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Marc Hochstein is the editor-in-chief of CoinDesk. The opinions expressed here are his, so do not blame his collaborators.
The following article originally appeared in CoinDesk Weekly, a personalized newsletter that is delivered every Sunday exclusively to our subscribers.
Imagine two $ 1 bills. One is fresh and spotless, just arrived from the United States Mint. The other is crumpled and covered with crumbs and boogers.
Each is exactly the same as the other. It does not matter if the old man previously belonged to a coke dealer or a brother of Koch. It is still good for bus fares.
This is fungibility. It is one of the essential properties of money that we take for granted. But in cryptocurrency, the fungibility is at risk, thanks in part to the transparent nature of the blockchain, where the addresses of the portfolios are pseudonyms but the flows of funds between them are exposed to all to see.
Last week he recalled this risk when Bitfury, a startup, introduced Crystal, a set of software tools to help keep track of illegal activities on the public bitcoin registry.
As Michael del Castillo of CoinDesk reported, the platform is Bitfury's attempt to "help Bitcoin once and for all to overcome its association with black market transactions." Valery Vavilov, CEO of Bitfury, said that Crystal will allow users to "see if this bitcoin directs you" to get money from it's green or black. "
Taking a step back, Bitfury, which started as a mining operation, is not the first company to offer this type of snooping service – as noted by the CoinDesk, Chainalysis, Elliptic and Skry article (now part of Bloq).
And to be sure, capturing criminals, on equal terms, is a worthy goal. (For the sake of argument, suppose all the "crimes" that are resolved here are real crimes, the type with the victims).
Moreover, the surveillance provided by these companies can produce another advantage, helping other startups to obtain or maintain accounts with traditional financial institutions. Banks have been reluctant to serve the sector because of its association with illegal activities. If they can prove that their customers are not transferring "dirty" money, they could convince their regulators to feel comfortable with the industry.
But the use of blockchain in this way could also have perverse effects.
Sale on a blacklist
As Chris Burniske and Jack Tatar write in their book "Cryptoassets":
"A danger for bitcoins, especially for the balances known to be used for illegal activities, is that if an exchange or other lists of services are balanced, then that balance becomes illiquid and probably less valuable than the other bitcoin balances."
Woe to the merchant who sells a pair of alpaca socks to a drug dealer and therefore can not spend the contaminated coins.
And this is not half. Burniske and Tatar continue:
"Although thin, losing the fungibility could be the disappearance of a digital currency and distributed, damaging the value of all units, not just those used for illegal activities".
The developers of cryptocurrency are well aware of this danger and have worked for years to strengthen the privacy of users, who in turn would have preserved (or restored) the fungibility.
Some of these techniques, such as zk-snarks and ring signatures, have been pioneers on altcoins such as zcash and monero, respectively. (The loss of fungibility, Burniske and Tatar write, "is a problem that Monero does not have to face.") Other privacy enhancements, such as TumbleBit, have been developed for bitcoins themselves.
"Ultimately I think the challenge will be for any analytical tool to keep pace with cryptocurrency changes, with particular attention to the challenges posed by those who seem designed for anonymity," said Jason Weinstein, Bitfury strategic advisor and former 15-year veteran of the US Department of Justice who now practices the legal profession at Steptoe & Johnson LLP
Yet these improvements can exacerbate regulatory challenges.
"If you make the private accounting level like zcash, you could sacrifice an entire market," said Charles Hoskinson, founder and CEO of IOHK, a company that has developed several blockchain projects including Cardano.
For example, Japan's financial services agency, which must approve cryptocurrencies before being listed on the country's licensed stock exchanges, "can never authorize a high-security token," he said.
On the other hand, "if you do not build these types of functionality", once de-anonymized, the entire "financial history of a user from the beginning of time" will be displayed.
"It's worse than the traditional banking system," Hoskinson said.
Double standard?
All in all, it seems that the cryptocurrency is kept at a higher level of "clean money" than the fiat, at least in the physical version. Very few people are reading serial numbers on dollar bills. (To be honest, the comparison is not apple-apples, since you can not do without a suitcase full of banknotes around the world.)
Satoshi has created bitcoins so that people who do not trust each other can make transactions on the Internet. The exposure of all the transactions on the blockchain was the price paid for trust in the system, and he (or she, or they) thought that pseudonymous addresses would mitigate the loss of privacy.
Radical transparency is often advertised as a feature of blockchain technology, which could be for businesses and governments. And in bitcoin, it also produces secondary benefits for ordinary users. For example, keeping an eye on withdrawals from an exchange portfolio can help identify a race.
But in the case of the use of money, the opening of the blockchain could also prove to be a bug. Even for law-abiding citizens.
Image of dirty money through Shutterstock.
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