When people discuss Bitcoin, one of its properties that is often considered is its presumable anonymity. In this respect, it is often compared to cash. However, it shall be recognized and understood that Bitcoin is not as anonymous as cash; far from it, actually. Its anonymity relies on the concept of pseudonyms, which delivers some (unjustified) sense of anonymity, but very weak anonymity in practice.
What are pseudonyms?
A pseudonym of yourself is an identifier which is not directly linked to you by any mapping that is readily available. If you have a nickname, which does not clearly resemble your real name, and if you make sure that mapping from your nickname to your real name is not trivial (e.g., by not using both your real name and your nickname interchangeably), then your nickname is a pseudonym.
Pseudonyms in Bitcoin
Bitcoin uses a similar concept to identify players. Each participant in the system has a randomly-looking string – the hash of his public key – which is used as his identity. This string identifies you in the Bitcoin system. When Bitcoin money changes hands, it is moved from one such identity to another, and a public ledger indicates which identity paid what identity and how much. There is no clear mapping between your real-life identity and your identifier in the Bitcoin system, and moreover, you can have as many identities as you like in the Bitcoin system, and move funds between those identities as you like.
How is Bitcoin not anonymous?
The Bitcoin use of pseudonyms does not provide anonymity, certainly not of the type offered by cash.
Both academic and practical research had shown methods of “unmasking” pseudonyms, that is, of mapping them back to real identities, based on their being persistent across uses. When a pseudonym is used multiple times, its level of anonymity erodes. Each particular event in which it is used potentially narrows the circle around its owner. For example, imagine that you are “anonymously” surfing the web, identifying yourself only with a pseudonym. As you repeatedly use your pseudonym, it can be used to link your surfing actions over time. After some time, your real identity may be inferred from your surfing pattern alone. Narrowing on your identity is especially easy if you also surf to one or more uncommon websites. Also, one instance in which you surf to a location that discloses your real identity burns the entire pseudonym mask forever, and retroactively.
This situation is the same with Bitcoin, and is even more severe, for two reasons:
All transactions are always available to everybody, in a clear and condense form.
Gateways, which are run by financial institutions that operate with real heavily-verified identities, burn the mask easily.
Bitcoin security is based on crowd-sourcing. The entire ledger of transactions is always available to the entire public. Therefore, finding patterns is made easier. Unlike with cash, all changes of hands are clearly documented. The fact that you can have many identities does not make a difference when all your internal transfers are documented along with the external ones.
The second point applies if you ever buy or sell Bitcoins for “real” currency. Trading Bitcoins for other currencies is done by entities that are bound by banking, fraud-prevention, and money laundering prevention regulations, and thus obtain your real world identity. As soon as a single Bitcoin finds itself out of your system, or gets into your system, your relevant Bitcoin identity is eternally revealed, as well as most likely any other Bitcoin identity you maintain.
We conclude that Bitcoin is not as anonymous as cash. For cash, there is no clear recorded trail of all its change of hands. Consequently, even when you withdraw or deposit cash, you only surrender information about your present ownership of the bills and coins you trade, nothing about what you did or will do with them. Moreover, I stress that Bitcoin may be considered as less anonymous than credit cards. The credit card company indeed knows all about your transactions, without de-anonymizing any pseudonym. However, it is only the credit card issuer that has this information (at least theoretically). In the Bitcoin case, revealing your identity requires some effort of de-anonymization, but this effort can be undertaken by anyone on earth, using the all-public records.
Bitcoin has the power to change economy, if it ever gains its critical mass and if it is fully commercialized. It has many advantages over traditional currency, such as by being decentralized and free of artificial inflation. Bitcoin has its advantages; but cash-like anonymity is not one of them.