The Breakdown - The Tornado Cash Lawsuit Advances

Episode Date: May 27, 2023

Today on The Breakdown, NLW covers: Tornado Cash lawsuit and hack The latest in Ledger The Debt Ceiling debate nears a conclusion Enjoying this content? SUBSCRIBE to the Podcast: https://pod.link/1438693620 Watch on YouTube: https://www.youtube.com/nathanielwhittemorecrypto Subscribeto 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, May 26th, and today we are moving the weekly recap up one day. Before we get into that, a quick note. If you were enjoying the breakdown, please 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, friends, well, those of you who are in America know that this is Memorial Day weekend. That is the traditional kickoff of summer. And my family, like so many of you, are traveling a little bit to celebrate the beginning of the new season. Functionally, that means there will not be regular breakdown episodes on Sunday and on Monday. And so I'll be moving Long Read Sunday up to Saturday. And that means I'm moving the weekly recap up to today. Now, there are a number of situations from earlier in the week to catch up on, including Ledger, including the debt ceiling, so let's dive right in. Hardware wallet manufacturer

ledger have spent the past week on damage control, trying to repair the trust lost after they announced their new social recovery feature, Ledger Recovery. The feature, which would allow a group of three companies to store an encrypted partial copy of users' private keys and assist with wallet recovery, appeared to many to change the fundamental assumptions made when using a hardware wallet. That assumption, of course, is that a user's keys could never leave the device. In a blog post on Tuesday, the Ledger CEO discussed the PR disaster. Ledger never compromises on security, he wrote. Our unintentional communication mistake took everyone by surprise

and affected our customer's ability to accurately understand Ledger recover, its role for the growing crypto community, and for Ledger's future offering. Ledger's CTO, Charles Gillamay, had insisted from the beginning that the security tradeoff being made was acceptable and that new users with less experience handling private keys would appreciate that additional layer of safety in a fail-safe recovery option. Also in a blog post on Tuesday, he said, we believe wholeheartedly in the need for a service like Ledger Recovery.

The main pain point for crypto self-custody adoption is precisely the problem of seed phrase recovery. Now, part of the issue was, of course, that Ledger's firmware is closed source, meaning that experts aren't able to audit the code to ensure that keys can only leave the device when a user activates the feature. To that end, the CEO Gothier said that Ledger would provide additional information about how Ledger Recovery works to calm fears. He wrote, We will open source the Ledger Recovery Protocol,

enabling the community to have as much choice as possible over your self-custody, in addition to the service being fully optional. We are doing this for more transparency going forward. This has not changed the security of your device. Now, one potential issue with storing sharded keys with trusted companies is the risk that governments could subpoena those keys and decryp them. While the scenario is somewhat theoretical, requiring governments to subpoena companies across three separate jurisdictions, and requiring their assistance with the decryption process, the risk was serious enough to be put under the microscope. Appearing on what Bitcoin did this week, Ledger's CEO acknowledged that the risk factor was real, but argued that it was unlikely to occur, stating, quote, the only concern really is

if we get subpoenaed by a government to say now this user specifically, we would like you to retrieve the three shards, etc. He said that subpoenas were rare, almost always in cases of terrorism financing or drug trafficking. It's not true that the average person gets subpoenaed every day, he said. Now, the community was still pretty skeptical of this. Zero X Fubar wrote, Ledger is now doing a podcast tour to tell the world that they plan to hand over your private keys if a government asks them. Regardless of the PR Roadshow, Ledger has for now delayed the release of the feature. Next, an update on Tornado Cash. The U.S. lawsuit challenging the validity of the tornado cash sanctions has progressed to its next stage as plaintiffs filed their response. The argument being made is

quite technical, but hinges on the idea that the Treasury has sanctioned a protocol rather than sticking to the powers granted to it by Congress, which are limited to sanctioning people organizations and the property related to them. In addition, sanctioned individuals must be foreign nationals. The sanctions declaration, its claimed, failed to identify any entity that could be clearly defined that way. Even on a broad reading that the underlying tornado cash governance Dow is the sanctioned entity, it's difficult to claim that organization clearly belongs to any particular foreign jurisdiction. Regarding whether there is some property involved in the sanctions process, plaintiffs claim that, quote, the department has failed to establish that the immutable

smart contracts can be owned. Given the seriousness, of sanctions law, the plaintiffs argue that an extremely narrow reading of legislation is appropriate, adding that, quote, the requirement of property is central to the legislation, not a loophole. If Congress wishes to expand the legislation to authorize the regulation of ownerless software, it may do so. They also argue that tornado cash does not meet the definition of an unincorporated entity. There is nothing in the record, they wrote, to suggest that those token holders have combined to execute the supposed common purpose of operating, promoting, or updating the tornado cash privacy protocol. And if those claims fail, the plaintiffs

falling back on a constitutional argument. Again, they write, the Department's actions violate the First Amendment's free speech clause as it prohibits plaintiffs and thousands of other law-abiding American citizens from interacting with open-source code to engage in a wide range of speech protected by the First Amendment. The plaintiffs argued that the Treasury's characterization of Tornado Cash as a tool for money laundering is weak, noting that the Treasury only gave, quote, three examples of money laundering that have been found from millions of transactions. Meanwhile, in the Netherlands, Tornado Cash developer Alexei Perzev, has been granted the to cross-examine blockchain analytics firm Chainalysis as he fights charges of money laundering.

Perzsev was arrested in August just days after the tornado cash sanctions were announced. In presenting his defense, Pertsev will now be allowed to question the evidence presented by chain aliasis, along with their methods for gathering information from the blockchain and the conclusion they present using that information. In some jurisdictions, expert witnesses are not able to cross-examine as their evidence is presumed to be limited to a fact-based presentation made to benefit the court rather than a subjective assessment of the situation in question. There has been some criticism of chain analysis's methods,

complaining that their process is too opaque to be properly scrutinized and verified, and that the procedure by which they trace on-chain transactions often involves numerous assumptions about identity rather than merely presenting concrete proof. In Perzzev's case, he's being charged with money laundering but claims not to have financially benefited from developing the protocol. Outside the courtroom, Pertssev's lawyer Keith Chang said he was happy that he would be allowed to directly ask chain alysis in writing about its methods.

Chen claimed there were some technically unsatisfactory issues with chain analysis as evidence, which include discussions of user agents which do not exist on the Ethereum blockchain. Perzev has been bailed to await trial in home detention. Now, as for the actual Tornado Cash Protocol, it appears to be entering a death spiral at least as far as its governance is concerned. The protocol is an immutable smart contract on the Ethereum network, so it continued to remain operational despite the imposition of sanctions. However, last week, the Dow which holds the keys to the smart contract, was taken over

in a governance attack. Nifty noon on May 22nd tweeted, Tornado Cash Governance effectively ceased to exist on 520, 2023, at 725-11 UTC. As through a malicious proposal, an attacker granted them 1.2 million votes. So this attacker took over control of the Dow and began minting additional governance tokens, but initially declined to steal Ethereum from the Dow Treasury. They even floated a proposal to revert all of the malicious changes performed during the week. On Wednesday night, the attacker moved 100-Eth and 38,000 governance tokens, to a new address. The actual tornado cash protocol is unaffected, and no user funds are believed to be

accessible to the attacker. However, users of tornado cash are warned that the attack could upgrade the smart contract using their governance control, a process that would take about seven days to complete. Even the dull days in crypto are not dull. Now shifting back to the macro, debt-sealing negotiations moved along on Thursday with multiple sources reporting that we could be close to a resolution. There now appears to be the rough sketch of a deal coming together, with details still to be hashed out and a final agreement reached. This would, of course, allow the government to extend its debt limit beyond the current level of $31.4 trillion and resume net issuance of bonds into the market. President Biden and Republican House Speaker McCarthy will continue to move towards

this goal, with McCarthy flagging that he expects to work through this holiday weekend to pin down details. We so appreciate your sacrifice. McCarthy told gathered reporters at the Capitol on Thursday, we know where our differences lie. We do not have an agreement yet. We knew this would not be easy. It's hard, but we're working. And we're going to continue to work. work till we get this done. Now, according to anonymous sources, the cornerstone of the deal is a cap on government spending over the next two years. The size of that cap is one of the major details remaining to be negotiated. The deal would include a measure to upgrade the nation's electricity grid, which is a cornerstone of the Biden administration's climate policy. The trade-off is that permits for pipelines

and other fossil fuel projects would be fast-tracked, a major concession for GOP negotiators. The controversial IRS funding measure would be downsized, with the tax agency taking a $10 billion dollar haircut on their $80 billion funding package. Democrats had argued that this funding would pay for itself, with the president signaling earlier in the week that he would not accept any deal that benefits tax cheats and wealthy crypto traders. Now, I did a whole show yesterday about how crypto has entered the political discourse, what it means that new Republican candidate Ron DeSantis has pledged to protect Bitcoin, what it means that RFK Jr's Dark Horse Challenge to Biden has embraced Bitcoin. But in any case, you can see here that it's become just another partisan cudgel, at least when it

comes to the debt debate. National security spending was another major issue during the negotiations, with Republicans reportedly pushing for an even larger increase than the $886.3 billion put forward in the president's budget. That number represents a 3.3% increase on current levels. GOP negotiators have apparently abandoned this push for a military buildup, with the Pentagon receiving $842 billion of that figure as originally budgeted. McCarthy indicated to reporters that some in his party would be disappointed by this concession. I know people would like to spend more, but this is where we'd. are. Defense spending already makes up more than half of the U.S. discretionary budget, leading some

Democrats to question the logic of demanding additional spending in that sector while proposing deep cuts to social programs. Overall, the deal appears to be dramatically reduced from the original Republican position. Early in the negotiations, Republicans had reportedly put 10 years of spending caps on the table. The House Freedom Caucus made up of the most ideologically extreme members of the GOP, balked at the idea of a smaller deal, and penned a letter to McCarthy on Thursday demanding that he refused to compromise. Republicans, meanwhile, will need the support of at least some Senate Democrats to pass any deal, making a tough stance a little indefensible unless there is a willingness to push the nation over the brink into an actual debt default scenario. As of now, Tuesday

is currently looking as the likely day for a vote in the House, with the bill needing to be fast-tracked through the Senate and onto the president's desk ahead of June 1st. That is when the Treasury is projected to run out of cash. Now, there was some speculation during the week as to whether there was some wiggle room with the so-called X-date proposed earlier this month by Treasury Secretary Janet Yellen. Some commentators suspected the X-Date had been exaggerated to push negotiators to move quickly to close a deal. However, checking in on the Treasury's cash balance, the coffers are looking precariously low. The Treasury had just $49.5 billion remaining on Wednesday, down from $76.5 billion the previous billion on May 12th. Wednesday's spending was the biggest one-day drop in the cash

balance since May 15th, with government accounts now sitting on their lowest balance since December 2021. A TD security strategist said, this just shows you how close to the abyss we're getting. While some in Congress questioned the Treasury's math, I think the cash balances speak volumes. We're going to be going over the cliff very soon. Honestly, we're on borrowed time. On Wednesday, Yellen once again warned of the risk of a rapidly approaching default, noting that signs of market stress were beginning to show up as the Treasury's account dwindled. One month Treasury bills traded with interest rates as high as 5.7% on Thursday, a remarkable 45% basis points above the current Fed funds rate. This, of course, reflects the risk that holders may not

get paid on time. Representative Patrick McHenry, one of the chief negotiators for the Republicans, was asked on Thursday night what he would tell investors about the progress of the talks. He quipped that he's, quote, glad the markets closed. On Wednesday, Ratings Agency Fitch had put the AAA credit rating for government debt on watch for a potential downgrade. The White House and Treasury said this move demonstrated the need for a hasty resolution to the debt standoff. McCarthy, however, said he didn't need ratings agencies to remind him of the importance of closing a deal in a timely manner. The last time the U.S. debt was downgraded in 2011, the move sparked a massive sell-off in risk markets. The S&P 500 took a 15% drawdown over the following two months, while gold and long-maturity

bonds outperformed as investors searched for a safe haven. Gold was up 25% and long-maturity bonds were up 16%. Notably, the 2011 downgrade occurred a few days after the debt ceiling had been raised, reflective of analysis from rating agencies that fiscal policy settings were unsustainable moving forward rather than a risk of outright default. So once the debt ceiling impasse is resolved, the next big question will be the effect on markets as the Treasury refills its accounts. Over the last two years, the Treasury has maintained a buffer of around $500 billion in cash, which will need to be funded by a massive issuance of new government debt. As this new issuance is funded by private investors, it could represent a significant liquidity drain across other markets.

Uri and Timmer, the director of global macro at Fidelity, said, This is where it gets interesting. When the debt ceiling gets raised and the Treasury can start issuing debt again, it will likely rebuild its cash balance at the Fed. How? By not spending the coupon payments that accumulate on the Fed's balance sheet. Ironically, that could be seen as a drag on the overall liquidity profile at a time when QT will still be in force.

It should be a net negative for the market, even though the headline of a raised debt ceiling will be welcome news. Blockware macro analyst Blake Davis wrote, With all this talk of the debt ceiling, it's important to understand what happens if and when a deal is struck. The Treasury's general account is nearly depleted. Once a deal is struck, the Treasury will draw liquidity from the system by issuing bonds to refill their account. This compression of monetary liquidity, combined with the Fed's QT regime, has the potential to create a severe liquidity crisis for U.S. and global markets alike. The Treasury market has begun pricing this in, with one-month yield spiking relative to the three-month in recent sessions.

Now, for those of you who are watching markets this week, you'll note that the one other countervailing force was, of course, AI stocks. Invidia gave a very impressive and surprising earnings report. They revised their quarter one earnings up to $7.1 billion or so, which was higher than what analysts expected at $6.5 billion. And more than that, they said current quarter profits were likely to be over $11 billion, which was more than 50% higher than the $7 billion or so that analysts had projected. This triggered an enormous rally in Nvidia stock. It was up something like 28% in a single day and is encroaching on a trillion dollar valuation. Invidia is now the fifth biggest company on Wall Street. Now, it wasn't just Nvidia, though, people recognize that the underlying

reason that their stock is surging is the broader shift into AI world. Other companies like C3 and Palantir were also up meaningful percentages on the week. This has caused some to speculate that AI stocks in the short term and AI itself in the long term could be a solved to the problems of Wall Street. In the short term, of course, they're talking about the performance of these companies, but in the long term, they're talking about how it might change productivity. Paul Tudor Jones called it potentially one of the biggest productivity booms in the last 75 years. This is a theme that obviously cuts across both the breakdown and the AI breakdown, so is something that I'm watching extra closely. If you're interested in that topic, I would suggest you go check out the AI breakdown.

It's got a combination of this type of macro analysis, some more detailed surface level tool discussion, and you can find all the information you need about that on breakdown.network. Anyways, guys, that is it for this one day early weekly recap. I hope that wherever you are, even if you're not in the U.S., you are looking forward to the weekend and good times ahead. I appreciate you listening as always, and until next time, be safe and take care of each other. Peace.