Bitcoin right now is not really anonymous. While Bitcoin addresses aren't necessarily linked to real-world identities, they can be. Monitoring the unencrypted peer-to-peer network, analysis of the public blockchain and know your customer (KYC) policy or anti-money laundering (AML) regulation can reveal a lot about who's using Bitcoin and for what.
This is not ideal from a privacy perspective. To show some examples; Bitcoin users might not want the world to know where they spend their money, what they earn or how much they own, while businesses may not want to leak transaction details to competitors.
Additionally, bitcoins being traceable, possibly “tainted” and potentially worth less than other bitcoins is at odds with fungibility. This could even challenge Bitcoin's value proposition as money.
One solution to increase privacy and protect fungibility is to exchange bitcoins for fiat currency without being required to identify yourself.
The Problem
Exchanges, brokerages, money transmitters and other service providers that serve as the “on-ramps” and “off-ramps” between bitcoin and fiat currency, form an important part of the Bitcoin ecosystem. But from a privacy and fungibility perspective, a heavy reliance on these companies is not ideal: Practically all fiat-facing bitcoin-companies are required to apply AML/KYC-checks on their customers.
Moreover, these checks can be (and are sometimes) combined with wider blockchain-analysis, pertaining to the past trail of bitcoins, to in some cases even monitor where bitcoins move to after leaving these services. This allows for extensive mapping of the Bitcoin ecosystem. (In a recent blog post, R3CEV Director of Market Research Tim Swanson even described this as a “de facto Kimberley Process”.)
There are some ways to avoid these kinds of checks. Most obviously, users can exchange bitcoins for fiat outside of any exchange, for example, at Bitcoin meetups. But it becomes a bit more tricky online: Users need to trust their counterparty or maybe a dedicated middleman to actually send the bitcoins or wire the fiat currency. Alternatively, converting bitcoins to fiat currency can be done by purchasing Bitcoin debit cards such as Cryptopay or BitPlastic. Converting fiat currency to bitcoins, vouchers such as the Bitupcard may also offer a solution.
Most of these options, however, are rather expensive, clunky or both.
Local Exchange
A perhaps more sophisticated solution is the use of exchanges that don't require identity-checks; there are several.
The earliest of such alternatives is the Finland-based exchange LocalBitcoins, launched in 2012. As opposed to typical exchanges, LocalBitcoins is a platform that does not touch fiat currency itself. Instead, users send the fiat through typical wire transfers or other methods. And, as the name of the website suggests, users can also meet up locally and trade bitcoins for cash on the spot. This allows LocalBitcoins to be more lenient when it comes to AML/KYC-policies – although some sellers do require their counterparty to identify themselves through the LocalBitcoins-platform to some degree. (In the United States, some LocalBitcoins.com sellers have been charged under anti-money laundering laws.)
Building on this concept in 2014, the Mycelium mobile Bitcoin wallet introduced Local Trader: a Bitcoin exchange built right into the wallet. Mycelium users who want to buy or sell bitcoins for cash can make an offer on the Mycelium platform where they indicate a price and maximum distance they’re willing to travel. Once a match is made with another trader, they can meet up and complete the trade locally, typically with cash. The Bitcoin side of the trade is taken care of in-app, which also includes a reputation system.
Decentralized Exchange
However, even if the fiat side of the trade is handled locally, LocalBitcoins and Mycelium types of solutions still rely on a central intermediary to some extent: LocalBitcoins and Mycelium. And in the end, these companies can be required to apply AML/KYC-types of regulation as well - or be shut down entirely. (LocalBitcoins had to cease its operations in Germany back in 2014.) An interesting alternative, therefore, is fully decentralized exchanges that rely on no central intermediary to process fiat or Bitcoin transactions.
A first attempt at establishing a decentralized exchange was Coinffeine, launched in late 2013. Coinfeinne partly solved the counterparty risk – the risk of a trading partner not paying up – through a combination of security deposits and an incremental trading protocol. In short, both parties in a trade, deposit a specific amount of bitcoins into a two-of-two multi-address, requiring a signature from each to unlock. Subsequently, the trading partners trade in incremental amounts: no single trade is bigger than the security deposit. As such, neither trader has an incentive not to pay their part: they would lose their security deposit worth the same amount if they did.
Coinfeinne is a novel idea, but it doesn't hold up as nicely in practice. The security deposits leave room for certain types of fraud or extortion. A victim might, for instance, prefer to get half of his deposit back rather than nothing at all. Additionally, trading in incremental amounts is not exactly user-friendly nor fast, especially if it takes a wire transfer to complete each time.
More recently, the decentralized Bitcoin exchange Bitsquare launched. Bitsquare solved the counterparty problem with dedicated arbiters, as well as – again – security deposits. These deposits are locked up along with the traded bitcoins in a two-of-three multisig address where the third key is held by a dedicated and mutually agreed upon arbiter. As such, the buyer is incentivized to send the fiat currency; he'll lose his deposit otherwise. And once he receives the fiat curremcy, the seller is incentivized to release the bitcoins for the same reason. If either attempts to cheat, the arbitrator helps the victim get his bitcoins.
To prevent bank-chargeback fraud, Bitsquare limits trades to a maximum between .75 and 1.5 each, for now.