Bitcoin was originally thought to be fully anonymous and in its early days it probably was. However, as most moved from mining Bitcoin to buying, systemic entry points, or exchanges, sprang up.
As a ledger history was created, known addresses, often those belonging to Bitcoin exchanges, became, in effect, de-anonymising tools.
Financial regulation of Bitcoin exchanges
When Bitcoin became more prominent and popular, regulators took enforcement action.
The community’s pushback secured no regulation of the protocol itself, but Bitcoin exchanges were forced to comply with numerous financial regulations.
Although Bitcoin addresses are made of random letters and numbers, each address is unique. Once ownership of the address is revealed, everyone can see all the transactions it performed.
If, therefore, that address received or deposited to a known illegal or even undesirable (as regulators deem it) service provider, exchanges may freeze the account or deny service as well as perhaps or rather likely share data with third parties.
If all exchanges or service providers share their data with a central entity, then it may be possible to track most transactions with reasonable confidence as the centralized points (exchanges or service providers) shed light on what likely occurred when the transaction is onchain.
Retaining privacy
One method to retain privacy is to use a new address every time a new transaction is made.
However, one could easily assume such action was performed, especially if subsequent transactions re-inforce the assumption in one way or another.
There are mixing services, like coinjoin, which pools different amounts, mixes them all together and sends them off to different addresses, as well as other methods.
However, would non-technical users be able or willing to spend time and effort into employing such methods?
Should they, therefore, be incorporated in the protocol itself and if they are, how would regulators, which are currently engaged in an intense fight with Apple in the so-called crypto wars 2.0, react?
Many companies, including Apple, are now employing end to end encryption and other cryptographic methods which provide full privacy for the masses.
Sending transactions off-chain
For Bitcoin, the answer is slightly more complex. Although methods have been suggested, such as Confidential Transactions or a Zerocash sidechain, some suggest that sending transactions off-chain to the Lightning Network may be the answer.
In a short interview Peter Todd states:
“The Lightning Network inherently means that less information about transactions ends up in the public blockchain, which makes anti-privacy coin tracking efforts like Chainalysis much less effective; Chainalysis is a perfect example of a company whose business will likely be wiped out entirely by Lightning.”
As most transactions would occur off-chain, there would be no global ledger of transactions to track. However, it is not clear how much privacy within Lightning transactions would provide as Lombrozo states that it is not yet decided what algorithm Lightning will use.
Lombrozo says:
“You could use onion routing (like tor) so that hubs don't know the original source and destination. If you directly connect to the counterparty then you could use encrypted messages and nobody but the two of you would know about any of your transactions.” However, onion routing has trade-offs as “it tends to be slow and relatively inefficient.”
Routing algorithms
While tor is a valuable tool, it has seen little adoption, primarily because it is slow. Moreover, many websites have taken action to deny access to tor users, thus increasing inconvenience.
It may well be the case therefore that “several different routing algorithms will be used for different purposes” with most, probably, using the Firefox version of Lightning and the tor onion routing version.
This ensures privacy for those who spend time and effort, comparable to the use of the inconvenient PGP tool today.
The level of privacy for the rest, if any, is unclear with some suggesting that as scale is achieved, Lightning hubs would be able to see all transactions, comparable to exchanges and like exchanges can deny service if they so wish.