Privacy on Bitcoin

The Problem

One of the many benefits of bitcoin is that, by default, it is pseudo anonymous. This means that all the information contained on the blockchain is not tied to your actual identity, but an alias. When you transact across the network the primary items that are communicated are: the amount you’re sending, the sending wallet, the receiving wallet, and the miner fee, among other things. Your identity is not included in this. This pseudo anonymity is beneficial for multiple reasons, but the most important one is that it allows you to transact privately on bitcoin. 

Why is privacy in this manner important? Eric Hughs communicated it best in his 1993 work titled “A Cypherpunk’s Manifesto”

“Privacy is necessary for an open society in the electronic age. Privacy is not secrecy. A private matter is something one doesn’t want the whole world to know, but a secret matter is something one doesn’t want anybody to know. Privacy is the power to selectively reveal oneself to the world.”

Furthermore, privacy is a right guaranteed to us under the 4th amendment. In a world where there is seemingly nothing that is private anymore, the fact that we can use bitcoin to maintain some form of it, is powerful. 

The unfortunate reality of this privacy, however, is that most people that are using bitcoin, do not have it. When you sign up for an account on an exchange to buy bitcoin, you give the exchange all of your personal information, this process is called KYC or Know Your Customer. They are required by law to have this information. So, if you decide to move your bitcoin off the exchange after you have purchased it, your identity is now tied to an on chain wallet address. From there, even if you move your bitcoin to other wallets, chain analytics companies can still “follow your trail” so to say. This means that you are forevermore not transacting privately on bitcoin. Once you have established that your identity is tied to certain addresses or UTXO’s, it becomes fairly easy to follow this link, no matter where you send your bitcoin.

This sucks, huh? Well, it’s still not the full story. There are ways that you can maintain privacy while transacting on chain, even if you bought your bitcoin originally from a KYC exchange.

Before I dive into how to accomplish this, I want to give you a compelling why, as in, why this matters. If the above didn’t already convince you, that is. It comes down to fungibility. Fungibility means that one unit of a good is exchangeable in equal value for another good. A $1 bill is worth just as much as any other $1 bill. It follows that 1 bitcoin should be worth the same as any other bitcoin. If a monetary good (such as bitcoin) does not have high fungibility, then its usefulness as a monetary good is neutered. One cow does not always exchange equally for another. 

If all (or even a majority) of bitcoin was tied to real world identities, it would severely hamper the fungibility of bitcoin and its ability to act as a monetary good. Why? Because due to those ties some bitcoin could be worth more or less than others. There could be vanity UTXO’s, where some famous person once owned it, and so now there is a price premium for those. There could be diluted UTXO’s which are tied to some criminals’ history. No longer would 1 bitcoin = 1 bitcoin. 

This would introduce a new risk, a lack of censorship resistance. If all bitcoin is tied to an identity, then there could be organizations that restrict interacting with certain bitcoin. This would likely be implemented as a blacklist. I.e. “These wallets & addresses are banned from being interacted with or face fines & penalties”. If censorship resistance is lost, then there is much less value to using bitcoin as a monetary good over any other centralized monetary system. 

To summarize, bitcoin is pseudo anonymous by default, but most bitcoin is tied to your real world identity when you buy it on an exchange that uses KYC practices, ergo you’ve lost this default anonymity. By tying your identity to bitcoin, you hamper bitcoin’s fungibility, loss of fungibility can result in loss of censorship resistance and therefore bitcoin as a monetary system & good becomes much less useful. 

Problem, Meet Solutions

As I alluded to already, there are ways to maintain privacy and your default pseudo anonymity while transacting on bitcoin, even if you acquired your bitcoin from a KYC exchange. There are 4  primary ways to accomplish this. 

1. No KYC Acquisition
2. Coinjoin Transaction
3. Layer Swaps
4. Chain Swaps

We’ll go through these, but please note that the intention of the following is to summarize each option for you, not to give you an in depth guide. Please DYOR prior to attempting any of the below as there is technical proficiency required by all of them, and it is (unfortunately) quite easy to undo your privacy gains. 

Additionally, this is not an all or nothing process. This can (and probably should) be done with only a portion of your stack. A fully non KYC stack could lead to issues down the road. 

No KYC Acquisition

While it is certainly more popular to acquire your bitcoin through a KYC exchange, there are options available to you that do not require KYC to get bitcoin. Three of the most popular ways are: 

1. Buy your bitcoin through a no KYC exchange such as bisq or RoboSats
2. Buy your bitcoin through a voucher system such as Azteco
3. Buy your bitcoin from a trusted third party in person via a private transaction

Do expect to pay a premium over the going market value of bitcoin if you purchase this way and make sure that when you acquire bitcoin this way that you only hold or send it to wallets that are also non KYC. 

The last 3 options are all applicable if you have already bought KYC bitcoin. You can certainly utilize them with bitcoin acquired  via no KYC too, to increase your anonymity, but it’s not “required” per se. 

Coinjoin Transaction

This bitcoin wiki article summarizes this best: “​​CoinJoin is a trustless method for combining multiple Bitcoin payments from multiple spenders into a single transaction to make it more difficult for outside parties to determine which spender paid which recipient or recipients.” The end result of a coinjoin is that you have what’s called “forward privacy”, which means that even though the bitcoin you own used to be tied to your identity, it no longer is. To put it another way: you and your 10 closest friends all put a quarter (whose serial number is tied to you) in a machine, the machine then shakes all the quarters up,  mixes them really well & gives them all new serial numbers, then it drops out a new quarter for each of you (with this new serial number) to take with you. This process is done in a private location where no one can see who took which quarter with them. That’s an overly simplistic way to think of coinjoins, but the premise is this – you start with bitcoin that is tied to your identity (via KYC), then you go through a process that makes it extremely difficult to know (or even guess) which bitcoin is tied to your identity at the end of the process. This process can be done multiple times to increase your privacy gains as well. The most popular services for this are Samouri’s Whirlpool and Wasabi Wallet. 

Layer Swaps

As you (hopefully) know, bitcoin has multiple layers. Layer 1 is the bitcoin blockchain itself, and Layer 2+ is any technology that uses the bitcoin blockchain as its base, but allows for additional features that the main chain (Layer 1) doesn’t. The most popular of these is the Lightning Network. A layer swap, then, is the process of transferring your bitcoin from Layer 1 to Layer 2 (or even between separate layer 2 protocols), and then back to Layer 1 (eventually). This transfer, when done correctly, can allow you forward privacy much the same way that a coinjoin can. This forward privacy is not to the same level of a coinjoin, though. A layer swap is best done with smaller amounts where as a coinjoin can be done with quite large amounts of bitcoin. The most common way to accomplish a forward privacy layer swap is by following this method, which uses the Lightning Network. 

Chain Swaps

Finally, there are chain swaps. These look much like a layer swap, the difference is that they are accomplished by transferring your bitcoin to a completely different blockchain. The most common way this is done is by transferring your bitcoin to monero (another crypto asset), and then back to bitcoin. The forward privacy afforded by this method is similar to layer swaps. It is still secondary to the effectiveness of a coinjoin. Additionally, it is more technically difficult than a layer swap. Only the most technically proficient should attempt this.  

Don’t Undo Your Hard Work! 

It’s important to note that while these options get you started on the right foot, it is possible to still tie your identity to your bitcoin in the future. Namely, by combining them in the same wallet as you hold other KYC’d bitcoin or by sending them to a KYC exchange to sell at some point in the future. You must be very careful to keep your non KYC bitcoin segregated from your KYC bitcoin. 

Wrapping Up

There you have it. You now know why privacy on bitcoin is important, how most do not currently have this privacy when transacting, why you should desire to have some of your stack owned in a non KYC manner, and 4 different ways you can make that happen. This is part of the beauty of bitcoin, that we even have the option to accomplish this. This is not available anywhere in the traditional financial system outside of cold, hard cash. Stay humble & stack sats.