For transactions on trustless blockchains, users employ the cryptographically generated strings of alphanumeric characters, or addresses, to substitute their real identities. It functions as a pseudonym and can be shared with other network participants to receive some cryptocurrency. At the same time, the blockchain is fully transparent, and anyone can view any transaction on it using a block explorer.
In the early days of Bitcoin, users had a firm trust in its anonymity. Back then, Bitcoin was accepted by WikiLeaks and human rights activists in totalitarian states, but also by all sorts of cybercriminals and drug dealers on darknet marketplaces. It seemed that there's no way your actual identity can be linked to your wallet address unless you explicitly reveal it yourself. But it was just an illusion. So, how can the state track your cryptocurrency transactions?
How does crypto forensics work?
Ben Weiss, the CEO of American Bitcoin ATM operator CoinFlip, commented in June 2021, “Bitcoin transactions are more traceable than cash” and that it would be “stupid to launder dirty money using Bitcoin.” Indeed, any cryptocurrency on a public blockchain is susceptible to clustering, which is the primary method of linking user’s identity to their address.
A cluster is a collection of addresses that are somehow connected to the same entity. To group addresses in clusters, crypto forensics specialists usually examine the blockchain’s entire history and build a chain of contacts. Once a single identity from the cluster is known, the rest can be deanonymized using other crumbs of data like activity patterns, connected wallets, the amount of funds sent, etc. And knowing that a certain address is connected to the specific criminal activities, law enforcement can track money across the blockchain to exit points through exchanges and into regular bank accounts.
How is it technically possible? Of course, no one is mapping tens of thousands of transactions manually; it’s a task for specialized software that often uses machine learning algorithms. The leading provider of such blockchain analytics tools is Chainalysis, the $8.6b startup that gets over half of its US revenue from government contracts. The company also provides its services to law enforcement agencies, major financial institutions, and crypto exchanges.
The story of Chainalysis started in 2014 when hackers stole 650,000 bitcoins from the Japanese Mt. Gox, the then biggest cryptocurrency exchange. Michael Gronager, at that time chief operations officer at Kraken, suggested that the stolen funds could be tracked across the blockchain. Shortly after, he founded Chainalysis together with Jonathan Levin. Just in two years, Chainalysis solved the case of Mt. Gox. The endpoint of the stolen money turned out to be a crypto exchange BTC-e, run by Russian national Alexander Vinnik, who was sentenced to five years in prison on money laundering charges.
Obviously, Chainalysis is a team government, and that worries many hardline cryptopunks. Some accuse the company of defeating the purpose of the system designed for anonymity, corrupting the idea of decentralized, untraceable, and state-free money. However, Chainalysis isn’t the only player in the crypto forensics industry. The lucrative field of blockchain analytics counts many companies, including Elliptic, CipherTrace, Coin Metrics, and others.
However, it’s not just private companies providing their service to all interested parties. Some states are eager to build their own tools that would trace crypto transactions. For instance, Russia’s financial watchdog Rosinfomonitoring created a tool dubbed “Transparent Blockchain” that is designed to analyze crypto transactions and filter ones connected to illicit activity. The state-owned platform collects all information about blockchain addresses in its database, including the number of transactions, owner’s identity, account balance, and other metrics. “Transparent Blockchain” is designed to track payments in Bitcoin, Ethereum, Omni, Dash, and Monero.
How to preserve your privacy
Chainalysis keeps its tools secret from the general public, but there are methods to counter tracking your crypto transactions. In 2019, a Redditor who claimed he was a Chainalysis employee shared some tips on how to remain anonymous on blockchain during the AMA session. After 12 hours, all original comments were deleted, but the content of the thread was archived.
The Redditor praised CoinJoin technology, a trustless method of mixing coins to protect users’ privacy, claiming that the company would have gone bankrupt if everyone had used it. “I personally love it. The company management hates it, of course. Things like that destroy the need for our/their software. It can make the software completely irrelevant.”
According to him, even privacy coins provide decent protection, and combined with anonymization techniques, they make Chainalysis’ software completely useless. “Now I would say Wassabi is enemy number one. There is no way to de-anonymize it, and I don't see how the government can legally take Wassabi down, so it will probably persist. Put it this way, if everyone used Wassabi, Chainalysis would go out of business. Obviously, that won't happen, but you can see the point.”
Redditor also advised that the best way to avoid having your IP tracked is to run your own node and electrum server and warned against mobile wallets.
“Not a single person in the company has displayed any sort of concern over the ethics of our software except for one person being concerned that law enforcement would use our software and abuse their authority in enforcing the laws. And none of that could have happened without Reactor [Chainalysis software that links transactions to real identities] providing investigative leads to the cops. He left. Maybe I'm him. Maybe not. Maybe him and I have similar beliefs. Or just different types of concerns.”