The Breakdown - The IMF Finally Realizes You Can't Ban Crypto

Episode Date: September 9, 2023

Today on The Breakdown, NLW looks at a new paper from the IMF and FSB that -- among other things -- acknowledges the un-reality of successfully banning crypto. Plus a look at the new privacy paper co-authored by Vitalik Buterin. Enjoying this content? SUBSCRIBE to the Podcast: https://pod.link/1438693620 Watch on YouTube: https://www.youtube.com/nathanielwhittemorecrypto Subscribe to the newsletter: https://breakdown.beehiiv.com/ Join the discussion: https://discord.gg/VrKRrfKCz8 Follow on Twitter: NLW: https://twitter.com/nlw Breakdown: https://twitter.com/BreakdownNLW

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. What's going on, guys? It is Friday, September 8th. And today we are wrapping up the week with a little bit of discussion of some new guidance about how crypto is not going to be successfully banned, as well as a new paper on privacy that's generating a lot of conversation. But before 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. Hello friends, happy Friday. Today we are rounding out the week with a number of different stories across the industry and we're kicking off with something that I think everyone who is in this industry knows intuitively, but which is finally being recognized from the outside in as well. The International Monetary Fund and the Financial Stability Board have just released a new paper called Policies for Crypto Assets. The abstract reads, Crypto Assets have been in existence for more than a decade and have displayed significant volatility. Alongside their volatility, crypto asset activities have also grown in complexity. So far, direct connections between crypto assets and systemically important financial institutions,

core financial markets, and market infrastructures have been limited. Nevertheless, they have the potential to emerge as a source of systemic risk in specific jurisdictions if they gain traction for payments or retail investments. Now, this is something we've heard from this set of international institutions quite a bit. Basically, that crypto isn't that risky now because it's not really fully integrated into the existing financial system, but that should it get integrated into that system, it could indeed create a number of risks. We've seen this language, for example, quite a bit from the Bank for International Settlements, and particularly around areas such as stable coins. Now, this is a big overarching paper. Back to the abstract again, it reads,

At the request of the Indian G20 presidency, the IMF and the FSB have developed this paper to synthesize the IMF and the FSB's policy recommendations and standards. The collective recommendations provide comprehensive guidance to help authorities address the macroeconomic and financial stability risks posed by crypto asset activities and markets, including those associated with stable coins and those conducted through so-called decentralized finance. So as you heard from that, the paper was commissioned by the G20. Currently, the leadership of that organization is India and is set to be presented at a meeting of the G20 this weekend. The headline taken away by CoinDesk and many of the other crypto outlets out there is that the paper basically says that blanket crypto bans just will not work. According to the report, quote, imposing blanket bans that make all crypto activities including trading and mining illegal in one jurisdiction, is not only expensive and technically challenging, but could also lead to

activity migrating to other jurisdictions creating spillover risks. This is again something that we know really intuitively. When you ban mining in one place, you're really just saying you're banning companies in your jurisdiction from mining. Now, this language echoes things that we've heard from the IMF before. In June, in a blog post about central bank digital currencies in Latin America and the Caribbean, the IMF wrote, while a few countries have completely banned crypto assets given their risks, this approach may not be effective in the long run. Governments instead should focus on addressing the drivers of crypto demand, including citizens' unmet digital payment needs, and unimproving transparency by recording crypto asset transactions and national

statistics. Now, hold aside any cynicism. I do think the world would look a lot better if governments were recognizing why people wanted to get out of their monetary systems and try to address those issues. And yet, I believe many of us here don't really think that that is a particularly plausible thing to happen. So what does this new report suggest instead of these blanket bans? Well, it says that the first line of defense against the macroeconomic and financial risks posed by crypto assets are robust macroeconomic policies, credible institutional frameworks, and comprehensive regulation and oversight. That said, quote, some jurisdictions in particular emerging markets and developing economies may want to take additional targeted measures that go beyond the global regulatory baseline to address specific

risks. Coinbase sums up, the IMF and FSB say jurisdictions might consider targeted in temporary restrictions to manage some risk factors in stressful times or while countries find better internal fixes. The examples that the paper gave included targeted restrictions on privacy coins in places like Dubai, as well as a ban on Nigerian banks servicing crypto firms. Now, once again, as we've seen before, these international institutions are really concerned about stable coins. The paper says, rapid capital flight or reversals could materialize if foreign currency denominated stable coins became easier and cheaper to hold in large quantities relative to foreign currency bank accounts. They say that global stable coins that are

adopted by multiple jurisdictions, quote, may transmit volatility more abruptly than crypto assets and may cause significant risk to financial stability. So overall, there is nothing shocking or crazy new in this paper. Instead, I think it's a reflection of where the discourse is with these big international institutions right now. Grudgingly, they are accepting that crypto is here to stay and are recognizing that their time is probably better spent trying to help member governments figure out how to mitigate the worst risks rather than entertaining some fantasy of blocking it out entirely. Now, of course, as you heard, one of the ways in which they might look to do that, or at least one of the examples that was given, was targeted restrictions on things like

privacy coins. Privacy in the crypto asset space has been particularly contentious, especially as global regulations and the fat of travel rule get more deeply implemented, and in general, the more that crypto comes into the Bank Secrecy Act sort of regulatory apparatus. Obviously, of the things that we have talked about a huge amount on this show has been the tornado cash sanctions and then criminal accusations against the founders. And I think that that's part and parcel of this process of figuring out how crypto integrates with the larger system. On that front, a really interesting paper came out this week that was notable in part for who wrote it, one of the authors being Ethereum creator of Italic Vuteran, and for its exploration of this particular question,

i.e. whether you can bring privacy to a protocol without it just becoming another tornado cash. The paper was titled, Blockchain Privacy and Regulatory Compliance, towards a practical equilibrium. Its authors include Vitalik Boudarin, who I just mentioned, Jacob Illam of Chainalysis, as well as supporting authors including Fabian Sharb and Matthias Nadler, as well as Amin Soleimani. It proposes a similar system to existing mixers like Tornado Cash, but that have built-in protections against money laundering. The proposed protocol would allow users to deposit funds to be mixed within a shared pool. Users could then withdraw funds to a fresh wallet, severing the link between wallets. In other words, basic mixer functionality to provide privacy to users. The twist is that

the protocol would use zero-knowledge proofs to allow users to prove that their funds came from a particular set of deposits. By restricting the ability to deposit into these pools to users who can provide a known legal source of funds, the protocol can ensure that no illicit funds are mixed. The paper's abstract says that, quote, the core idea of the proposal is to allow users to publish a zero-knowledge proof, demonstrating that their funds do not originate from known unlawful sources, without publicly revealing their entire transaction graph. The paper goes on to explain that, quote, all users with quote unquote good assets have strong incentives

and the ability to prove their membership with a good-only association set. Bad actors, on the other hand, will not be able to provide that proof. Now, the proposal builds on prior comments from Vitalik, where he stated that Tornado Cash was a good privacy solution but had limited options to disassociate between deposits from good actors and bad actors on the network. Vitalik's opinion is that the regulatory crackdowns on the illicit use of crypto networks are inevitable, and so the industry should be proactive in demonstrating that compliant privacy tools can be built. The paper argues that, quote,

"...in many cases, privacy and regulatory compliance are perceived as incompatible. This paper suggests that this does not necessarily have to be the case, if the privacy enhancing protocol enables its users to prove certain properties regarding the origin of their funds. Introducing the paper, Amin wrote, Privacy Pools is an open-source project attempting to fix the most important flaw in Tornado Cash. Tornado Cash users were not able to proveably disassociate from illicit funds, except by revealing their entire transaction history, which only a few did. With privacy pools, users can publish zero-knowledge proofs that their withdrawal originated from

an association set that excludes known illicit deposits. In theory, this allows users to prove regulatory compliance and still maintain privacy while using public blockchains. The importance of this paper is difficult to overstate. As crypto builds toward a world where financial intermediaries are optional, it is also our responsibility to engage regulators and implement new compliance tools designed for self-custody. So what were people's responses to this? Dragonfly managing partner Hasib Qureshi says, here's my issue with it. Privacy pools would still allow North Korea or any bad actor to use the protocol. They just wouldn't be able to generate high-quality white-list proofs. They could still generate low-quality or stale whitelist proofs. Is that enough to satisfy the DOJ's

bar for compliance? Note that Tornado Cash had a compliance tool that allowed any user to prove their chain of custody to a third party, such as to an exchange or law enforcement. They also blocked sanctioned addresses from the front end. Even when blocking OFAC sanctioned addresses from the front end and implementing this ability for depositors to prove their provenance, the DOJ concluded that they were nevertheless liable for how Tornado was being used by Lazarus Group. All that said, obviously, there are other facts to the Tornado case. And I'm not a lawyer, so this is not legal advice.

And there are a lot of cool ideas in this paper. But I'm not sure this is going to be a sufficient improvement from the perspective of the DOJ. So basically, Haseeb is saying lots of cool stuff in here. but if the question is whether the U.S. government is cool with this, he remains skeptical. Interestingly, Austin Campbell responded and said, it might not fully satisfy the DOJ, but that's not the bar. The bar is satisfying a judge. I think the actual success here would depend upon the adoption across the ecosystem of tools to make sure people only interact with the high-quality actors if someone has touched this. Now, another line of conversation is that this is way too much

compromise when it comes to critical issues of privacy. Matt Carrallo tweets, this is absolutely awful. Anyone working on this should seriously reconsider why they're working on quote-unquote cryptocurrency at all. Enabling more effective global automated blocking of coins based on things like chain aliasis is breaking the biggest reasons why cryptocurrency exists. Now, Matt's post did a great job of pinpointing a key critique and getting people to respond to that. A lot of the discussion in the comments then becomes about what compromise people should be willing to take. Masari's Ryan Selkis responds, serious question. Do you think we have a shot at anonymous transactions at scale? If so, why isn't Bitcoin forking in confidential transactions?

Why are the privacy coins getting banned in Europe? This is the most elegant solution I've seen, to be honest. Scott Lewis writes, I think it makes more sense to go halfway first. The next best competitor is a CBDC, run on one computer by the government. Isolating crypto too aggressively will leave the entire global citizenry in a much worse place. We have to be pragmatic if we want to win. Rainier-Styles Grant toes of middle line saying, Not quite perfect, not quite terrible.

But we're back to trusting forensics for the association set. I personally think forensics is inescapable because you need legal indemnity in 2023, but we need extreme scrutiny of on-chain analytics companies. We need chain analytics and it's going to be forced on us, but these people need to be regulated to the gills and hilt. The burden of proof needs to be immense, and it needs to be internationally situated outside of exclusive American diplomacy. Now, there is a ton to debate in here, and debate the community certainly has. Some questions are extremely political, whether one thinks there should be any compromises in this area, or whether cypherpunks need to keep fighting for true privacy when it comes to transactions.

Some are really excited and engaged that there are promatic solutions being offered by people from within the industry. Others are pointing out specific technical problems, and in some cases recommending different approaches. Ultimately, I find myself agreeing with Bill Hughes when he writes, We need more people proposing sharp technical solutions to problems we currently solve in a terrible no-good way because we have stopped looking for alternatives. The pattern in general of things becoming real in the world is when debates move from theoretical to practical and specific. And so to the extent that this is what that represents, I think it's at least in that shift in the conversation, pretty cool thing. However, that is going to do it for today's episode. I appreciate you guys listening

as always. Until tomorrow, be safe and take care of each other. Peace.