium prices because it’s the purest form of bitcoin.

Bitcoin Censorship From The Miners

Exchanges blocking accounts or rejecting transactions isn’t the only type of attack on fungibility. Some bitcoin miners like Marathon Digital Holdings or Blockseer decided to mine only blocks that are compliant with U.S. regulations, anti-money-laundering (AML) regulations and the Office of Foreign Asset Control’s (OFAC) standards. Marathon filters transactions and rejects any that are not compliant.

Another factor that affects bitcoin’s fungibility are the location of the miner and the type of energy used to mine it. Some miners and institutions are now looking to offset carbon footprints as an important factor. Bitcoin mined with energy using fossil fuels won’t be accepted. The dichotomy of bitcoin being from different energy sources or geographic locations only adds oil to the fungibility debate. If government regulations force miners to mine bitcoin only with green energy or accept only compliant blocks, then we could see a split into two economies: clean and dirty bitcoin. It’s possible, but it’s not certain. One rebel miner could be all that is needed to break the compliant block chain.

Fungibility Attack Injected Into The Code

Bitcoin covenants which are spending restrictions on UTXOs may be another potential attack on bitcoin fungibility. New rules are introduced to protect the property rights of a specific UTXO by controlling how and who bitcoin can be spent. A UTXO with a covenant is different than one without it. Because they are not interchangeable or equal, the price must be different. This becomes even more complicated if a UTXO can be owned jointly by several people. It could also be a way for a bank or government to control UTXOs. The government could have the ability to control how bitcoin is spent.

No Privacy, No Fungibility

This discrepancy in bitcoin’s use and value depending on transaction history is an attack on the soundness of bitcoin as money. It can also be used to target anyone who holds bitcoin. An attacker can send a small amount of dark bitcoin to public addresses in order to poison the addresses and anyone associated with them. Public addresses of influencers or other public figures could be a target. This could involve many people and spread around depending on how many hops surveillance agencies include in the trials.

Fungible monies disregard past use and always maintain their purchasing power. Futigibility cannot be affected by uncertainty about the future and past use. If there is, it means that trust in money as an exchange for value is compromised.

The fall of the dollar as well as the rise of Bitcoin are the result of compromised trust in the banking sector and government policies. Bitcoin may be vulnerable to regulatory capture if it doesn’t address the problem of fungibility caused by the lack of privacy.

Satoshi himself talked about privacy in his Bitcoin white paper,

“The traditional banking model achieves a level of privacy by limiting access to information to the parties involved and the trusted third party. The necessity to announce all transactions publicly precludes this method, but privacy can still be maintained by breaking the flow of information in another place: by keeping public keys anonymous … As an additional firewall, a new key pair should be used for each transaction to keep them from being linked to a common owner.”

Unfortunately, he probably didn’t envision that most bitcoin would be traded on exchanges with such strict know-your-customer (KYC) and AML rules. He didn’t anticipate that all UTXOs sent from these exchanges would be owned by known, identifiable users.

The Solution

While Bitcoin’s transparent ledger provides auditability, the lack of privacy is hurting its fungibility and introduces censorship attacks of different kinds. One solution is to increase bitcoin privacy. There are many privacy-focused projects (CoinJoin and Dandelion, confidential transaction, Coinswap etc. However, privacy-enhanced Bitcoin is not allowed to be banned or treated differently. The fungibility of privacy-enhanced Bitcoin will not be affected if they aren’t treated differently.

Another privacy-oriented solution would be to promote non-KYC exchanges like Bisq or Hodl Hodl and privacy tools like Samourai wallet with Whirlpool and Ricochet. The less fungibility loss is the more popular CoinJoined bitcoin becomes. There is more to be discussed about covenants. It could be that something is introduced into the Bitcoin code which could make it vulnerable to an attack. This would create two sets UTXOs that cannot convert to other units.

Conclusion

The gradual loss of fungibility in bitcoin should not be ignored. We may find ourselves with an oppressive tool rather than freedom-enabling money if regulators continue to force miners into following certain regulations. There are other ways to catch criminals, and they don’t need to compromise bitcoin’s fungibility. One thing is certain: Bitcoin’s fungibility and privacy are closely connected. There is no other way around this. Because Bitcoin is not controlled by any government, fungibility cannot be ordered. It must be solved on the chain.

While regulators can require miners to use green energy sources only, there will always be areas or miners in which fossil-fuel mining is still possible. It might prove to be a losing battle to remove non-compliant transactions. The miners will eventually find out for themselves.

This is a guest post by Aneta Karbowiak. Opinions expressed do not necessarily reflect those held by BTC Inc. or Bitcoin Magazine HTML1.

Read More