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Applications connect to the local Tor proxy using the SOCKS protocol. The local proxy chooses a path through a set of relays, in which each relay knows its predecessor and successor, but no others. Traffic flowing down the circuit is unwrapped by a symmetric key at each relay, which reveals the downstream relay.
Warnings: Tor does no protocol cleaning. That means there is a danger that application protocols and associated programs can be induced to reveal information about the initiator. Tor depends on Privoxy and similar protocol cleaners to solve this problem. This is alpha code, and is even more likely than released code to have anonymity-spoiling bugs. The present network is very small -- this further reduces the strength of the anonymity provided. Tor is not presently suitable for high-stakes anonymity.