The Breakdown - Tether Chooses to ‘OFAC Around and Find Out’

Episode Date: August 27, 2022

This episode is sponsored by Nexo.io, Chainalysis and FTX US.   On today’s episode, NLW looks at the latest news on Tornado Cash sanctions. Specifically, he looks at Tether’s announcement this week that the stablecoin issuer would not blacklist addresses from Tornado Cash unless U.S. law enforcement specifically asked it to do so.  - Nexo is a security-first platform where you can buy, exchange and borrow against your crypto. The company safeguards your crypto by relying on five key fundamentals including real-time auditing and insurance on custodial assets. Learn more at nexo.io. - Chainalysis is the blockchain data platform. We provide data, software, services and research to government agencies, exchanges, financial institutions and insurance and cybersecurity companies. Our data powers investigation, compliance and market intelligence software that has been used to solve some of the world’s most high-profile criminal cases. For more information, visit www.chainalysis.com. - FTX US is the safe, regulated way to buy Bitcoin, ETH, SOL and other digital assets. Trade crypto with up to 85% lower fees than top competitors and trade ETH and SOL NFTs with no gas fees and subsidized gas on withdrawals. Sign up at FTX.US today. - I.D.E.A.S. 2022 by CoinDesk facilitates capital flow and market growth by connecting the digital economy with traditional finance through the presenter’s mainstage, capital allocation meeting rooms and sponsor expo floor. Use code BREAKDOWN20 for 20% off the General Pass. Learn more and register at coindesk.com/ideas. - “The Breakdown” is written, produced by and features Nathaniel Whittemore aka NLW, with editing by Rob Mitchell 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 “The Now” by Aaron Sprinkle and “The Life We Had” by Moments. Image credit: sesame/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.com, and FTCS, and produced and distributed by CoinDesk. What's going on, guys? It is Thursday, August 25th, and today we are talking about the latest in OFAC sanctions around tornado cash. Before we get into that, however, 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 find us on the Breakers Discord. You can find a link in the show notes or go to bit.ly slash breakdown pod. Also a disclosure as always, in addition to them being a sponsor of the show,

I also work with FTX. So today we're discussing the continued fallout and response to sanctions of Tornado Cash. And specifically, we're looking at how different companies are handling them. In the hours following the announcement, Jeremy Aller from Circle wrote a thread about his company's response. Yesterday, U.S. Treasury designated for sanctions ETH addresses associated with Tornado Cash. As a U.S. regulated financial institutions subject to Bank Secrecy Act requirements, Circle, together with our partner, Coinbase, restricted the movements of U.S.D.C. funds in these sanctioned addresses. It is likely that near all responsible registered virtual asset service providers also took steps to block customers from transacting with these addresses

or face charges of willfully avoiding U.S. sanctions compliance obligations, which can bring up to 30 years in prison. The regulatory intervention in this case crossed a major threshold in the history of the internet and the history of open blockchain finance, with a major government obliging parties to outright block or limit the functioning of open source software on the internet. It raises extraordinary questions about privacy and security on the internet and the future of public internet digital currency. We have noted the tension between privacy and security as a policy matter. Yesterday, this stopped being an abstraction. Crypto and blockchain infrastructure heralds an open internet of value exchange and

challenges decades of old regulatory frameworks for everything from market structure, payment systems, custody and settlement, risk management, and, of course, fundamental privacy and security. To date, policy efforts have focused primarily on issues of market supervision and stable coins, alongside a global effort to continue to enhance AML-CTF controls for digital asset operators and intermediaries. But the rapid growth of open-source self-running protocols is challenging policymakers everywhere, and the result, unfortunately, will be more blunt force enforcement actions if we don't take action now. In the next days, Circle will call on crypto industry leaders, associations, and protocol developers to come together and help advance legal frameworks and policies

to safeguard user privacy and security while evolving financial integrity rules to deal with open source protocols. This is a pillar in the fight to protect defy and the future of public internet digital currency. It's not about any one organization. It's about all that we collectively have built and represent and the future we believe in. Now, USDC was far from alone in restricting access to these blacklisted addresses. Indeed, many folks in the defy space were shocked to see how many protocols that were theoretically decentralized and censorship resistant following what OFAC had seemed to tell them. This has sparked an important industry-wide conversation around what compliance with these

types of regimes should actually look like or not. Circle for their part followed up Jeremy's thread a few days later, with a blog post titled OFAC's designation of tornado cash, protocols, privacy, and a call to action. In that post, they wrote, This week's far-reaching OFAC sanctions of the mixing service tornado cash materially raised the tension between the interaction with open-source protocols, the presumption and preservation of privacy, and financial crime compliance. We feel that sanctioning the protocol itself is a new escalation of policy issues,

akin to ongoing policy developments on self-hosted wallets, or the use of public blockchains in open software and regulated financial markets. While we are broadly making progress on many of these long-range policy issues, the intersection of privacy, open-source software, and security clearly warrants consolidated policy action, education, and advocacy. The blog post says that recent episodes show that the tools that crypto has for compliance work, but at the same time, quote, have demonstrated that under the banner of national security, free expression as software, code, and GitHub repositories may become collateral damage. This is tantamount to banning email or the open internet, because for all the good

it brings, it also harbors bad actions, bad actors, and negative externalities. From there, circle goes on to lay out what is kind of a policy platform to discuss. Modernization of the 52-year-old Bank Secrecy Act, continuous development and support for industry-wide market integrity and financial crime compliance tools, encouragement of the use and development of privacy-preserving technologies, protection and defense of open-source software and its normalization, and the development dissemination and normalization of the use of privacy-preserving decentralized identity tools. They conclude, as we are so close to long-held goals of legal and regulatory certainty for crypto in the U.S., UK, Europe, and other democratic nations, we should resist the urge to

retreat to the shadows and bring the financial privacy debate to the light of day. Basically, they're saying this is emblematic of, but not the only instance of, a fight which is much larger, a fight for the normalization of privacy on the internet, and a discussion of where the goals of crime fighting ends and people's rights needs to begin in the context of these new technologies. Now, you'll notice that this blog post didn't address the actual blacklisting of addresses directly, but Jeremy Aller did about a week later on an appearance on odd lots. He said there that Circle is subject to global AML and terrorism financing compliance and auditing standards. Quote, under a binding court order from a competent jurisdiction in the U.S., we have

the ability to block an address from transacting. That has happened, I believe, 18 times in the history of U.S.D.C. And the vast majority of those are specific addresses that OFAC has deemed to be sanctioned addresses. We have a statutory obligation to prevent transactions from happening. Aller, however, noted that many of the more complex legal obligation scenarios, such as a non-U.S. nation-state requesting the freezing of a foreign nationals wallet, quote, have not been pressure tested. This is an opportunity, Aller said, for policymakers to really figure out what are the inherent values of an internet financial system and what obligations do different entities have. Now, here I think it's important to put into context the role USDC is trying to play in this larger ecosystem.

They are extremely focused and have always been on being a stable coin player that could work within the existence. financial system. A force that helps the Beltway establishment understand that these technologies are not just some nefarious Wild West for criminals. Their belief is that financial innovation in America has tended to come from the private sector, but then been formalized and integrated by the government, and that's kind of how they've positioned themselves. My read on what they're trying to do now is to use some of the capital they've accrued to really start asking questions about the efficacy of the BSA and KYC regimes and try to push the discussion in a way where the values embedded in the crypto system are enshrined. Basically, like their approach or not, they are the inside the system folks.

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visibility and maximize your potential with the leading blockchain data platform by visiting us now at chainalysis.com slash coin desk. The breakdown is sponsored by FTXUS. FtXUS is the safe, regulated way to buy and sell Bitcoin and other digital assets with up to 85% lower fees than competitors. There are no fixed minimum fees, no ACH transaction fees, and no withdrawal fees. One of the largest exchanges in the U.S. FDX U.S. is also the only leading exchange that supports both Ethereum and Solana NFTs. When you trade NFTs on FTCS, you pay no gas fees. Download the FTCS app today and use referral code breakdown to support the show. Then there are the other guys. For many crypto critics and antagonistic regulators, the boogeyman of boogeymen Tether, USTT. Now before we just as ascribe the same take as those critics have, let's be clear that Tether has been on a steady path towards inside the systeming. Much of this was forced via settlement with the New York Attorney General, but ultimately the outcome remains the same. We're now getting regular reserve attestations, and on top of that,

a move away from the more questionable reserves within those attestations. Specifically, there has been a focus recently on Tether's commercial paper holdings. Some of that has been good faith concern, in that short-term corporate debt represents a black box on those balance sheets that we just don't know who's debt it represents. Then again, because this is Tether, some of the critique has been outlandish, like when people were accusing Tether of having fraught Chinese real estate developer debt on their books just because it might. People have also been concerned about who was doing Tether's reserve attestation, saying that the firm was too closely tied to Tether. Well, last week, Tether announced that BDO Italia would

be taking over its regular attestations from MHA Kaman. In a press release, they wrote, the decision to work with the BDO organization represents Tether's promise to deliver considerable transparency for those holding Tether tokens, providing updates about issued tokens and reserves on a daily basis, supplemented by monthly assurance opinions. This monthly piece is key. They're moving from a quarterly attestation schedule to a monthly attestation schedule. In their first report, one of the most notable aspects was that Tether had reduced its commercial paper holdings 58% over the last quarter to $8.5 billion. That's compared to $28.8 billion in Treasury bills, $5.4 billion in cash, and $6.8 billion in money market funds.

But the reason people have really been discussing Tether for the last couple of days has to do with their response to the OFAC tornado sanctions. Yesterday, they published a post basically saying that at this time, they were not going to blacklist these addresses. The post reads, Tether works closely with law enforcement worldwide to assist in investigations, including freezing addresses. We are in almost daily contact with key law enforcement officials

and pride ourselves on the timeliness with which we respond to their requests. When Tether receives an applicable or legitimate request from a verified law enforcement agency to freeze a privately held wallet, the company complies with the freeze. So far, OFAC has not indicated that a stable coin issuer is expected to freeze secondary market addresses that are published on OFAC's SDN list or that are operated by persons and entities that have been sanctioned by OFAC. Further, no U.S. law enforcement agency or regulator has made such a request, despite our near daily contact with U.S. law enforcement, whose requests always provide precise details.

We have already stated that this is the protocol we are following. Unilaterally freezing secondary market addresses could be a highly disruptive and reckless move by Tether. Even if Tether recognizes suspicious activities on such an address, completing a freeze without the verified instruction of law enforcement or other government agencies might interfere with ongoing and sophisticated law enforcement investigations. In fact, in our dealings with law enforcement, we are sometimes made aware of addresses potentially related to crime, and are specifically instructed not to freeze the addresses without the explicit request from law enforcement, as this could alert suspects of the law enforcement investigation, cause liquidations or abandonment of funds, and jeopardize

further connections that might have been established. Tether has not been contacted by U.S. officials or law enforcement with a request to freeze the addresses sanctioned by OFAC. But as noted above, Tether normally complies with requests from U.S. authorities, being in contact with them on an almost daily basis. For example, we have been cooperating on various freezes with U.S. law enforcement, including in the last two weeks after the OFAC public disclosure about tornado cash, and no specific request has been put to us related to freezing relevant tornado cash addresses. We would expect the same process of detailed communication and coordination even in this case. It is also worth mentioning that Tether is not a U.S. person, does not operate

in the United States or onboard U.S. persons as customers. However, Tether does consider OFAC sanctions as part of its world-class compliance program. We'd like to note that other digital asset providers, for example, Paxos, a New York regulated stablecoin that issues BUSD and USDP, and accounting for around 20 billion of the total cryptocurrency market capitalization, haven't frozen Tornado Cash wallets. We believe that, if made without instructions from U.S. authorities, the move by USDC to blacklist tornado cash smart contracts was premature and might have jeopardized the work of other regulators and law enforcement agencies around the world. It should also be noted that Dye, an algorithmic stablecoin that accounts 36% of its reserves in USDC,

around 3.4 billion U.S.D. also didn't proceed with any freeze. Basically, Tether is saying that it is not sufficient for OFAC to make this announcement, we need to see U.S. law enforcement request these freezes explicitly. They also draw particular attention to the fact that they are not a U.S. entity and that it doesn't service any U.S.-based clients. Speaking with the Washington Post, however, Scott Anderson, a former State Department advisor now with the Brookings Institution said, quote, the restrictions generally apply to all U.S. nationals or corporations, or any person or organization in or doing business in the United States or any transactions touching the United States. I don't know whether Tether falls within that scope or not,

but if there is a chance that they or their employees might, noncompliance could carry real legal risk. Many have also seen this as just Tether poking the bear. An unnamed former senior official for OFAC told the Washington Post that Tether was playing with fire. Quote, it's never a very good idea to test OFAC. Right now, it's a particularly bad time for any crypto-related company to do that. It looks like that's what they're doing.

However, to get a sense of the general crypto sentiment, just look at developer Sudo's response to that quote. LMFA, oh, fuck off. It has never been a better moment to challenge OFAC. And this actually gets at the core of the issue right. There is a strong argument that many are making, coin center notably, that OFAC doesn't have statutory authority to sanction a protocol, as opposed to, for example, specific crypto addresses that are owned by people.

OFAC sanctions are intended to alert and reform financial institutions and specifically not to punish, which has made the targeting of an autonomous smart contract puzzling from the beginning. Michael Mosier, a former head of Treasury's Financial Crimes Enforcement Network, and now working as General Counsel at Cryptoprivacy firm Espresso Systems said, quote, it's like shouting at a vending machine. It's not the way to make a behavior change, so it's not going to effectuate the national security goals the system was set up to achieve. Miller White House Levine, policy director at Defi Education Fund, said that the use of sanctions against an immutable smart contract was contrary to the intention of sanctions legislation. Quote, the effect of the sanctions

is not to attempt to change the behavior of foreign persons, but practically is a prohibition on U.S. persons using an open-source software protocol. It has broad societal implications with respect to privacy and individual sovereignty, and whether we are okay with a foreign policy tool that can be applied unilaterally with zero public process to regulate U.S. person's behavior. OFAC sanctions are also explicitly intended to be used to bar foreign national assets from entering the U.S. financial system, rather than being used to affect assets owned by U.S. persons. A large outstanding issue with the tornado cash matter is whether that the tokens held within the smart contract by U.S. persons are deemed to be the property of

tornado cash and hence subject to sanctions, or if U.S. citizens have a valid legal claim for the return of those tokens. To this end, J.W. Verrett applied for a license from the Treasury last week to use tornado cash for his nonprofit, in his words, quote, biting the nose of OFAC and seeking either clarity or a right to sue. Other crypto organizations, including CoinCenter, the Blockchain Association, and the Defi Education Fund are also looking into applying for a general license to allow U.S. citizens to legally withdraw their money from Tornado Cash. Eric Hess writes, even if you fundamentally believe that OFAC's designation of Tornado Cash's smart contract achieves an important national security goal, the process was horribly flawed,

set to dangerous precedent, and broadly tramples privacy in the process. And by the way, he's not the only one who thinks so. On Tuesday, Congressman Tom Emmer tweeted, I sent a letter to Treasury Secretary Janet Yellen regarding the unprecedented sanctioning of Tornado Cash. The growing adoption of decentralized technology will certainly raise new challenges for OFAC. Nonetheless, technology is neutral and the expectation of privacy is normal. The letter asks a number of specific questions related to the way sanctions were intended to operate, including which legal person OFAC believed they were targeting in this instance challenging the legality of the sanctions, and what U.S. citizens who have had their funds trapped as a result due to obtain release of those funds. Meanwhile, Alexei

Perzev, the developer alleged to have worked on tornado cash, remains behind bars in the Netherlands. He was arrested two weeks ago and brought before an examining judge who agreed he should be held in custody for two weeks pending charges. Now that the two weeks have expired and no charges have been brought, Persev appeared again seeking bail in a closed court on Wednesday, but bail was refused and the court set a 90-day time limit for an initial public hearing of charges to be held. Jill Gunter from Espresso writes, we are absolutely not hearing enough about the arrest of Tornado Cash Dev Alexei Perzev. I have been following this as closely as anyone and am still totally confused as to the status of charges against him.

This is scary. It's a hard one to be noisy about because we just don't know. We don't know enough to know if the charges in the approach to the situation is legit. But the fact that we don't know is a big, scary problem. If any of you ever get arrested and detained with no clear allegations against you beyond writing code, I promise I'll keep asking questions until there is clarity. So what next with this whole mess? Tropical Fun wrote the tweet that inspired this title and all credit goes to them. Quote, Tether chose the path of OFAC around and find out. For my part, I'm glad that Heather is waiting for explicit law enforcement guidance. One of the scary things about this whole situation is that even if it is successfully challenged in court, even if it begets a new

set of changes around the Bank Secrecy Act, all of those power shifts are things that tend to take an immensely long time, and a huge amount of consequences can accrue in the meantime. Surely one way or another, it will provoke a response. For now, I want to say thanks again to my sponsors, next to dotio, chain analysis and FTX, and thanks to you guys for listening. Until tomorrow, be safe and take care of each other. Peace. I want to tell you about CoinDesk's new event, the investing in digital enterprises and Asset Summit or Ideas.

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