The futility of prohibiting bitcoin trade

The Reserve Bank of India (RBI) has banned regulated entities from providing services related to virtual currencies, citing concerns over consumer protection, market integrity, and money laundering. I question the necessity of this step, since the perceived anonymity of bitcoin transactions can be penetrated. What’s more, the ban may drive nefarious activities further underground, making them harder to detect. I suggest improving forensic skills might be a more effective approach.

This article was first published in The Mint. You can read the original at this link.

Recently, the Reserve Bank of India (RBI) prohibited, with immediate effect, all regulated entities from providing services to anyone who deals with or settles any virtual currencies, citing concerns about the risks that these virtual currencies pose in the context of consumer protection, market integrity and money laundering. The true reason behind it is not entirely clear.

Over the past year, the price of bitcoin has spiked in speculative frenzy. People have rushed to purchase coins in the hope of offloading them at a higher price—and then been disappointed as the prices tumbled from their previous highs. I can see how the government might think that imposing a ban will protect gullible investors from losing their shirts. But by this logic the government should, just as actively, be considering a prohibition on trading in rare stamps, antiques and hard-to-find Pokemons.

So this cannot be why the government has taken this drastic step. From the text of the RBI notification it appears that there is a concern around the anonymity inherent in the platform and the attendant challenges this poses for law enforcement. As a matter of fact, while every transaction on the bitcoin blockchain is, by design, public, the transactions reference electronic addresses that do not contain any information about the person making it. This means that even though every bitcoin transaction is recorded and open to inspection, no-one knows the person behind the address who made the trade.

This is why, at least superficially, bitcoin serves as an effective way to cover your financial tracks—making it the ideal means of exchange for criminal activities like money laundering and trading in illicit goods—as well as for lesser transgressions like tax evasion. This veil of anonymity is also a useful shield behind which purveyors of fraudulent products— goods and services—can hide, providing them greater cover as they swindle unsuspecting marks of their money.

But if you dig a little deeper into how the technology operates online, it rapidly becomes evident that there was no real need to take this step. As a matter of fact, the much vaunted anonymity of the bitcoin blockchain is by no means perfect. It is a lot like writing books under a pseudonym. As long as your nomme de plume remains hidden, no one will think to link you with the books you have written. The moment the connection between you and even one of your books is revealed, the whole subterfuge comes crashing down.

On the internet, it is relatively easy to make such links. Given how freely information leaks during most internet transactions, it is relatively straightforward to link individuals with the bitcoin transactions they make. Web trackers constantly send all sorts of information to the other large platform companies, allowing them to track page usage, purchase amounts, browsing habits, and a variety of other types of information.

In certain circumstances these cookies also leak personally identifiable information like the email address and names of the users. Even where it doesn’t, it is possible for malicious trackers to use JavaScript to extract bitcoin addresses from web pages that do not leak them by default. Law-enforcement agencies should, relatively easily, be able to collect and analyse this information to link a user to his bitcoin address.

Sophisticated users of bitcoin will try and mask their purchases by using services like CoinJoin that get multiple users who are each spending the same value of bitcoin to transact at the same time so that it becomes virtually impossible to identify which transaction corresponds to which user. While this does make it harder to track one-off transactions, as soon as someone begins to regularly use CoinJoin to mask his trail, they actually make their transactions easier to identify as the same bitcoin address pops up across multiple joined transactions— allowing them to be identified with close to 98% accuracy.

There will always be intelligent criminal elements who will be able to cover their tracks online despite the most aggressive investigative efforts. The vast majority will not. That being the case, it might be far better for us to improve our forensic skills to the point where we can use the veneer of anonymity that bitcoin purports to provide to ferret out the criminals behind the transactions, instead of than simply banning, outright, all use of bitcoin technology.

Prohibiting a service rarely ever serves to completely halt its use. The only people who abide by the terms of a ban are those who always intended to use the service for legitimate purposes. Everyone else simply takes their already nefarious activities deeper underground. If the government’s objective was to prosecute those who use cryptocurrency for illegal activities, they’d have been far better off allowing these transactions to continue in the open where there is a chance that they may be detected using the forensic mechanisms outlined above. Now that the technology has been banned and we have driven all who use it underground, bitcoins will be purchased through cash or other untraceable commodities. It will continue to be used but we will have less of an ability to link the transaction to the person.

As other countries consider meaningful regulation designed to specifically address the challenges of a distributed ledger, India with this ham-fisted approach runs the risk of becoming an outlier.