Like bitcoin mining, privacy is one of the most important and least understood concepts associated with Bitcoin. The business of tracking money flows through blockchain analysis is growing rapidly, but most bitcoin holders probably don't know what that means yet. With the Taproof activation process looming, we've done our homework and discussed the implications of Taproof with experts in privacy and blockchain analytics. In this article, we'll cover what we've learned about the future possibilities of Bitcoin privacy and Taproof scalability.

How to track money flow through blockchain analysis

Before we talk about privacy, let's first state that blockchain analytics itself isn't a bad thing. Many of the metrics used to measure things like user adoption and investment sentiment are derived by analyzing public ledgers. In fact, we recently published an article on how Coin Metrics is analyzing Bitcoin ledgers to predict miners' spending behavior. We think this is a really cool move by Coin Metrics.

But when blockchain analysis is used to figure out the real identity (and its transactions) of a wallet address, it's a long story. In other words, it is an invasion of personal privacy. However, we will not discuss the ethics of blockchain analytics here. Instead, we assume that privacy protection is always good because it enhances Bitcoin's fungible and censorship resistance.

Now, let's consider a few simple dimensions to measure privacy. The first is the identity dimension, that is, how confident blockchain analysts are about the identity of the person or group behind a particular wallet. The leftmost value is 0%, meaning that no information is known about the owner of the wallet. The right-most value of 100% means that the wallet owner has been identified through regulatory compliance (such as KYC) or other means.

Anonymous sets and Taproot privacy

You've probably heard that Taproot can improve the privacy of Bitcoin. This is because Taproot can make many different smart contract transactions (e.g., multi-sign, opening and closing lightning network channels, etc.) look like simple blockchain transactions. By obfuscating the nature of transactions, Taproot can hide these smart contract transactions between ordinary transactions and other transactions masquerading as ordinary transactions.

Since there are many heuristics that blockchain analysts can use to classify UTXO and wallet addresses, we must take this into account when considering how to improve privacy. This is a potential weakness of Taproof.

Taproot introduces a new address type, P2TR (pay-to-Taproot), that can be easily distinguished from existing address types. Therefore, when Taproot is activated, the first group of users will enter a small anonymous set with other users of P2TR, as most transactions are still concentrated on other, more popular address types.

Smaller anonymous gatherings make it easier for blockchain analysts to track money on the blockchain, especially if the sender and receiver of a transaction use different classes of addresses. One important reason is the one we mentioned earlier: most transactions have change. In the vast majority of cases, the type of address that receives change is the same as the type of address that sends change, even if the address itself is different. Therefore, it is relatively easy for analysis software to flag the change UTXO when all other output is sent to other types of addresses.

If exchanges were to use Taproof on a large scale, that would be a good start. This is advantageous for exchanges, which are likely to be the most frequent users of multi-sign trading, and Taproof can help them reduce the cost of multi-sign trading. If exchanges adopt Taproof and wallet service providers decide to adopt Taproof for their users, the on-chain transactions of single-sign users withdrawing money from multi-sign exchanges will become indistinable.

And it all starts with education. Most early Bitcoin adopters probably don't understand or care about address types and other bitcoin tech aspects. But as early adopters, as voices in the future Bitcoin ecosystem, we have a responsibility to follow best practices, educate others, and support service providers to drive Bitcoin forward.