Could Taproot’s ‘privacy’ features make BTC illegal?

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BTC’s proposed “fix” to its protocol—Taproot—is set to activate in a few days, aiming to make contracts on BTC “more efficient and private.” Core developers have branded this change as an “upgrade” to the Bitcoin protocol when in fact, it moves BTC even further away from the original 2009 Bitcoin protocol which already enables all the important things Core says Taproot will bring—except for enabling participants in a contract to hide not only their identities, but their public keys as well. In doing so, BTC could fall foul of several proposed laws combating anonymous digital asset transactions in major jurisdictions like the European Union and United States.

“Privacy coins” have been delisted from most major (legitimate) digital asset exchanges. What would happen to BTC if it suddenly, and irreversibly, became a privacy coin itself? Could BTC even become illegal?

First proposed by BTC Core developer Gregory Maxwell, one feature of Taproot is the ability to “aggregate” keys prior to broadcasting a transaction to the network. The transaction that eventually gets verified by miners/processors is the “aggregate key” only—hiding the identities of those who contributed to it.

This allows the creation of private contracts that exist completely outside of blockchain records. Though the BSV blockchain permits complex contracts thanks to its unbounded scaling capacity, all its records are kept on-chain. You might not be able to see instantly what happened and by whom, but the public keys are on the blockchain for timestamped security and auditability.

Meanwhile, the U.S. and EU are proposing financial regulations that would make “anonymous cryptocurrency transactions” illegal in the name of combating money laundering and financing of terrorism (AML and CFT). The EU’s proposals (which will likely come into force by 2024) would prohibit anonymous transactions over EUR10,000.

FinCEN is actively seeking to “close the gaps” that allow obfuscation of identities behind digital asset transactors. Its proposed amendments to the Bank Secrecy Act (BSA) are aimed squarely at convertible virtual currency (CVCs, another word for digital assets) users, including those using “unhosted” wallets. It intends to finalize its new rules in November 2021.

Dr. Craig Wright has often said that Bitcoin transactions could be reversed or altered with a court order, miners having little choice but to comply thanks to the size of their investments in their operations. Taproot, as we’ve mentioned previously, could put BTC users at regulatory risk even if they don’t actually use Taproot features.

Financial regulation is only moving in the direction of less anonymity, and it is almost a certainty that these proposals will be formalized into law within a few years. So what happens if BTC users try to go outside the system?

Taproot is a “soft-fork” upgrade to BTC

As one news report put it: “Taproot is an upcoming Bitcoin upgrade that aims to change the entire philosophy and technology behind the cryptocurrency.” It’s important to note, however, that none of the forks that took place since BTC left the original Bitcoin protocol in 2017 could be considered an “upgrade” since all the important things that those so-called “upgrades” promised were already possible in the original protocol—and this change in particular would make BTC illegal.

Taproot is essentially a mixing service as it allows all parties to participate in mixing coins, a criminal activity under the EU legislation and now in the U.S. under the just-passed Infrastructure Bill. Remember the plight of Larry Harmon, who was indicted for money laundering conspiracy, among other charges, in connection with his role in the Helix tumbler and mixing service on AlphaBay?

A change called “pay-to-script-hash” (P2SH) was introduced to BTC in 2012, after Satoshi Nakamoto had departed the project. While P2SH took some steps towards obfuscating transaction details and requiring conditions to be met before a transaction could be activated, the final transaction allows conditions and participants to be revealed. P2SH does not exist on BSV.

Taproot includes MAST (Merkelized Abstract Syntax Trees) to combine individual transactions into a single hash, hiding participants keys even from each other. It also permits Schnorr signatures, which allow even the existence of a MAST structure to be hidden in the final, combined transaction. To an external observer, a complex contract would appear on the BTC blockchain as a simple payment transaction, as if from one person to another. There is no more information on the record.

Proposers “locked in” Taproot in August 2021 with 90% support from BTC miners, signaling willingness to activate the soft fork to implement the necessary changes in November 2021. Once activated, it’s a one-way street. It would be extremely difficult, and realistically impossible, to “undo” Taproot once it’s part of the BTC protocol.

Taproot does not promise full anonymity—at least in most public reports. In an op-ed piece titled “We have entered the age of anonymous crypto,” a CoinDesk writer described the “privacy protecting enhancements” of the protocol as “allow(ing) smart contracts written in the Bitcoin scripting language to appear like normal transactions, so more complex code can populate the blockchain undetected.”

Reports detailing the advantages of Taproot frequently mention “privacy” as a secondary benefit, paying lip service to “efficiency” and “flexibility” by listing these features first. However, making life difficult for blockchain forensics investigators, and obfuscating the public keys of a transaction’s originators, are nearly always mentioned as benefits. Put simply, Taproot will enable potential money laundering activities.

Developers and reporters are usually careful to say “privacy enhancements” instead of “anonymity.” Saying “the A word” would immediately raise red flags with regulators and lawmakers.

But what can governments do to stop this? On the surface, it would appear they can do very little. Without the ability to unmask participants or conditions to a complex contract, or even notice that a contract exists. No records, nothing to investigate.

In reality, the situation is always different. In the early days of BTC and other digital assets, users could even sign up for trading accounts on exchanges like Coinbase without providing anything more than an email address. As serious money began to flow into the ecosystem, that changed quickly. Most exchanges now have strict identity and KYC requirements to sign up for an account, and even those that don’t are constantly under scrutiny and fire for their actions. U.S. federal agencies shut down BTC-e completely and confiscated its wallets. Binance is a frequent target for investigators.

At the very least, governments can make it difficult for people to use digital assets. Anonymity concerns have already seen “privacy coins” like Monero delisted from several major exchanges. BTC itself is extremely limited as a payments network, perhaps by design—this means relatively few actually accept it as money, which in turn means most BTC holders need fiat gateways to use BTC value in the real world. And governments control those gateways, quite easily.

Developers themselves could be put under pressure. Despite their claims that they are merely coders and thus not subject to financial regulation, there are plenty of arguments to support the case that they are indeed fiduciaries—that is, they are just as responsible as companies, banks and exchanges that actually hold assets.

Researcher Angela Walch from the St. Mary’s University School of Law; UCL Centre for Blockchain Technologies authored a 2018 paper titled, “In Code(rs) We Trust: Software Developers as Fiduciaries in Public Blockchains” detailing this view.

In testimony before U.S. Treasury Secretary Janet Yellen’s President’s Working Group on Financial Markets, Walch said the notion of “censorship resistance” was perhaps “overstated” and pointed to miners as intermediaries that could be held accountable for the transactions they verify and commit to the blockchain. She said:

“While many characterized crypto systems as lacking intermediaries and enabling the direct transfer of value between transacting parties, that is technically untrue. Transactions do not appear on the blockchain record unless a miner chooses to put them on.”

Even if fiat currencies suddenly became optional for digital asset holders, governments will define any digital asset transaction as being the same as fiat currency ones. They effectively already are. With developers and miners also subject to financial regulation, it puts any blockchain network offering near or total anonymity to transacting parties under threat. With Taproot irreversibly activated, BTC could find itself in regulators’ crosshairs.

Follow CoinGeek’s Crypto Crime Cartel series, which delves into the stream of groups—a from BitMEX to Binance, Bitcoin.com, Blockstream, ShapeShift, Coinbase, Ripple and
Ethereum—who have co-opted the digital asset revolution and turned the industry into a minefield for naïve (and even experienced) players in the market.