The Breakdown - OFAC Backtracks (Somewhat) on Tornado Cash Sanctions

Episode Date: November 12, 2022

This episode is sponsored by Nexo.io and Circle.   On this edition of the “Weekly Recap,” NLW looks at some small but potentially significant shifts to the Office of Foreign Assets Control’s sanctions against Tornado Cash, the Securities and Exchange Commission’s victory over LBRY and more.  - Nexo Pro allows you to trade on the spot and futures markets with a 50% discount on fees. You always get the best possible prices from all the available liquidity sources and can earn interest or borrow funds as you wait for your next trade. Get started today on pro.nexo.io. - Circle, the sole issuer of the trusted and reliable stablecoin USDC, is our sponsor for today’s show. USDC is a fast, cost-effective solution for global payments at internet speeds. Learn how businesses are taking advantage of these opportunities at Circle’s USDC Hub for Businesses. - “The Breakdown” is written, produced by and features Nathaniel Whittemore aka NLW, with today’s editing by Eleanor Pahl and research by Scott Hill. Jared Schwartz is our executive producer and our theme music is “Countdown” by Neon Beach. Music behind our sponsors today is “War” by Enoch Yang. Image credit: Staff/Getty Images, modified by CoinDesk. Join the discussion at discord.gg/VrKRrfKCz8.

Welcome back to The Breakdown with me, NLW. It's a daily podcast on macro, Bitcoin, and the big picture power shifts remaking our world. The breakdown is sponsored by nexus.io and circle and produced and distributed by CoinDesk. What's going on, guys? It is Saturday, November 12th, and that means it's time for the weekly recap. Before we get into that, if you are enjoying the breakdown, please go subscribe to it, give it a rating, give it a review, or if you want to dive deeper into the conversation, come join us on the Breakers Discord. You can find a link in the show notes or go to bit.ly slash breakdown pod. All right, guys, so again, sorry to disappoint, but as of recording, this is Wednesday, November 9th.

I still don't know anything. I still can't say anything. So obviously, it's quite clear what the big story of the week is. But at the moment, I must continue to remain quiet on that particular story. That said, there were a few other important stories, things that would be covered this week normally as the title for an entire show. And so I wanted to use the weekly recap to do a couple of those stories. First, one of the most significant tipping points in the regulatory discussion this year

happened when the Office of Foreign Asset Control or OFAC sanctioned Tornado Cash. Tornado Cash is a mixing service that adds privacy to crypto transactions by making it difficult to see inputs and outputs. The sanctions brought up some serious questions. In fact, I would argue that they were one of the most galvanizing actions the government has ever taken against crypto. One of the big questions was, did OFAC actually have the authority to sanction a smart contract. This was completely new territory and caught a lot of people

off guard. We've seen sanctions in the past, but they've always been for individuals, but not for entire protocols or smart contracts. Another question was, even if OFAC did have that authority, is it technically feasible in the case of digital asset addresses are of course public, meaning that people could be sent tainted assets against their desires? That is in fact exactly what happened in the hours after the sanctions were announced. Last week, I had David Hoffman from bankless on the show to discuss the lawsuit that he, Coin Center, and others were party to against the Treasury. The lawsuit was focused on the compliance requirements now placed upon him for life because he was dusted with Tornado cash-related ETH as a prominent public figure.

Anyway, this has obviously been a situation that people are watching closely, and this week we got some updates. The Department of the Treasury who runs OFAC and who is responsible for maintaining the sanctions list has delisted and re-designated tornado cash. This is perhaps in response to legal challenges, but it also could be a measure to turn up rhetoric regarding North Korea. The first sanctions happened in August, and again, the big issue was that the quote-unquote designated person being sanctioned appeared to be the actual smart contract that governs the operation of tornado cash rather than a person or organization as required theoretically by sanctions legislation. In what appears to be a step to rectify this situation, the Treasury

has clarified that the organization being sanctioned is the tornado cash organization. The Treasury goes on to describe the organizational structure consisting of Tornado Cash's founders and developers, as well as the Dow formed around the service. However, they were also explicit in saying that none of the founders' developers or members of the Dow were sanctioned as individuals, which is definitely dancing in some strange gray areas. The legal issue now turns to whether or not the smart contracts deployed by Tornado Cash developers can properly be classified as their property. Sanctions only prevent U.S. citizens from participating in dealings with a sanctioned person's property or interest a property. The TC-smart contracts are immutable once deployed, but the Treasury still seems to be framing the situation as one where the TC organization is providing ongoing services which can be withdrawn. As mentioned before, CoinCenter is currently conducting a lawsuit against the Treasury,

which seeks to dismiss the sanctions against Tornado Cash. CoinCenters' head of research, Peter Van Valkenberg tweeted, OFAC today repealed the Tornado Cash designation that CoinCenter is challenging in court and then replaced it with a new one. Nothing they've announced changes our strategy in the lawsuit. There's also a new FAQ about the entity being sanctioned, which creates more questions than answers. These developments underscore the arbitrary and capricious nature of Treasury's actions and their continued misunderstanding of the technology. Now, from the Treasury's note, in discussing the implications of the sanctions, they seem to imply that the current censorship of Ethereum blocks by US-based validators is required to avoid penalty, and noted that, quote,

any foreign financial institution that knowingly facilitates a significant transaction, or provide significant financial services for any of the individuals or entities designated today could be subject to U.S. correspondent or payable through account sanctions. The announcement also leaned heavily into discussions of TC by North Korean state-sponsored hackers Lazarus Group, stating, quote, Tornado Cash, an entity that provides virtual currency mixing services, obfuscated the movement of over $455 million stolen in March 2022 by the OFAC designated DPRK-controlled Lazarus Group in the largest virtual currency heist date. They also explicitly referenced the connection with North Korea's nuclear program.

Quote, this action is part of the United States' ongoing efforts to limit the DPRK's ability to advance its unlawful weapons of mass destruction and ballistic missiles program that threaten regional stability and follows numerous recent DPRK ballistic missile launches. Now, one of the critiques of this entire saga

has been that the Treasury appears to be making rules for crypto technology that it doesn't sufficiently understand. For example, this round of sanctions appears to include an Ethereum TestNet address in its list of prohibited wallet addresses. Michael Lewillin, a blockchain security specialist who sits on the board of the Texas blockchain council tweeted, If you check out the tornado cash contracts list, you'll notice a match on Gorley.

So OFAC is now sanctioning a deposit TC address on a test net because the DPRK is trying to launder fake USDC tokens? Seems like they just copy paste at the TC docs without understanding any of them, not looking good for their case. Even if I believe that the U.S. Treasury had the legal authority to do what they're doing, which I don't, I would still be absolutely infuriated with the level of incompetence with which they've gone about it. Sending this all up, Gabriel Shapiro from Delphi Lab says, OFAC revokes TC designation and redesignates with clarity on what person's tornado cash is,

i.e. the unincorporated association of TC founders and developers. A tacit surrender to coin center's lawsuit, but also a more legally credible pivot. To be clear, this raises slash leaves various questions. How can we determine what property this alleged entity owns it has interest in when it's some kind of novel joint venture with no contracts? Who exactly is included in the tornado cash Dow at any given moment and more. Want to keep more profits when trading? Get the best possible prices and trade with 50% lower fees on NXO Pro. The new Spot and Futures trading platform uses aggregated liquidity of over 3,000 order books collected from multiple sources.

Utilizing the complete NXO suite allows you to earn interest and borrow funds as you wait for the next trade setup. Visit pro.nexo.io. That's PRO.N.E. and sign up today. This episode is brought to you by Circle, the sole issuer of USDC, and a leader in crypto that's held to a higher standard. USDC is a fast, safe, and efficient way to send money around the globe. USDC is always redeemable one-to-one for U.S. dollars and has over $45 billion in circulation

as of October 13, 2022. Plus, Circle posts weekly reserve reports and monthly attestations of reserve capital, letting users know that USDA is safe, transparent, and compliant with regulations. Just go to circle.com backslash transparency to see why USDC is a trusted staple coin. Now, staying on the regulatory theme, a federal judge has ruled that LBRY sold its tokens as unregistered securities, finding in favor of the SEC's regulatory action. The SEC sued LBRY in March of 2021, claiming that the blockchain-based file sharing protocol had illegally offered its tokens for sale without registering.

LBRY's claim was that the SEC had not given them fair notice that their tokens were considered securities. Federal Judge Paul Barbadoro ruled on Monday that, quote, no reasonable trier of fact could reject the SEC's contention that LBRY offered LBC as a security, and LBRY does not have a triable defense that it lacked fair notice. LBRY founder Jeremy Kaufman has frequently commented that the results of their case could have a dramatic effect on the rest of the industry, stating that the facts of the case, quote, basically apply to every company. In further comments, he told Coyndes, quote, the SEC versus LBRY case establishes a precedent that threatens the entire U.S. cryptocurrency industry.

Under the SEC versus LBRY standard, almost every cryptocurrency, including Ethereum and Doge, are securities. The future of cryptocurrency in the U.S. now rests with an organization even worse than the SEC, the United States Congress. End quote. With the ripple case coming to a close on very similar facts and arguments, concerns are being raised throughout the industry. Coinbase and the blockchain association have filed amicus briefs in the Ripple case, arguing that the rules have been applied inconsistently by the regulator, creating uncertainty for the industry. The judgment in the LBRY case was rendered early, meaning the matter will not go to a full trial, which could be a key difference with the Ripple trial process now coming up to its ninth month.

In applying the Howie test, the judge found that simply the act of retaining tokens meant the company was incentivized to work to increase the value of the token satisfying the test. Now, you might be thinking, wouldn't this logic mean that sneakers or beanie babies are securities as well? The judge had the same thought and offered an opinion that an investment in a Beanie Baby consortium could also be a security, although not directly addressing whether the toys themselves would be considered securities. Overall, the verdict is a very concerning one across the industry. Before the verdict came out, Gabe again at Delphi wrote, SEC versus LBRY transcript is fascinating. The judge does grok the unique challenge of tokens

as mixed consumer investment product but sticks tightly to Howie Test, thinks Beanie Baby sales could be securities and wonders why value of LBRY isn't capped like in the quarter's NAL. There's a lot of other interesting stuff in the transcript, some positive for LBRY, some for SEC. For example, judge discusses the partnership exception to securities laws. I kind of wish this were a real strong governance token case in front of this judge. He might get that. The SEC also makes crystal clear here its view that even if you never market your token as being profitable, you just say STFU about it completely. It can still be a security just because people know you have an incentive and ability to increase its value, which is absurd, in my opinion.

I think this case has better pro-token facts than Ripple because of the clear direct consumer utility of LBRY and will be decided sooner. My guess, Judge will side with SEC, mainly swayed by fear that mixed tokens create securities law loopholes. Hope I'm wrong, though. Narrator says he was not wrong. In response to the verdict, Dr. Nick A from Factory Dow wrote, this is bad news. Even the weak signal of we have some tokens too is enough to be considered a security apparently. Americans are going to have a hard time using anything with a token in the future. By this definition, ETH is a security. Now, LBRY, for their part, put a pin in the problem on November 7th, saying,

The most f***ed up part about this whole situation is that even after five years of fighting and a court ruling, we still honestly do not know how to legally launch a public blockchain in the United States. Does anyone? Next up, another story that in any other week might have been bigger. The U.S. has seized 50,000 Bitcoin stolen from Silk Road in 2012, valued at around $1 billion. The seizure took place last November, but was announced this week by the DOJ. At the time, this was the largest ever seizure of Bitcoin, but was later surpassed by the Bitfinex hack seizure in February. A Bitcoin wallet was found hidden in a popcorn tin at an address in Georgia connected to James Zong,

who goes by the username loaded in the crypto community. Damien Williams, the U.S. Attorney for the Southern District of New York, said, quote, this case shows that we won't stop following the money no matter how expertly hidden, even to a circuit board in the bottom of a popcorn tin. Accompanning the disclosure from the DOJ was a description of the theft, which was redimentary to say the least. Zong had simply made a Bitcoin deposit on Silk Road, then spam the withdrawal button, triggering multiple withdrawals. With this recent seizure, the U.S. government now holds around 210,000 Bitcoin that we know of, making it one of the single largest Bitcoin holders in the network. In 2014, multiple

Bitcoin seizures were auctioned off by the DOJ, but we've yet to hear what the government plans to do with these recent confiscations. Cameron Winklevoss of Gemini said, if the U.S. government hoddled all the Bitcoin it got during seizures, it might actually close the deficit. Bankless wrote, Breaking, the U.S. seized $3.36 billion in Bitcoin from a guy who stole 50K Bitcoin from the Silk Road 10 years ago. Dude was just hanging out in his house in Gainesville, Georgia for 10 years with billions of stolen Bitcoin. A diamond is forever. So is on-chain crime. Now, last up today, we're catching up on a story from a couple years ago. Back in 2020, we covered the economic collapse of Lebanon, as some were pointing out the

country as a potential test spread for crypto as an alternate set of financial rails. Last week, McKenzie Sigalos of CNBC published a deep dive into how the crypto economy was developing alongside what is continuing to be one of the worst banking and political failures in the last 50 years. The Lebanese pound or lira has completely collapsed. It's lost 95% of its value in less than three years since the latest failure. of the crisis began. Inflation is running near 200%, which is worse than Zimbabwe, and electricity has been cut down to only operating for one or two hours per day. Politics have become completely

dysfunctional, with no government able to be formed since the resignation of the prime minister in January 2020. In the month, the president resigned with no replacement able to be agreed upon, Parliament left the richest man in the nation sitting in as caretaker prime minister. And while economic collapses are always about politics, this one is especially so. A recent UN report, which claim that more than 80% of citizens are now living in poverty, said, quote, the political establishment knew about the looming cataclysm for years but did little to avert it. Well-connected individuals even moved their money out of the country, facilitated by a legal vacuum that allowed capital to flow out of the country. Truth and accountability must be

sought as a matter of human rights. Throughout the crisis, support has been offered by the IMF, the World Bank, and the European Union. But without a functioning political body that can enact the demanded and desperately needed reforms to root out corruption within the state, supporters are refusing to extend additional aid. The World Bank has called the economic crisis one of the top 10 and possibly top three since 1850. The focal point of the crisis is the nation's banking system, which the World Bank has called the Ponzi scheme. Lebanese banks would offer high interest rates for U.S. dollar deposits between 15 and 30 percent, in order to capture strong dollar inflows to fund unsustainable government spending, much of which was skimmed off in corrupt schemes to administrators. In April 2020, ongoing protest turned on the banking sector, which had established draconian withdrawal limits on dollar deposit.

More recently, in September this year, citizens started taking matters into their own hands, performing bank robberies, seeking only the return of their own deposited money. The situation had become so normalized that one member of parliament staged the sit-in with her lawyer to demand release of her deposited money in order to pay for cancer treatment of a family member. In this context, the crypto economy has sprung up as the payment rails of last resort. Without reliable access to money and banking, citizens are turning to Bitcoin for long-term savings and tether as a more readily available U.S. dollar proxy.

The CNBC report spoke with numerous people across the country to discuss how they are using crypto to maintain their access to basic economic functions. Some are mining crypto using the cheap hydro power, which is still plentiful in the south of the country to find a steady income on non-state currency. Others are freelancing online to receive payment in Bitcoin. Right now, unemployment is at 13% and the minimum wage has plunged to about the equivalent of $17 per month. One of the most interesting examples is the black market exchange that has sprung up around tether. Tether is now readily exchangeable for physical U.S. dollars from a network of unlicensed money changers. Some merchants are also beginning to accept tether directly. Georgio Abu Gabriel,

an architect who was interviewed for the article, said, quote, the use of USDT is widespread. There's a lot of copy shops, restaurants, and electronic stores that accept USDT as a payment. So that's convenient if I need to spend, not in fiat, but for my Bitcoin savings. The government has much bigger problems right now than to worry about some stores accepting cryptocurrency. So obviously, this is a fast-developing situation, and whenever I talk about crypto's use in these sort of lifeline scenarios, and ever want to make it seem like the most interesting, important, or relevant part of the story is the use of crypto. Obviously, what matters is the big-picture power shifts that led these countries to these terrible situations and outcomes, and the lives

of the people who have to sort it out from there. What's interesting and why it's worth looking into crypto is that it's a permissionless technology that doesn't end run in these cases around the governments and economies that created the problem in the first place. And I think if even a few people, a few families are protected because of that, it's a good reminder of why this is all worth it. For now, I want to say thanks again to all of you for listening and supporting the show. Until tomorrow, be safe and take care of each other. Peace.