Bitcoin layer 2 Statechains are gaining recognition as the reality of privacy erosion sets in

On August 8, the US Treasury Department added Tornado Cash to its Office of Foreign Assets Control (OFAC) list. Officials alleged that the crypto mixer was used to launder over $7 billion worth of crypto tokens since its inception in 2019.

This included over $455 million in tokens stolen from the Axie Infinity Ronin bridge hack, for which North Korean affiliate Lazarus Group claimed responsibility. And the Harmony bridge heist, where hackers collected $96 million.

Since then, several third-party providers have moved to cut their ties with Tornado Cash, including Circle, which blacklisted the company’s USDC wallets. The net result of compliance with sanctions led to the platform shutting down operations.

There are fears that the US government is deliberately targeting privacy-focused crypto projects by increasing its regulatory efforts. By doing so, personal freedoms and the right to privacy can be further eroded.

However, a number of Bitcoin developers, including Mercury Wallet developer Nicholas Gregory, have been working on transaction privacy for some time. While their work remains relatively unnoticed, the actions of the US Treasury Department in sanctioning Tornado Cash have inadvertently put a spotlight on this area.

Bitcoin is an open ledger

Bitcoin transactions are publicly visible and permanently stored in the ledger. Bitcoin addresses are pseudo-anonymous, meaning the only information tagged to them is the flow of transactions.

However, once an address is used, it “takes on” the history of all transactions that have interacted with that address.

Although this setup does not directly reveal one’s identity or personal information, off-ramping, usually done on a centralized exchange with KYC requirements, will link transactions to an individual. Non-KYC P2P marketplaces exist, but exchange rates are generally unfavorable compared to CEXs.

Privacy experts often recommend using a Bitcoin address only once. However, since most wallets do not offer a perpetual address feature, the practicality of using a single burn address for each transaction is unrealistic for most average users.

Crypto mixers offer a degree of privacy by mixing traceability between users, thereby obscuring direct transaction flows. However, there is great confidence that the mixing service does not defraud users or keep transaction records.

Privacy is being eroded

With crypto adoption growing over time, little consideration has been given to monitoring and censoring personal transactions. Since the Tornado Cash sanctions, people are beginning to rethink the potential monitoring of blockchain transactions and the threat this poses to privacy.

Removing a person’s ability to act can be seen as the stuff of dystopian nightmares. Yet, far from being science fiction, this is happening now, with the recent Canadian protests a prime example of discontent.

In February, Canadian truck drivers protesting the vaccine mandate had their GoFundMe account frozen at the behest of law enforcement. At that time, the truckers had collected a total of CAD 10 million.

Shortly after, when cryptocurrency was used as a way to circumvent the GoFundMe ban, Prime Minister Justin Trudeau passed emergency measures that gave the government the power to freeze or suspend bank accounts without a court order.

Pierre Poilievre’s decisive victory in the leadership contest of the Conservative Party showed a growing awareness of the problem in Canada. Poilievere’s campaign centered on reducing the size and scope of government, greater personal freedoms, and advocating for cryptocurrencies. He also expressed support for the truckers and attacked the World Economic Forum.

Increasing privacy solutions

In the weeks following the Tornado Cash sanctions, interest in privacy solutions, such as CoinJoin and Mercury Wallet, has gained momentum.

Talking to CryptoSlate, Gregory discussed the importance of blockchain privacy. In particular, he thought it was important to point out that while Mercury offers users transaction privacy, the protocol is primarily a layer 2 running on Statechains. This technology works by switching outputs between unknown participants.

The advantage of this method is that the exchanges do not occur on Bitcoin’s open ledger, making transactions untraceable to a blockchain analyst. Additionally, since Statechain has a larger block size base layer capacity, the system is much more scalable than the main chain.

By taking a Bitcoin UTXO, the technology enables a collection of different transition states. Essentially, the UTXO, or the private key to access the transaction output, can be passed between users, meaning ownership changes, but the funds do not “float”.

Gregory believes that if Bitcoin is to be used as money, technologies such as the Mercury Wallet can help bridge the current fungibility gap. With that, he remains hopeful that the value proposition of Statechains will draw more users to the Mercury platform.

“I hope that the technology behind Mercury, Statechains, becomes one of the scaling layers of Bitcoin. I think it will. There are a lot of synergies between it and Lightning, it solves a lot of problems that Lightning solves…”

As an additional move, and to counter the issue of privacy platforms keeping transaction records, Gregory mentioned that developers are working on making Mercury “completely blinded.” By doing this, the protocol will not collect any user data.

With further efforts centered around selling Statechains to bring in more liquidity, Gregory is optimistic that the incentives will be in place to spur a flood of new users to the platform.