Much hype has been frothed about the anonymity of Bitcoin, and how that makes it ideal for illegal activities. (Let’s not even go into the illegal activities that the ever-so-anonymous cash is used for.) So it’s worth setting the record straight: Bitcoin is not anonymous. But it can be.
First, rather than anonymous, Bitcoin is pseudonymous. All your bitcoin transactions are linked to your bitcoin address (or addresses). In the Bitcoin transaction sphere, you are known by that address, no-one else can use it. It is your “pseudonym”. Totally anonymous transactions would have no attached pseudonym.
True, figuring out that that address belongs to you, specifically, is difficult. Difficult, but not impossible. How would one go about doing it? By combing through all other transactions to and from that address and looking for clues such as delivery destinations, transfers to private sidechains, links to other addresses that have been identified, donation requests in forums… Or, investigators could look for transactions that combine two Bitcoin addresses into one input. For instance, if you had 3 bitcoins in one address, 2 in another and wanted to buy something that cost 5, you’d combine your two bitcoin addresses into one transaction. If the identity behind one of the input addresses is known, then the other one is, too.
Another technique used for figuring out bitcoin ownership is patterns in activity. Parallels can be drawn between transaction activity and Twitter activity, for example. Periodic repeat purchases, even from different addresses, can be a giveaway.
And most of us get our first bitcoins on an exchange. In general, exchanges are regulated and have to comply with the local Know Your Client laws, which generally involve verifying your identity with authorised documents such as passports or ID cards. That address is linked to your real self (in theory), as are other addresses that that address transfers to. Even simple wallets (not related to exchanges) that don’t ask for your identity need to keep records of all transactions associated with your bitcoin address, in order to know how many bitcoins are rightfully yours. Records are hackable, and can be subpoenaed by the authorities.
The anonymity of Bitcoin has been one of the main barriers to banks’ willingness to work with Bitcoin-related businesses. Chainalysis (which recently signed a deal with British bank Barclays) intentionally combs through transaction data to de-anonymize the network and to provide banks with a compliance service. While this will no doubt bother many Bitcoin users who value the philosophical benefits of the freedom that anonymity brings, Chainalysis’ goal is to get banks more comfortable with working with Bitcoin users, which will help the digital currency’s spread and influence.
However, with some extra effort, Bitcoin can be anonymous. It is possible to buy bitcoins anonymously using cash and local exchangers. Bitcoin users can employ a different address for each transaction to make ownership harder to trace. The heavily encrypted network Tor makes it much harder to track transactions (among other features, IPs are not recorded), but even just using Tor can alert authorities that you are hiding something.
These aren’t foolproof anonymity methods, but they do make it harder to follow a bitcoin through the network. Mixing services, which shuffle your bitcoins with those of other users, do provide a very high level of anonymity, but are much riskier than traditional wallets in that they are unregulated and often unaccountable. If Bitcoin anonymity is important to you, your best bet would be to use a mixing service and withdraw your funds immediately, and to use a different address for each transaction. Of course, the best way to avoid getting caught for illegal activity is to simply not do it.
(For more on how Bitcoin works, see Bitcoin Basics.)