Confidential transactions (CT) is a cryptographic protocol which results in the amount value of a transaction being encrypted. The encryption is special because it is still possible to verify that no bitcoins have been created or destroyed within a transaction but without revealing the exact transaction amount.
However, confidential transactions require a soft fork consensus change to be added to bitcoin, although they could be added to a sidechain too.
The basic essence of a Confidential Transaction is that information is open to only the sender and the receiver. The outside observer is not privy to any information pertaining to the amount being transferred.
However, the network must also be able to determine the validity of a confidential transaction. This is achieved by ensuring that the number of inputs at the beginning of a transaction is equal to the number of outputs at the end of the transaction.
So how does Confidential Transaction benefit?
In the current structure, the Bitcoin protocol suffers from a few lacunae.
- Lack of anonymity
- Lack of fungibility
Lack of anonymity
When it first appeared on the fintech scene, Bitcoin was marked as a truly decentralized anonymous digital currency. However, this is not the case. Because each user on the Bitcoin network is represented by a public address, their transaction history can be traced using a block explorer. If a link between a public address and a real-life user were ever to be established, other users would be able to know exactly who it was they were transacting with. At best, the Bitcoin protocol can only be described as pseudonymous.
Lack of fungibility – Fungibility means the ability for one unit of a good or currency to be interchangeable for another unit, e.g. the US dollar is fungible because 1 dollar can be exchanged for another one without loss of value. Conversely, because Bitcoins can be tracked through an open and accessible blockchain, if those Bitcoins were ever used for, or gained by, illicit activity, they may be labeled as “tainted”. Merchants may refuse to accept these tainted Bitcoins, and thus, they may become less valuable when compared to other Bitcoins. Exchange without loss of value is no longer possible, i.e. these Bitcoins are said to be non-fungible.
To overcome these pitfalls the process of Confidential Transactions was created by Adam Back, a Bitcoin developer. With the advent of cryptocurrencies, this will hold in good stead.