III. Expectations and Limitations of Blockchain Analysis
1. What Is Blockchain Analysis?
In this section, we look at blockchain analysis as an investigative method that has proven useful in addressing tax enforcement challenges arising from the anonymity and decentralization of cryptocurrencies. By examining transaction data on the blockchain, it is possible to detect patterns, relationships, and activities among entities—such as identifiable individuals or organizations—involved in crypto transactions.
Transactions involving cryptocurrencies are recorded on the blockchain, and on public blockchains in particular, anyone can view and verify this information without special permission. This means that if a wallet address is known, it becomes possible to trace its transaction history and balances, as well as to infer which CEX accounts or wallets may be controlled by the same person. Blockchain analysis takes advantage not only of the traceability and transparency of cryptocurrencies, but also of their pseudonymous nature.
That said, blockchains themselves do not contain personally identifiable information. However, the process of converting fiat currency into cryptocurrency (known as an “on-ramp”) and converting it back into fiat (an “off-ramp”) is typically handled by centralized institutions that are subject to Know Your Customer (KYC) and anti-money laundering/counter-terrorist financing (AML/CTF) regulations.
As a result, these on- and off-ramps serve as key points of connection between on-chain activity and real-world identities. It should be noted, however, that decentralized exchanges (DEXs) generally do not offer services that directly convert cryptocurrencies into fiat currency.
Because centralized institutions still play a major role in providing crypto-related services, opportunities to receive payments in crypto remain limited compared to fiat currency, and real-world use cases for crypto as a means of payment are still relatively narrow. This situation persists in part because most cryptocurrencies are primarily used for purposes other than everyday payments.
For example, suppose that (1) an unverified CEX account or wallet address—one that has not completed identity verification—has conducted transactions on the blockchain with (2) a domestic CEX or another exchange that does require identity verification.
If it can be determined that both (1) and (2) are controlled by the same individual, then the identity of the person behind (1) can also be established. From there, other CEX accounts or wallets likely managed by the same person can be identified as well.
