How governments are analyzing Crypto and Blockchains

Governments have been seeing blockchains and cryptocurrencies as a threat since the time Bitcoin started gaining popularity. The perception was not misplaced because initial uses were only limited to the dark web for illegal and immoral purposes. From drugs to hitmen, child pornography to hackers, you could buy or sell anything on the dark web’s infamous marketplaces like The Silk Road. 

However, as Bitcoin and the overall cryptocurrency market grew, so did the legitimate uses and applications of the underlying technology called the blockchain. Today, top Fortune 100 corporations and government departments alike are experimenting with and developing on blockchain. With legal uses comes regulation. The Wild West phase of the cryptocurrency market is about to end in the next few years. Regulators across the world are waking up to the fact that they need to trace crypto transactions. As laws are being formed, tools are being developed to track crypto transactions, especially on the Bitcoin network. 

The anonymity bubble is about to burst. But it is not all bad. Regulation has its positives too. 

Misconceptions about traceability

There has been a long-standing public misconception that transactions of the Bitcoin network are anonymous and cannot be tracked. In reality, the transactions are pseudonymous. This means they are connected to a wallet, which can be traced to an IP Address or even to a user if the wallet is hosted by an exchange or a third party that tracks users in some form.

Why track crypto transactions?

Governments want to track cryptocurrencies for various reasons. Some of them are:

Taxation

One of the foremost reasons is taxation. Many people have gained a lot from crypto and many individuals and businesses are conducting trade using cryptocurrencies. This is a huge loss for governments and they want users to pay taxes on the money earned. 

Criminal behavior

Cryptocurrencies have been rightly accused of being used for many criminal activities. The government can track the perpetrators only when they can unravel the chain of transactions that lead the dark way.

Money Laundering (AML)

One of the concerns governments have about cryptocurrencies is that people will transfer their wealth to another country. In simpler words, money laundering. By tracking cryptocurrency transactions, governments hope to stop this. This is also often done under the pretense of national security.

Most exchanges have already started being compliant with the KYC and AML or Anti-money Laundering laws of their state. It is a matter of time before every major exchange follows suit.

Regulation – Insider trading

Cryptocurrency markets are not yet regulated. And they do not deal in banks like traditional stock markets. So there is no way for regulators to know if someone is engaging in malpractices like insider trading unless they track all transactions with the help of blockchain analysis software.

How do they track?

Now the important part is what are the means that major governments are using to track cryptocurrency transactions. Here are some ways we identified:

Traditional tracking

This is the traditional ‘follow the money’ principle that was used in the banking sector for all of the known history. The government tracks the flow of funds, flags certain wallets, checks withdrawal or cashing out patterns and tries to map them to IP Addresses. Sometimes these wallets can also be linked to an exchange that requires KYC / AML. A rigorous analysis of this data usually provides some leads or suspects who can then be traced to the origin of funds.

Exchanges

Regulated exchanges are obligated to report suspicious transactions. Most of these exchanges require banking-standard KYC and AML at the time of user sign up. With an increasing number of checks in place, exchanges can track suspicious activities. They are obligated to report this to the authorities.

For example, Japanese exchanges willingly reported data about over 5000 illicit transactions on their exchange in 2018. In the US, authorities filed a case against the popular exchange Coinbase to force them to share user data. 

Chainalysis

Chainalysis is a blockchain analytics company that is at the forefront of uncovering tracks of transactions made on various blockchains. They have developed tools that enable corporations, governments, and even investors to analyze large blockchain data to know where the money is flowing. 

This company was hired by the US Internal Revenue Service (IRS) as early as 2017 to find ‘anonymous wallets’ that cryptocurrency holders use to store their tokens. By 2018, most law enforcement agencies already had access to this software. 

Elliptic Enterprises

This is another company that has developed some advanced tools to flag and identify sources and flow of funds since Bitcoin’s early days. The company has developed a Bitcoin Map that serves as an example of its software capabilities. 

CipherTrace

Another major player that helps de-anonymize these transactions is CipherTrace. They claim to be able to trace over 700 crypto tokens. Although privacy coins like Monero are not included, this is a significant chunk of the market. Malta’s financial regulators have already appointed CipherTrace to combat money laundering and terror financing cases on blockchain.

Private Contractors

Diar reported that the US government agencies have spent at least $5.7 million to hire private contractors to track cryptocurrency funds. This includes the IRS, the DEA and the FBI.

Data Analytics

Data analytics involves tracking publicly available cryptocurrency data to trace the transactions back to the users. This involves the clustering of addresses that are known via one of the various routes of identification. Once these addresses have been tagged, regular monitoring flow of funds through these can help expand the net of identified wallet addresses that conduct trade with it. 

The US IRS already sent letters to crypto traders reminding them to pay taxes. They also said that they will keep using data analytics to find more non-compliant taxpayers who trade in crypto.

Does privacy still exist?

All is not lost. While many do not mind sharing their transaction data with their governments, some hardcore cryptocurrency enthusiasts want absolute privacy. Although no way is foolproof, there are ways to achieve utopia.

Mixers are one of the most important tools for this. Mixers take your tokens and randomly mix them with other users’ tokens, run them through many obscure addresses and anonymously deposit your tokens in a private wallet for you. They charge a substantial fee for this service. But for privacy fanatics, it may be a price worth paying.

Another way is to hold privacy coins like Monero. These cryptocurrencies are designed for privacy and they do not feature a public address that can be tied to every historical transaction. This makes software like Chainalysis ineffective. There is, however, a risk of being detected via third party wallets or exchanges. So if you want to have absolute privacy, hold Monero in your private wallet or a paper wallet. It is highly unlikely anyone will be able to trace it.

Conclusion

While it is not impossible to stay anonymous, it is definitely getting harder by the day. It is easier to declare gains on crypto trading and pay taxes. As tools evolve, so will privacy options. But this race between the government tools and privacy options will likely never end.

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(Featured image by WorldSpectrum via Pixabay)

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