Post Syndicated from Bruce Schneier original https://www.schneier.com/blog/archives/2018/03/tracing_stolen_.html
Previous attempts to track tainted coins had used either the “poison” or the “haircut” method. Suppose I open a new address and pay into it three stolen bitcoin followed by seven freshly-mined ones. Then under poison, the output is ten stolen bitcoin, while under haircut it’s ten bitcoin that are marked 30% stolen. After thousands of blocks, poison tainting will blacklist millions of addresses, while with haircut the taint gets diffused, so neither is very effective at tracking stolen property. Bitcoin due-diligence services supplant haircut taint tracking with AI/ML, but the results are still not satisfactory.
We discovered that, back in 1816, the High Court had to tackle this problem in Clayton’s case, which involved the assets and liabilities of a bank that had gone bust. The court ruled that money must be tracked through accounts on the basis of first-in, first out (FIFO); the first penny into an account goes to satisfy the first withdrawal, and so on.
Ilia Shumailov has written software that applies FIFO tainting to the blockchain and the results are impressive, with a massive improvement in precision. What’s more, FIFO taint tracking is lossless, unlike haircut; so in addition to tracking a stolen coin forward to find where it’s gone, you can start with any UTXO and trace it backwards to see its entire ancestry. It’s not just good law; it’s good computer science too.