Privacy on open blockchains: framing the problem

The increased institutional adoption of public blockchains for financial activity has intensified the debate on how to enable privacy on open networks. The idea may initially sound like a belated attempt to reconcile two contradictory goals. But it is, in fact, the evolution of a discussion that began with the Bitcoin White Paper itself, which has a section devoted to privacy. 

The general claim is that individuals who pay for everyday purchases with digital assets risk revealing their transaction history and current balances to any merchant. Or that institutions trading onchain might be giving away strategic business information that any competitor could see. 

But what exactly is the source of the privacy problem on open blockchains? And how can this problem be solved? 

Public blockchains are intrinsically transparent – a feature that makes them a poor vehicle for illicit activity. All transactions with digital assets are recorded on the blockchain, which reveals at least the sender’s and the receiver’s public addresses, the asset exchanged, and the related amount. And this information can be easily found and seen by anyone through a block explorer available online.

In itself, though, blockchain transparency doesn’t create privacy problems. The sender’s and the receiver’s public addresses are represented by a string of letters and numbers that don’t contain any information about the sender’s or receiver’s identity. From that perspective, blockchain pseudonymity provides transaction confidentiality by default.

This reality changes when onchain information is combined with off-chain data that can lead to the identification of the sender and receiver. And it becomes problematic when this data combination happens in violation of data protection and financial privacy laws that apply to any financial transaction.

For compliance reasons, especially with rules against the criminal use of funds (AML/CFT framework), some institutions are required to perform this data combination regardless of whether a financial transaction is done on traditional or blockchain rails. Issuers of regulated assets and centralized exchanges, for example, must collect off-chain data that allow them to know with whom they’re interacting onchain. 

Except for these institutions with compliance obligations, no one else should be able to perform this data combination and identify the person or institution behind the pseudonymous public addresses. The expectation is that transactions remain confidential.

But blockchain transactions have one specific feature that sets the privacy debate apart: when parties transact onchain, they reveal their public addresses to each other. 

From that point on, the sender knows which public address is associated with the receiver and vice versa. With that piece of information in hand, both sender and receiver can now view not only all past and future transactions associated with the same public address but the balances of all assets linked to this address. 

Sender and receiver end up breaking the confidentiality of their private transactions by “self-doxxing.”

This situation might seem harmless to those who use a custodial wallet linked to an institutional account that pools assets under a single public address, as some centralized exchanges do. 

But it’ll be detrimental to any user who chooses to manage their digital assets through non-custodial wallets or has their holdings and transaction history associated with individualized public addresses – even when the user creates a new public address for each transaction (“disposable” or “single-use” addresses), as they can invariably be linked back to a known address. 

“Self-doxxing” is therefore the distinctive problem that must be solved to enable privacy on open blockchains. And any effort to find a solution in this case must balance two goals, especially to advance institutional adoption: creating confidentiality while still allowing compliance. 

A viable institutional solution for onchain privacy will then have to answer two fundamental questions: who will provide the privacy solution that allows users to add confidentiality to a transaction, and who will be responsible for revealing the confidential information when required for compliance purposes.

For regulated assets, like stablecoins and tokenized securities, “the issuer” might be the natural answer to both questions, as the issuer is a regulated entity with compliance obligations in relation to their counterparties. Whether issuers should be the sole arbiter of privacy in this case is a question to be explored.

For non-regulated assets, especially those without an issuer, like most network or utility tokens, the answers will require more consideration. An external privacy solution, like privacy pools, could be offered by regulated or non-regulated providers. But it’s open to debate who should be responsible for disclosing the confidential information to regulators and public authorities when needed.

One thing is certain, though: building onchain privacy is critical. The next breakthrough in blockchain adoption relies on combining the benefits of open and transparent networks with the privacy people and institutions expect from their everyday financial services.