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Bitcoin can be coldly unforgiving of mistakes, and nowhere is this better demonstrated than with change addresses. Although change addresses provide a key privacy tool, they can also lead to confusion, loss, or theft when not understood. It ends with a list of common pitfalls and ways to avoid them.
This article was first published in March Since then, wallet software has improved, eliminating some of the threats described below. Specifically cases 1 and 4 should only be encountered when using older, unsupported software.
Imagine paying for groceries with a debit card. The checker totals the amount due and you swipe your card as usual. However, you notice the payment terminal is asking for all of the money in your account. You have three options: Many Bitcoin users are surprised to find eerie similarities between this diabolical debit card and the way transactions seem to work.
Thinking about Bitcoin in terms of past experiences with online banking and debit cards can lead to problems. Fortunately, an older payment method offers better insights into how Bitcoin works and why. The similarities between Bitcoin and cash run deep.
Imagine needing to track different pools of paper bills, maybe as part of a collection drive. Like a cash envelope, an address can hold zero or more units of electronic cash.
The balance of any address can be found by summing the value of each unspent output it contains, just like the amount held in a cash envelope can be found by counting the values of all bills. The purpose of the Bitcoin network is to enable the regulated transfer of unspent outputs between addresses through transactions.
A more detailed explanation may be helpful when reading this article. Imagine that Alice, who owns an address containing one unspent output worth 10 bitcoin BTC , wants to pay Bob 10 bitcoin. After the transaction, Bob can give the unspent output he received from Alice to someone else. However, Alice will neither be allowed to take back the unspent output she transferred, nor will she be able to spend it again. Alice has a problem: To resolve this dilemma, Alice uses a transaction that splits her payment, a feature fully supported by Bitcoin.
In the previous examples, Alice directed change into the same address she spent from. Privacy depends on the strict separation between addresses and personal identities, a model referred to as pseudonymity.
Any observer capable of linking Bitcoin addresses to personal identities can begin to draw conclusions about money transfers between people. Users make this job more difficult by sending change to newly-created addresses. To see why, imagine a transaction that sends funds from Address A to Address B. If change is returned to Address A, the block chain clearly reveals that the person controlling Address A paid the person controlling Address B.
The same reasoning holds if two or more addresses are involved. Any transaction involving Address A as a sender reveals the receiving address unambiguously. Should the identity of the person controlling either receiving or payment addresses become known, the identities of the other parties could become known as well. Now imagine that Address A initiates a payment to B, but this time directs change to a newly-generated change address C.
The identity of the person controlling Addresses B or C may or may not be the same as the identity of the person controlling Address A. Given another transaction from Address C, the picture becomes even murkier. Which of the transfers represent payments and which represent the receipt of change? An observer trying to link personal identities to addresses must gather more secondary information and expend more resources when all parties send change to newly-created addresses.
Coordinating multiple addresses is a complicated task. Wallet software frees the user from the need to do this manually. Although change addresses play a key role in improving privacy, wallet developers can implement this feature in a number of ways.
Four strategies are currently in use, each with its own implications for privacy and security. Incorrect use of Bitcoin change addresses account for many cases of loss or theft of funds. Here are some disaster scenarios and ways to avoid them. Understanding the importance of backups, she created an encrypted wallet backup long ago and stored it in a safe place.
Alice bought a new hard drive and then re-installed Bitcoin-Qt on it. She then restored her wallet backup. To her horror, Alice discovered the restored wallet was empty. Alice generated enough change addresses to overflow the original pool of Restoring the backup only restored empty addresses. Using data recovery tools, Alice may be able to salvage the Bitcoin-Qt wallet from the faulty hard drive, and with it her lost funds. Bob uses Electrum to send infrequent bitcoin payments. Worried about possible theft, he wanted a way to keep an eye on his bitcoin balance from one of his many devices.
Bob decided on blockchain. A few weeks later, Bob made a 0. After receiving his merchandise, Bob decided to check his balance with blockchain.
Disturbingly, Bob discovered that part of his Overstock payment was transferred to an unknown address. Thinking that his computer running Electrum had been compromised, Bob re-formated the hard drive. This cleared the balance from the sending address, the only one Bob was monitoring. Electrum encourages the storage of its word address generation seed in a safe location.
Should Bob still have access to the seed, he can re-generate his old wallet and recover the change from the Overstock transaction. Carlos is a saver. One day Carlos noticed a deal on new laptops at Overstock and decided to pay using one of his saved bitcoins. But Carlos had a problem: After paying Overstock, he exited the program.
Carlos was worried about leaving any trace of his private key on his computer, so he securely deleted MultiBit and its data directory. He then returned his paper wallet to its safe location. To his shock, the balance read zero. Nineteen bitcoins were sent to an unfamiliar address on the same day as the Overstock payment. The 19 missing bitcoins were sent to a change address, leaving his paper wallet empty.
In securely deleting the MultiBit data directory, Carlos lost any chance of recovering the missing funds. Dave runs Bitcoin-Qt on two computers, a laptop and a desktop in his garage. Wanting to use both computers to make payments, Dave copied a clean wallet. After making many payments without a problem from both computers, Dave noticed something odd one day. His laptop wallet showed a zero balance, but his desktop wallet showed the correct balance. Instead, his copy of Bitcoin-Qt running on the desktop used the last available pool address held jointly with the laptop.
Back up the wallets on both the laptop and the desktop. Export all private keys from both computers, and sweep them into a new wallet. Frank received a paper wallet containing 2 BTC as a gift at a company event.
Not seeing a need to keep the paper wallet, Frank threw it into the recycling bin at his office. Over time, Frank depleted his Bitcoin funds. Shortly thereafter, Frank bought a set of sheets from Overstock for 0. Although this payment confirmed without issue, Frank noticed something odd. Without his approval, a second withdrawal was made to an unknown address, emptying his wallet of the remaining 1. Although Frank was the victim of theft, the route of attack was not his computer or network.
It was the paper wallet he threw into the recycling bin. Unknown to Frank, the paper wallet was taken from the recycling bin by Eve, a dishonest coworker.
Eve added the private key to a custom program that automatically detects deposits into a list of watched addresses, and then withdraws them immediately. MultiBit, working as designed, used the imported paper wallet address to receive 1. Frank cannot recover the funds, nor is he likely to determine the identity of the thief.
Although the examples in the previous section resulted in complete loss of funds, the same mechanisms also allow for partial loss. These conditions were assumed, which may or may not hold at the time a change address problem arises:.
For example, a single address that receives multiple payments will contain multiple unspent outputs. Likewise, wallet balances can become distributed across multiple change addresses as the user spends funds.
As expected, her wallet balance decreases to 9 BTC. After installing a new hard drive and restoring her wallet backup, Alice notices something odd. Before the hard drive crash, her wallet balance was 9 BTC. But the balance only read 8 BTC after recovering the backup. Why does 1 BTC seem to be missing?