Privacy and Bitcoin

Privacy and Ease of Use

As discussed in earlier posts, the primary of use case for Bitcoin thus far has been the store of value. For Bitcoin to gain mass market adoption beyond the core group of technical users and users looking for alternative stores of value, it needs to become simple for non-technical users to maintain their privacy and security.

Currently, in order to maintain basic privacy (say a person doesnt want her salary to be public information), a Bitcoin user has to understand concepts like merge avoidance, address reuse, deterministic wallets, mixing, CoinJoin or other fairly technical subjects. For the average user who does not know how to manually manage his privacy, Bitcoin actually offers less privacy than the current banking system. Without proper precautions, its fairly simple for an adversary to uncover purchase or income information. Unless Bitcoin (or another cryptocurrency) can address core privacy issues in a simple, non-technical way, it wont be competitive for mass-market users, and wont be competitive with the traditional banking system. At best, it will evolve into a niche technology for users who are highly motivated to store their funds outside of traditional systems. If, however, privacy is achieved, the market for cryptocurrencies could be greatly expanded.

Theres currently a lot of community energy being dedicated to projects like Zerocoin, DarkWallet, CoinJoin, CoinSwap and stealth addresses. It seems likely that privacy issues will be solved to a usable level over the coming year or two. The more interesting question is about what happens when strong privacy for end users is achieved. What does that mean for the Bitcoin ecosystem? What kinds of use cases and business opportunities become viable? It seems to me that the importance of privacy for growth in the the Bitcoin ecosystem is underestimated.

Disruptive Privacy

While strong financial privacy seems to be a necessity for Bitcoin to succeed in the mass market, it also has the potential to be highly disruptive, as it makes criminal, regulatory and tax enforcement much more costly.

The combination of private cryptocurrency transactions with other privacy technologies like DarkMail and Tor would make it easier to conduct unregulated transactions for regulated or illegal goods online. Strongly private cryptocurrencies could also be used to facilitate offline transactions in prohibited goods.

As far as the impact on enforcement of money laundering regulations, if all Bitcoin transactions were done in a seamless, private way, it would render the existing strategy of enforcing AML/KYC at the exchanges ineffective. Once assets were converted into bitcoins, it would become impossible to associate assets with a particular person in a provable way. Anyone could claim that their keys were lost, and any subsequent purchases would be very difficult to locate without voluntary cooperation.

AML/KYC regulations can be effectively enforced in the traditional financial system because large transactions must go through the relatively small number of banks. If banks are disintermediated and transactions become private, it would be a much larger and more intrusive task to compel each person and company to separately comply with AML/KYC rules on their sales and purchases.

Tax collection would also be made more challenging if private cryptocurrency transactions became commonplace. For income taxes, if an employers salary payments to employees are no longer routed through banks and payment processors, the IRS would need cooperation from both employers and employees to properly evaluate income, while both of those parties would have an interest in non-compliance. Sales tax collection would also depend on two parties who would have a financial incentive to collude with each other against the taxing authority. Finally, it would become more difficult for authorities to calculate capital gains taxes, as asset sales would also take place outside of the banking system.

Consequences

If a transparent and seamless privacy infrastructure is created for Bitcoin, the most obvious consequence would be a much greater demand for Bitcoin and a much higher Bitcoin price, as the markets for illegal goods and tax shelters are very large. Transaction volume would also likely increase, as avoidance of sales taxes would become a compelling use case. Coupled with improvements in security and ease of use, private transactions could provide the killer app necessary to move Bitcoin beyond the store of value use case and into a mainstream transactional use case.

On the downside, if Bitcoin becomes heavily used for tax avoidance and trafficking in illegal goods, there will almost certainly be attempts by governments to crack down on its use, and there could be attempts to shut down Bitcoin exchanges and transactions in the name of national security or drug enforcement. Bitcoin business opportunities would multiply along with the price, but it could become more difficult to operate a legitimate business in the cryptocurrency space.