A few months ago a media report suggested that the United States Internal Revenue Service (IRS) had sent out letters to cryptocurrency holders reminding them of their tax obligations. This is quite startling because prior to this revelation it had been common knowledge that decentralized cryptocurrency transactions were anonymous and untraceable.
In fact, the inability to trace bitcoin or altcoin transactions is part of the many reasons some authorities were and are still reluctant to embrace privately issued cryptocurrencies.
When Bitcoin was created, the vision was for it to become a peer to peer trading currency for internet based transactions, which is censorship resistant. The idea is for trading peers to settle obligations in much the same way as they would with hard cash, only this time digital cash would be used.
Just as cash transactions between peers cannot be traced, similarly the vision is for Bitcoin or cryptocurrency transactions on the internet to be untraceable as well.
However, according to the Coindesk report, the sources quoted suggested that the IRS may have found a way of unmasking the identities of those engaged in Bitcoin transacting as well as the nature of the transactions.
But can cryptocurrency transactions be traced?
Well according to claims made by Chainanlysis, there is an innovative software which can trace and reveal identities of those using or trading with bitcoin or other cryptocurrencies.
According this tech firm the software can follow Bitcoin as it moves from one wallet to another, and eventually to an exchange where the bitcoin user will likely cash out into dollars or another currency. This is the point where a law enforcement agency could issue a subpoena to the exchange to release the identity of a wallet holder that cashes out.
If this is true then this should concern bitcoin users involved in illicit activities or tax dodgers while the rest of users will be unsettled but not dissuaded from using cryptocurrencies. Cryptocurrency use will still grow regardless of advances in the technology to unmask holders of such currency. There are far many more positive reasons people use cryptocurrencies than just for aiding illegal activities.
History of a failing fiat currency
In fact, it may be necessary to refresh the memory of the reader and give context to why cryptocurrencies emerged in their untraceable format in the first place.
Bitcoin’s creation was a response to flaws observed with nationally issued fiat currencies. Fiat currencies are susceptible to tempering or duplication due to the flawed process of creating and distributing them. Duplication of a currency ultimately dilutes its value and the subsequent loss of purchasing power. A number of small countries have seen their respective currencies lose value and collapse leaving ordinary people worse off.
The problems associated with such flaws may have reached a crescendo in 2008 following the cataclysmic collapse of major financial institutions. These unexpected bank failures led to a global financial crisis not seen in several decades.
Now to illustrate why a fiat currency system is flawed, the US government through the US Federal Reserve responded to the 2008 crisis by creating money from thin air as it made frantic efforts to save collapsing industrial giants like General Electric, General Motors, Ford etc.
Hundreds of billions of dollars were created and poured into the financial system under the so-called quantitative easing undertaking, a major bailout of companies to ostensibly, save jobs and the US economy.
The untold horror of this tale was the resultant money supply growth which caused an erosion of personal savings and wealth. When money is created like that it dilutes the value of currency that is already in circulation and it did in a major way. And since there was no alternative at the time, people watched helplessly as their savings got decimated in real terms.
It seems that the actions of a few banks that are concentrated in the New York City had affected the entire global economy. This prompted the likes of Satoshi Nakamoto and partners to propose an alternative to a fiat financial system that is seemingly centralized in one country.
Satoshi hoped his creation would offer victims of poor economic policies and corruption an escape route should the same financial shenanigans that followed the 2008/9 recession happen again.
However, Satoshi was also acutely aware of the potential fallout that could result from such a creation and how this would discourage even potential users from adopting his innovation. So to support this virtual currency, Satoshi created an entire ecosystem that includes the blockchain, mining, cryptography and the peer to peer network.
It is this ecosystem that will pre-empt any attempt to censor, control or to kill the innovation while ensuring user satisfaction. Indeed cryptocurrencies are unlike anything before them hence their endorsement by some influential figures.
Strict laws protecting central banks
Indeed some governments have in the past descended heavily on individuals or institutions attempting to create alternatives to national currencies. Counterfeiting and money laundering charges have been preferred against individuals creating such alternatives.
The chronicles of Giacinto Auriti, the late Italian legal scholar, lawmaker and advocate for privately issued currencies come to mind.
Auriti is often quoted saying between him and central banks there is a mortal struggle.
At one point Auriti— a firebrand critic of monopolized currency issuing—created a currency which he gave in exchange for the Italian Lira to members of his immediate community. However the project was ended abruptly by the Italian financial police, the Guardia di Finanza in the year 2000. Apparently Auriti‘s venture was a threat to Italy’s financial system and it had to be stopped.
Before Auriti, another critic of currency issuing monopolies, Friedrich Hayek – a famous Austrian economist and a winner of a Nobel Prize in the field of economics—also questioned the rationale of enforcing a central bank’s sole right to issue currency.
Hayek is famous for making this quote, ‘I do not think it is an exaggeration to say that history is largely a history of inflation, usually inflation engineered by governments for the gain of governments.’
Hayek said he feared that since ‘Keynesian propaganda had filtered through to the masses, making inflation respectable and thus providing agitators with arguments, which the professional politicians are unable to refute.’
He concluded that depriving governments of their power over the supply of money was the only way to save civilization from this flawed system.
Both Auriti and Hayek were unconvinced with reasons often given to justify central monopoly.
Why trace financial transactions
But just why do states fight very hard to protect central bank monopoly over money creation?
Well, apparently when privately issued currencies enter circulation, central banks lose not only influence and control over the economy, but the ability to track or trace financial transactions.
In particular, it is this ability to trace transactions that is of concern to not only to central banks but law enforcement agencies as well. Losing this ability means law enforcement agencies cannot prevent terrorists or criminals from facilitating or financing heinous crimes. Law enforcement agencies want to retain this ability at all costs it would seem.
When authorities are vested with the ability to trace the movement of money it is only natural that this may come with an extra perk; the ability or power to veto certain transactions. For instance, the Office Foreign Asset Control (OFAC) is believed to have the ability to stop any US dollar transactions conducted via the internet or through a payment platform like SWIFT.
Unfortunately this power has been used for purposes that have nothing to do with stopping terrorists or fighting organized crime. Businesses and citizens of countries that are at odds with Washington have borne the brunt of restrictions imposed by OFAC as it enforces the foreign policy objectives of the US government. This unfair use of the ability to trace or monitor transactions naturally leads to a demand for an alternative that resistant to this kind of control and censorship.
Moreover, when Edward Snowden revealed the extent abuse as well as violation of the right to privacy by state security agencies, this further gave impetus to the movement advocating for the protection privacy and individual liberties.
It is within this context that innovations like bitcoin have been promoted and popularized. Bitcoin users are able to transact anonymously using alphanumeric addresses which governments have hitherto been unable to crack.
Evidence of traced bitcoin transactions
The bitcoin design and protocol embodies Satoshi’s vision of digital money for settling transactions on the internet while guaranteeing privacy at the same time. Early users of this financial technology quickly understood this aspect and swiftly made a switch to this peer to peer network.
However, it is this inability to know the identity of those behind the cryptocurrency transactions that has prompted some law enforcement agencies to conclude that terrorists and criminals are behind most bitcoin transactions. Indeed a number of convictions have been made of criminals who used cryptocurrencies to finance their activities and this fact is used to fight a wider adoption of such currencies.
It is within this context that a quest to find the means to trace bitcoin transactions arose something which the IRS and Chainanalysis claim to have achieved.
However, looking back at Chainanalysis’ claims, it seems its vaunted software cannot pinpoint with accuracy the real parties involved in a transaction unless they liquidates the cryptocurrency on an exchange. If the trading parties do not swap their cryptocurrencies with fiat via an exchange, it means this software will not able to unmask the identities of cryptocurrency users because trading between peers is untraceable.
Meanwhile as cryptocurrency utility grows and more merchants begin accepting them as means of payment, fewer users will find it beneficial to switch to fiat money. At that point peer to peer transactions which are hard to trace will increase and Chainanalysis’ software will become even less effective.
Moreover, there are alternative versions to the Bitcoin blockchain which are even harder to crack. Monero and Zcash are two cryptocurrencies that are impossible to trace because they are designed to offer complete privacy to users.
For example under Zcash transactions, a peer to peer transaction appears on the public blockchain, so it is known to have occurred and that the fees were paid. But the addresses, transaction amount and the memo field are all encrypted and not publicly visible.
Chainanalysis software cannot trace where there is no address and in any case, cryptocurrency users will simply switch to these if they believe that bitcoin has become compromised.