The second question from @alone_anarchist in #SatoshiReward contest is about anonymity in the Lightning Network (LN). But first I want to enlighten the difference between privacy and anonymity. Since people may confuse them with each other.
Privacy refers to the ability to keep a secret action separate from a (potentially) public identity. For instance, people may know where you live, but not what you do inside your house. One example of privacy is sending an encrypted email to a friend. Although intermediates such as mail transfer agents know that you are sending an email to someone, they are unable to see its contents. The recipient and you can decrypt and read the email's content, making it private to the rest of the world. Your action is private, but not anonymous in this situation.
On the other hand, anonymity means keeping your activities separate from your true identity. Although your actions may be public, your identity is hidden. Anonymity entails no attribution to your actions, rendering you nameless. For example, using a Virtual Private Network (VPN) to access a website may render you anonymous. However, when you publish a message on their public forum, that message becomes public. As a result, you have anonymity, but not privacy. [1]
Another important thing is that after the Taproot update, because of the update multiple adresses can merge their adress and make a new adress. This way it is very difficult to differentiate the transactions in the ledger and know which one is being processed on chain and which one is off chain. The following methods are for nodes and users inside the lightning networks. With that being said, let’s talk about anonymity in LN. There are some studies done on anonymity of LN. In a study which was done by Tikhomirov and colleagues, it was determined that if the attacker has control over 2% of the nodes in the LN. Sensitive information such as sender, receiver, and amount can be exploited. [2] Another research done by Sharma et. Al showed this amount is decreased to 1 percent. [3]
In order to achieve anonymity in LN and the most practical way is to use TOR method. But how does it work? In simple terms, the process of encapsulating data involves encrypting the information being sent and adding multiple layers of encryption. The data is then sent through multiple relays or 'hops' towards its destination. At each hop, a layer of encryption is removed to reveal the next hop along the path until the data reaches its destination. Each hop in the chain can only view the location of the hop immediately before and after itself but cannot view the data. As a result, it is impossible to determine the original sender or receiver, rendering the communication anonymous.[4]
Another way is called “route related anonymity” Within the LN, each node that facilitates a payment transaction is only aware of the previous and next nodes that the transaction should be directed towards. If only one routing exists, it becomes evident who the sender and receiver are, leaving no room for defense. However, the length of the payment route is unknown to intermediaries, making it impossible for them to determine whether the payment has one, two, or more steps, even if the payment involves just one intermediate step. Assuming Alice sends a payment to Bob via numerous intermediary nodes and channels, such as Carol, David, and Eddy, the aim is to prevent a selected intermediary, for instance, David, from identifying the sender and receiver of the payment transaction.[5]
This method is not very effective, there are articles which investigated the effectiveness of it. In contrast to Tor's random router selection, Lightning Network uses a routing protocol that selects the least expensive path based on fees, path length, and other global path properties. This strategic routing method results in smaller anonymity sets than random path selection. However, if an adversary controls the nodes immediately after the sender and before the recipient in a payment path, the sender and recipient's anonymity can be compromised. This study attempted to predict the sender and recipient of a Lightning Network transaction using knowledge of the routing algorithms. The results indicate that the anonymity level in Lightning Network is low, and the layered encryption of onion routing alone is not enough to guarantee substantial anonymity with almost deterministic path selection. It also suggests two protocols which are path related to be safe from the attacks they have done. These protocols are LAP and Dovetail. Since they are complicated for me I drop the link to the article here for readers who are keen to gain more knowledge in this area. [6]
The other method which improves both anonymity and privacy is CoinJoin. In August 2013, the developer Gregory Maxwell presented the concept in his BitcoinTalk account, providing a comprehensive explanation of its creation and functionality. He emphasized that his idea did not require any alteration to the Bitcoin protocol. This method was invented to improve privacy and anonymity in Bitcoin but later it was used in LN too. But later Adam Gibson, a leading developer of the CoinJoin system, suggested that the Lightning Network (LN) has the potential to elevate the anonymity of Bitcoin (BTC) to a higher level. He has proposed an upgrade to the CoinJoin system called CoinJoinTX, which incorporates an LN payment channel to enhance the anonymity process. With this upgrade, tracing the source of BTC transactions would become nearly impossible. Adam recently presented a proof of concept for his proposed upgrade, stating that the necessary technology already exists, but further development and research should precede any public releases.
The CoinJoin technique can be integrated into the Lightning Network by consolidating several payments into a single payment channel. This can be achieved using Payment Pointers, which enable different payment hashes to be used for multiple payments made to the same payment channel. By consolidating various payments into a single channel, it becomes challenging to associate specific payments with individual users. [7, 8]
Another way of increasing anonymity is by opening multiple channels. In 2017, Conrad Burchert, Christian Decker, and Roger Wattenhofer introduced a concept in their whitepaper titled 'Scalable funding of Bitcoin micropayment channel networks', which is also known as Channel Factories. Payment Channel Factories are an efficient method of opening multiple payment channels among numerous users using one transaction by using a smart contract that defines the regulations for the payment channels. When payment channels are opened in bulk, it becomes more complicated to link specific payments to particular users since the payment channels are not directly associated with individual users. [5, 9]
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