What happens when you try to sanction a protocol like Tornado Cash

TThe US government’s unprecedented decision to sanction a smart contract on Ethereum continues to produce perverse consequences.

On Monday, the US Treasury Department issued a blanket ban on the crypto mixing service Tornado Cash. Not all American “persons” are allowed to interact with the open-source protocol, which is likely to have wide-ranging implications for the crypto world.

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Circle, one of the issuing entities behind the USDC stablecoin, immediately banned 38 addresses that had ties to Tornado in their transaction history after the sanction. Anecdotal reports suggest that other platforms and companies are also enforcing bans.

The Treasury’s Office of Foreign Assets Control has created a huge hole in the center of the crypto economy by making it a crime to interact with Tornado Cash. Not only has it become more difficult to obtain transactional secrecy on the most widely used blockchain, Ethereum, but platforms and people must now determine their exposure and take steps to mitigate potential regulatory action.

“It’s a bit early to speculate here. This is new territory. We still see what is even possible,” Coin Center communications director Neeraj Agrawal said via email. The second-order effects of the ban are still being felt, and it remains to be seen whether regulators can enforce such a broad ban or whether crypto is able to comply with it.

Tornado Cash is an open source project that allows users to protect their transaction histories from public view. The US government alleges it is also a service that has been used to launder more than $7 billion in ill-gotten gains since 2019, including by North Korean hackers.

See also: What Does the Tornado Cash Penalty Mean for Privacy Coins

Instead of targeting said hackers or pursuing identifiable malicious actors, the government imposed a sweeping ban on the protocol. Elliptic, an analytics firm, said it identified some $1.5 billion in illicit funds earned through ransomware, fraud or hacks.

Meanwhile, data firm Chainalysis released a report claiming that the use of crypto mixers hit an all-time monthly high in April this year – after $51.8 million was laundered through various platforms.

“It is not a specific bad actor who is sanctioned, but rather all Americans who wish to use this automated tool to protect their own privacy when transacting online who have their freedom restricted without the benefit of a Due Process,” Coin Center Executive Director Jerry Brito and Research Director Peter Van Valkenburgh wrote earlier this week.

Tornado is also a key part of Ethereum’s “money pile”. It’s not the only way to anonymize transactions on the blockchain, but it was perhaps the most used. It is likely that the vast majority of applications that support ETH are exposed to the mixing service. (Ethereum co-creator Vitalik Buterin disclosed he used the platform before donating funds to Ukraine this year.)

Additionally, although Tornado now has a criminal designation, the government cannot actually shut down the app. It also cannot prevent people from interacting with the code or redeploying it to a new unauthorized address.

On Tuesday, a prankster shed light on the situation, showing the difficulty the government will have in enforcing its sanction by sending small amounts of ETH from a Tornado wallet to high profile crypto holders, including Jimmy Fallon and Coinbase CEO Brian Armstrong. Crypto transactions cannot be declined – and those who receive them can now be held liable for interacting with a sanctioned address.

“Protocols that strictly address transactional privacy face a difficult path, as their narrow focus makes them a target for regulators primarily looking to curb illicit financial activity,” said Tor Bair, founder of the secret network focused on privacy. privacy, at CoinDesk.

“Protocols that haven’t actively considered these possibilities from day one risk a nasty surprise. You can’t create a reliable or durable privacy solution without considering every threat and compromise,” he added. .

In a telling sign of how banning Tornado could shake the entire industry, MakerDAO community members are working on a contingency plan in case it gets “atomized” by regulators due to its exhibition at Tornado. Maker is the algorithmic issuer of stablecoin DAI, a platform that allows people to mint US dollar proxies by depositing crypto.

Maker founder Rune Christensen has begun detailing a contingency plan to end the “basic” contracts that underpin the stablecoin, which appears to be garnering majority support. Of particular concern is DAI’s exposure to the USDC stablecoin, which currently accounts for more than a third of its collateralized deposits. Some $3.56 billion USDC is currently held by Maker.

Maker is currently the largest decentralized finance (DeFi) protocol by value, so its moves here are significant. It is likely that DeFi platforms at all levels will strive to reduce their exposure to USDC and other offending assets, which sit on their balance sheets like ticking time bombs. Untangling this could be costly and time-consuming, but it is necessary.

See also: Cloning Tornado Cash would be easy, but risky

Circle touts its US dollar-pegged stablecoin as the most compliant and trusted on the market, and even before the Tornado sanction, Circle had blacklisted nearly 50 addresses to comply with law enforcement demands. USDC has therefore been largely integrated via the DeFi sector.

Directing anger at Circle for following the rules – even if the rules are too broad and misunderstand how crypto works – is not the answer. But protocols should consider following OG Erik Voorhees request and weaning off the USDC in favor of more censorship-resistant alternatives.

While it is unclear how things will play out over the next few days, weeks, and months, it is becoming clear that the desires of crypto and the demands of modern 21st century governments are not compatible. It is by design.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.


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