Europe Targets Self-Hosted Bitcoin Wallets—and Financial Privacy

Proposed EU rules would be equivalent to tracking all cash transactions

As inflation and economic disruption increase around the world, ostensibly stable governments look to increase controls on cryptocurrency. In particular, states loathe what they call "unhosted wallets," meaning cryptocurrency that is totally owned and maintained by an individual, as opposed to a regulated business that they can control.

The European Union is making moves to crack down on such self-hosted cryptocurrency wallets. What they are proposing would be equivalent to making businesses maintain dossiers on anyone who chooses to pay with cash. It's an incredible ratchet in financial surveillance and an unjustifiable attack on individual privacy.

In late March, the EU Parliament's Committee on Economic and Monetary Affairs approved a new rule to the existing Transfer of Funds Regulation that would prevent regulated entities (service providers like exchanges) from interacting with self-managed wallets, propagandistically referred to as "unhosted," without first undertaking invasive "know-your-customer" data collection. The rule will go up for a legislative vote later this year, after which point it could become effective within nine to 18 months.

The EU says that these rules will "ensure crypto-assets can be traced in the same way as traditional money transfers." But cryptocurrency transactions already can be traced in the same way as normal bank transfers. These rules go far beyond the status quo.

Generally these data-collection and anti-money laundering regulations have only applied to transactions that are managed by regulated entities. When you send a large amount of money from one bank to another, for instance, both banks will know who you are and the details of your transaction. Governments make these banks collect and keep this information to try to crack down on financial crime—even though this system of financial surveillance is highly ineffective.

But these rules have not traditionally applied to most cash transactions. Individuals and businesses are usually not required to keep this information anytime someone wants to pay with cash. It's not that governments wouldn't love to have this information, but they've been thwarted for a few reasons.

First, it's just not workable. One of the reasons that financial institutions are expected to keep financial records for businesses is that they largely needed that information anyway to effectuate the transfer. This isn't the case for cash transactions.

Then it would be noticeably invasive. Financial surveillance is so insidious precisely because it is so seamless. Governments have grafted onto everyday commercial activities to mine a rich vein of data with little notice or comment. If we were required to take down this information every time we interact with cash in some way, our quiet system of financial surveillance would be much more obvious. We might start asking questions.

The EU has realized that so-called "unhosted" wallets are one way to expand the ratchet of surveillance. Relatively few people use cryptocurrency, and an even smaller portion of those store their own keys and host their own wallets. If governments can secure these controls on sovereign transactions today, they can exert them in the future when many more may turn to cryptocurrency.

This is not to say that compliance would be easy for regulated exchanges. Cryptocurrency transactions can be quite complicated, with many parties and jurisdictions involved. The provenance of some of the inputs to the transaction may be harder to determine than others. And some parties may simply be unwilling to dox themselves to the European Union just to send a transaction.

Exchanges may decide to simply not do any business with a self-hosted wallet. This would not ban self-hosting, but it would cut off much of the crypto economy to those who wish to store their own keys.

That is probably the point. Consider the Canadian trucker's protest. The government couldn't prevent any individual from receiving funds from a self-hosted wallet. But it could, and did, lean against regulated entities to cut off activities to wallets associated with the protest. It's a way of exerting as much control against cryptocurrency as is possible.

Unfortunately, this isn't merely a case of "Europe gone wild," either. The United States has attempted to go after self-hosted wallets through Treasury rulemaking in the past. The Department of Justice likewise considers the use of sovereign cryptocurrency techniques to be a "high risk" activity. The Financial Action Task Force, a global standards-setting body for financial surveillance rules, is also opposed to the broad use of self-hosting.

Bitcoin critics point to rules like this and argue that the pursuit of financial sovereignty through technology is futile. Governments will just crack down on tools for freedom, so you shouldn't bother learning about them enough to wield them capably at all, they say.

But note that these rules are being imposed on already-regulated entities, not individuals who host their own data and money. That's because these individuals can't really be targeted, at least not effectively.

Governments know that cryptocurrencies impose parameters on their levels of financial control. They would very much like to clamp down on them as much as possible before financial privacy technologies take off even more than they already have. But they are largely limited to adding new rules on entities that already follow their rules.

In other words, governments will be mostly impotent to stop a large number of capable and motivated users of strong financial privacy techniques like self-hosting and good address hygiene.

Right now, we have a window of time where we can use existing bridges between the crypto and fiat economies to learn about these tools and prepare. The more people that do this, the less effective existing government controls on centralized platforms will be.

As inflation, financial surveillance, and shortages continue largely unabated, the need for a reliable and independent currency and payment system free from government control will only become more pressing. We can expect governments to target cryptocurrencies even more as they flail about for control.  Fortunately, liberty-minded individuals have the tools and time to protect their values using these technologies for financial freedom.