Some services, such as bitcoinlaundry.com, claim that they can launder your bitcoins.
Since all bitcoin transactions are publicly logged, how is this done? Wouldn't it be possible to trace back the transactions and find out the initial address?
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Say I received 10 bitcoins on a Bitcoin address I publicly advertise for donations. Anyone looking at the blockchain can put that address in a search engine and find me. Now say I want to use those 10 bitcoins to buy drugs. If the drug dealer's bitcoins are traced, they'll point right back to me.
Now I can create a lot of accounts if I want. And I can pass the 10 bitcoins I received through those accounts and then to the drug dealer. But likely because those accounts aren't used anywhere else, the trail would still lead right from the drug dealer to me.
Now suppose I put my 10 bitcoins in an account created just for me by a Bitcoin laundering service. And you and Fred do the same thing. Then the service sends my coins to Fred and your coins to me. Then I spend the coins I got on drugs. Now the trail looks exactly the same as in the non-laundering example, except the trail leads straight to you instead of me -- a pretty good deal for me, not so much for you.
If you purchase a bunch of Bitcoins with dirty money, and then sell the Bitcoins for clean money - you have essentially laundered your money with Bitcoins. You can then claim that your income came from Bitcoin mining, and it would be difficult to investigate.
It is exceedingly difficult to anonymize your Bitcoin transactions. I think the appeal is that it adds an extra hoop for the IRS to jump through.
Not only is it possible and proven that people can trace transaction origins, but it will likely be easier to do in the future if the Bitcoin core remains unchanged in this respect.
Bitcoin anonymity is a fallacy.
It will always be possible to trace a transaction back to its initial wallet. This is a design choice by the Bitcoin team, and could have been avoided (see the answers to this question for more). However, there could be some legal ways of avoiding this, because if they money goes through several wallets, even if you can't hide the wallets, you could deny ownership of the earlier ones, and argue that this was a random gift somebody gave to you.
Simply transferring bitcoins into an exchange or large private Bitcoin service has the net effect of breaking the trail of Bitcoin addresses. If your real identity is associated with an address you can send your bitcoins to an exchange and then send them back to yourself at a new address. It will appear that you cashed in the bitcoins at your first address, because you sent them to a known currency exchange address. The Bitcoin trail of the coins after that are clearly not associated with you. As long as you don't associate your true identity with your second address, it is indistinguishable from anyone who's bought bitcoins on that exchange even if you got some of your own coins back.
However, it's important to note that even this would probably not thwart a dedicated legal investigation. It just makes it more difficult to jump back and forth between the money trails in different currencies. Law enforcement could get a warent to search the records of the exchange which would quickly reveal the transaction. This would work just as well for a Bitcoin laundering service. If the service didn't retain your identity and a record of the transactions then they would be guilty of money laundering laws in most countries, so those services are highly motivated to maintain accurate records.
It's funny, but Bitcoin laundering services are most likley used by people wishing to do illegal activities.
So all the Bitcoin transactions on that laundering site are probably illegal and are criminal. Even though Fred would be caught for buying marijuana for Bob, whilst Bob would be caught for buying coke for Fred.
So all the police have to do is target everyone on the Bitcoin laundering website instead of one person. Then everyone will be caught paying for someone else's criminal transactions.
Unless the Bitcoin laundering site also had a twin sister site that did legal exchanges, and they mixed both of them up together.
It seems very much like normal money laundering services that banks offer.
The key is not having your real identity connected to any of the transactions, and then when exchanging your bitcoins for real money, using a fake ID to do so.
Bitcoin exposes many flaws in the current financial system, as it was designed to be an ideal. Yes all transaction are always visible after laundering - however the problem of matching entry and exit points is "computationally irreducible", to borrow a phrase from Stephen Wolfram, so the efforts of KYC and AML are kind of hopeless once funds go into any of the the blockchain systems and get pooled.
More funds in private hands would be a good thing. A notable reason why we labor under a top heavy world is because of ever growing state plunder by an entity that is answerable to nobody :
"Warfare, Welfare, and the State by Robert Higgs" http://www.youtube.com/watch?v=b7SA_5WeGZ0
It is actually much easier to launder Bitcoins. Just transfer your Bitcoins to an exchange site like cryptsy or btc-e, then exchange your Bitcoins into another currency like Litecoin for example. Now transfer these coins to another exchange site and exchange the coins back into Bitcoin. I think no one can find out the inital source now :)
If you send bitcoin through a good bitcoin mixer then one cannot directly see what mixer input address is linked to what mixer output address (nowadays dozens of output addresses have equal values). However, it's the users behavior which often makes it possible nevertheless. A friend of mine recently linked 22% of a wasabi mixer transaction output addresses to their inputs. This is possible if the user mixes the pre- and after-mixing coins. Assume you have before mixing funds on addresses 1a...., 1b... and 1c.... and analytics can group the three addresses together. And now you put 1a... as input into a mixing transaction, the output might be addresses 1d.... and 1e... . Then the user might do some traceable transactions with 1c... resulting in a change address 1cc.... and with 1e.... resulting in a change address 1ec.... . After a year the user lost the overview what belongs to the pre- and what to the after-mixing world and uses 1cc.. and 1ec.. as co-spend in a transaction. Then analytics can link 1a... and 1e... and traceability is possible through a mixer on the end of the day. So it's not very easy to keep traces hidden.
There is another risk if you use mixers for laundering. E.g. if you want to launder your drug bitcoin before cashing out. If the mixer has an operator (non-decentral solution) you cannot know if not your local police is or pays the mixers operator and can link directly your inputs and outputs in the mixer.