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This is a chapter from the book Token Economy (Third Edition) by Shermin Voshmgir. Paper & audio formats are available on Amazon and other bookstores. Find copyright information at the end of the page.
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The original Bitcoin protocol was groundbreaking but incomplete, as it had not yet fully addressed many critical issues, such as privacy or scalability. Additionally, new challenges emerged as blockchain networks gained broader adoption. Questions arose about how to decentralize off-chain storage solutions, how to trust information flowing into blockchain systems, how to make blockchain networks interoperable, and how to connect machines and objects to blockchains.
The initial launch of the Bitcoin network was designed as a live experiment by Bitcoin’s creators. At the time of the deployment of version 0.1 of the Bitcoin protocol in 2009, it was still unclear whether the economic robustness assumptions—upon which Proof-of-Work relied—would withstand manipulation attempts. It was expected that more research and development would lead to a refined Bitcoin protocol. However, once the first version of the Bitcoin network went live and its economic incentives proved to be stable, the network and the Bitcoin asset quickly gained traction and significant interest. Given its resilience, the network was maintained rather than being discarded in favor of a final iteration. Although the protocol was improved many times, especially in the early years, protocol improvements soon became the subject of political ideologies regarding how to update the Bitcoin protocol. Conflicting ideas about network governance and vested economic interests further politicized network upgrades. Protocol improvements became subject to political inertia and existing economic interests.
Many developers began to fork the Bitcoin codebase to address unresolved issues, such as privacy, scalability, or asset exchange, on their own modified versions of Bitcoin. These forks gave rise to new online communities, each contributing to its own network and services. Although some of Satoshi's intended innovations were realized within Bitcoin, much of the innovation occurred outside of it. New protocols emerged to solve specific issues that Bitcoin was not optimized to handle.
The promise of a collectively managed internet also depended on the development and integration of complementary protocols, because blockchain networks simply process decentralized applications, recording all token transactions and performing computation. Other P2P protocols needed to be developed, such as decentralized file storage, decentralized identity, decentralized interoperability protocols, decentralized oracle services, and a decentralized physical web for connecting objects and machines to blockchain networks in a trustful and decentralized manner. The transition from client-server to a decentralized web has been gradual, with many challenges along the way and standards still evolving. Partial decentralization currently dominates, as novel points of centralization continue to emerge.
The transparent nature of public and permissionless blockchain networks, which allows node operators to collectively verify the correctness of transactions, also makes those transactions publicly traceable. While this enhances institutional accountability, it comes at the cost of user privacy. In the Bitcoin network and other early blockchain networks, transactions are recorded in plaintext on the ledger, visible via block explorers. Transaction data—including sender and receiver addresses, the connection between them, and the transaction amount—is accessible to anyone. More complex smart contracts generate additional on-chain data, further increasing the visibility of interactions when data is recorded in plaintext. Even the process of broadcasting transactions can leak IP addresses, allowing user identification through metadata analysis, despite anonymization tools like Tor or VPNs.
The decentralized public key infrastructure used to create blockchain accounts enables users to trustfully interact without relying on centralized identity verification, such as Know-Your-Customer processes. However, blockchain addresses are only pseudonymous, not fully anonymous. Effective privacy can only be preserved if wallet addresses are never linked to real-world identities. In early blockchain networks, users who publicly shared their blockchain addresses—through social media posts, public token transfers, or blockchain-based interactions—risked de-anonymization through blockchain data analysis.
Since most cryptocurrency users purchase tokens using fiat currencies on cryptocurrency exchanges, which require KYC compliance, blockchain addresses can often be linked to real-world identities through exchange records. Law enforcement agencies and regulatory bodies use blockchain forensic services like “Chainalysis” or “Elliptic” to analyze transaction histories and track the movement of funds. These forensic tools allow authorities to trace the flow of assets, identifying past transactions, recipients, and spending patterns. While, in theory, customer data should only be shared with authorities in cases of fraud or money laundering investigations, this level of surveillance raises serious concerns about privacy rights and the potential for state overreach. Furthermore, token fungibility is affected, as certain merchants or platforms may reject transactions involving “tainted” coins—those previously associated with illicit activity—leading to potential discrimination between otherwise identical tokens.
To address these issues, blockchain protocols have started to implement privacy-enhancing techniques focusing on different levels: (i) wallet/address anonymity, which prevents blockchain actions from being linked to real-world identities; (ii) transaction data privacy, which conceals sender, recipient, and transaction amounts using cryptographic tools like zero-knowledge proofs, ring signatures, and confidential transactions; and (iii) network state privacy, which limits who can see the overall ledger state by restricting data visibility to authorized participants. However, implementing these privacy measures involves technological trade-offs, particularly in balancing individual privacy with network security, transparency, and regulatory compliance. The goal is to ensure sufficient privacy while maintaining trust and functionality within the system. These trade-offs are not only technological but also reflect legal challenges, where privacy laws increasingly conflict with anti-money laundering and counter-terrorism laws (read more on this topic in chapter “Token Privacy”).
Furthermore, the pseudonymous nature of blockchain addresses often limits their use in more complex decentralized applications that require real-world identity verification. At the time of writing, most decentralized applications rely on centralized mechanisms to verify real-user identities. More user-centric identity solutions—which allow users to control their digital identities and personal data without relying on centralized authorities—are currently being developed by various initiatives (read more on this topic in chapter “User-Centric Identities.”)
Blockchain networks function as isolated ecosystems, with no built-in mechanisms to communicate or share information with one another. Each network operates independently, meaning that tokens managed on one blockchain cannot be transferred directly to another. Nodes in the Bitcoin network have no information about the state of tokens in the Ethereum network and vice versa. They also have no knowledge of whether other networks have idle capacities (block space) to settle transactions. Interoperability of blockchain networks, however, is crucial for enabling cross-chain token transfers and smart contract execution across ecosystems. Without it, decentralized applications remain confined to the individual blockchain ecosystem, limiting their functionality and liquidity across ecosystems.