The Breakdown - The US Government Sends Mixed Signals on Digital Currency Privacy

Episode Date: February 13, 2020

To look at the US Government, it is the best of times and the worst of times for personal financial privacy.  On the one hand, in comments before the Senate Financial Services Committee, Treasury Secretary Steven Mnuchin says that FINCEN is planning more strict regulations around anti-money laundering and crypto.  At the same time, the CEO of DropBit was arrested on money laundering charges around a bitcoin mixing service he ran between 2014 and 2017.  In this new enforcement regime, one of the government’s major partners is Chainalysis, who have seen more than $10m in Federal agency contracts since 2015.  Yet privacy advocates are also surprisingly enthused by comments from Fed chair Jerome Powell, who suggested in testimony to Congress that any potential US digital dollar would need to be privacy preserving.

Welcome back to The Breakdown, an everyday analysis breaking down the most important stories in Bitcoin, crypto, and beyond, with your host, NLW. The Breakdown is distributed by CoinDesk. Welcome back to The Breakdown. It is Thursday, February 13th, and today we are going to be talking about one of the most significant and contentious issues in cryptocurrency, privacy. Privacy is at the heart of debates around cryptocurrencies for a couple reasons. On the one hand, there is a question of law enforcement. The chief concern over the 10-year history of Bitcoin and other cryptos that regulators have and that enforcement agencies have is that cryptocurrencies can be used to move around financial controls like anti-money laundering protections that are used to fight terrorism, drug trafficking,

and so much more. Now, on the other hand, users of cryptocurrencies are worried about things like encroaching government surveillance and the ability for governments to have better near-perfect visibility into their citizens' financial behavior. This brings with it a huge number of concerns about abuses, and so cryptocurrencies which are potentially harder to trace are incredibly important, especially in the context of a society and a world that is moving increasingly away from cash. Cash today remains the most private way of transacting. However, governments around the world are pushing to move to a cashless world.

Big corporates like Visa and MasterCard are obviously invested heavily in a world where there is no cash. And as the conversation about government digital currencies heats up, so too is the conversation about surveillance becoming even more important. So on the one hand, you have concerns from regulators about privacy as it potentially flouts and gets around important tools of law enforcement, and on the other you have concerns from privacy advocates, and really anyone who wants to live in a free liberty-having society about government surveillance and the potential of abuse in a world that has no cash and only digital currencies. Well, the last 48 hours or so have had some very interesting developments in

this space. So let's look at what's happened. At a Wednesday hearing of the Senate Finance Committee, Treasury Secretary Steve Mnuchin said that FinCEN, which is the nation's financial authority, it's the financial watchdog, was getting ready to roll out some what they called, quote, significant new requirements around crypto. The comments were in response to a question from Senator Maggie Hassan from New Hampshire who asked, quote, how will the Treasury's proposed budget increase in monitoring suspicious cryptocurrency transactions and prosecuting terrorists and other criminal organizations financing illicit activities with cryptocurrency. Neuchin said, we want to make sure that the technology moves forward, but on the other hand,

we want to make sure that cryptocurrencies aren't used for the equivalent of old Swiss secret number bank accounts. So in some ways, this is nothing new. This has been the line from the Department of the Treasury for a long time, and the narrative of cryptocurrencies as tools for criminals continues to persist even a decade later. It is the dominant narrative, right? When Donald Trump tweeted about Bitcoin last year, which, as we all know, was really more of an excuse to tweet about Libra, he made the same argument. He grabbed that old line of Bitcoin and cryptocurrencies being used by criminals. This is the most persistent fud that our industry has to deal with. And it doesn't help that in the last month we've seen major New York Times profiles talking about the rise in

criminal activity on Bitcoin and all this sort of thing. What is notable about Secretary Mnuchin's comments is that it comes on the back of a proposed budget for 2021 that does seem to indicate that there's going to be even more emphasis on this sort of enforcement activity and on this sort of regulatory battle. Coincidentally, and as if to make the point about growing focus on enforcement of anti-money laundering protections, we at the same time got news that the CEO of Dropbit had been arrested for money laundering in a major case. Dropbit is a crypto wallet provider, right? It is a Venmo for crypto. It's a send Bitcoin, get-bit type of experience. So this came as something of a surprise. Late last night on Wednesday,

news broke that Larry Dean Harmon, the CEO of Dropbit, had been indicted for supposedly laundering something like $311 million worth of Bitcoin around Darknet transactions. So the accusation is basically that between 2014 and 2017, Harmon laundered at least 354,468 Bitcoins via a mixing service called Helix. At current prices then, the Bitcoins would have been worth $311 million, but at today's prices, they're worth over $3.7 billion. So we're talking about a huge volume of activity. Now, I and many in the industry heard about this from Peter McCormick, who has had Dropbit as a sponsor. So Peter yesterday wrote, read Dropbit. CEO Larry Harmon has been arrested and is currently in Youngstown, Ohio federal jail, charged with conspiracy to launder money

instruments operating an unlicensed money transmitter business he faces up to 30 years. Speaking to Larry's brother, his source of funds is central to his arrest. Larry ran a tool called Helix, allowing users to mix coins for better Bitcoin privacy. Some customers also use dark markets such as Alfa Bay, Agora market, nucleus, and dream market. Larry has been denied bond as he has considered a flight risk even though they have confiscated all of his assets. Also, all coin ninja assets have been frozen. In terms of the Dropbit app, despite the accounts being frozen, Larry's brother and the developers

are using their money in time to keep it running. Federal prosecutors are seeking millions of dollars in financial penalties and his properties. I am currently digesting this information myself and would appreciate thoughts from the community. I personally support financial privacy and individual liberty. I have paused all adverts for Dropbit on the podcast for now. I will be scheduling an interview with Larry's brother and lawyer and will be looking to also meet and talk to Larry. So the central question here or the device of the potential infraction was a mixing service. And the reason that mixing services matter is that they basically allow users to obscure the trail of Bitcoin. Bitcoin is, as many will point out, not a completely anonymous cryptocurrency, right? It is not an untraceable cryptocurrency.

It is something where there is a record, but it is a pseudo-anomized record. However, if you have someone's public key, you can see all of the transactions that relate to that public key. and that's how law enforcement can use Bitcoin as a tool actually to trace illicit transactions. Mixers obfuscicate that trail of transactions and so they are very non-appreciated by authorities. Of course, and as we intimated at the beginning of this podcast, mixers are seen as potentially an important tool for people who value their own privacy. The challenge with mixers is basically that people who use them legitimately just as a way to not be surveilled, get lumped in and mixed, if you will, with people who use them for more illicit

purposes. Researcher and writer Ian Grigg wrote about this exact problem. He says, A problem with private money services is that even though honest users need such protection, some people use it to do illegal things. Unfortunately, privacy and money is a hard topic, having challenged the best brains in the business and nobody's really cracked the societal dilemma. E.G. David Chom's e.cash was somewhat private and only operated by bank. When MTV discovered porn shops, they shut it down. Privacy is set for a disastrous year. Expect mixers to be arrested and closed. Expect privacy coins to be delisted and attacked. The storm will eventually abate because there are other forces moving that will break it.

But in the meantime, don't be in its way. Okay, so now we've seen that the Fed and the Treasury are talking a bigger game about enforcement around AML and just cryptocurrency being used for illicit transactions in general. We're also seeing that come to practice in enforcement actions like this one against the Dropbit CEO. But how is this happening? How are law enforcement agencies actually able to dig into cryptocurrency forensics? Well, for that, they are partnering with cryptocurrency businesses that specialize in on-chain analysis. CoinDesk this week published an extensive review of Chainalysis's relationship with the U.S. government.

Now, Chainalysis is by far the biggest provider of on-chain data forensic services for the U.S. government. It's not even close in terms of their competitors, of whom there are a number. But it's fascinating to see just how significantly this business has grown. Their first contract was a $9,000 data software contract with the FBI, and that was in 2015. By the next year, they were working with five agencies. By 2017, they had over a million dollars in contracts. 2018 and 2019, they saw those numbers go up even more. And at this point, federal agencies have spent something like $10,690,000 with chain aliasis. What's more, if you include contract extensions that are possible in these contracts, they stand to make up to $14 million.

Additionally, the number of agencies using this has just ballooned, right? The current total includes the CFTC, the DEA, the FBI, ICE, the IRS, the SEC, and even the TSA. Danny Nelson, the author of the Coin Desk piece, makes the comparison to Palantir, the secretive Silicon Valley data company that has contracts up and down the government, and I think that there is something apt about the comparison. it wouldn't be possible for these agencies to do this level of forensic and protection work without the support of these types of companies. Now, there's a couple different ways to look at this, and I feel like the industry has a real strong bifurcated feeling about these intelligence tools.

On the one hand, there is a frustration in the sense that cryptocurrencies are meant to be a protection of individual liberty and privacy, and so when they are used against their users in some way, at least that's what it feels like, it can be easy to target the companies that are enabling agencies to do that. The flip side is that the better these tools get for actually providing forensic analysis that can identify real illicit transactions, the more it protects the ability for other people to use it in non-elicit ways. So there is a real give and take here. And of course, a lot of the question comes down to trust around how power is being used or abused. And of course, is an industry that is not known for its trust. In fact, it's predicated upon the idea of don't trust

verify. Now, just to show how prevalent these tools are getting, two more pieces of news. Tether announced that it was partnering with chain analysis as a way to bolster its anti-money laundering tools, right, to be seen as more legitimate. Tether's CTO said, this solution allows us to ensure a secure compliance program that fosters trust with regulators, law enforcement agencies, and users. This is achieved without sharing our users identifying information. As such, data is only kept on our servers. And as I mentioned, it's not just chain analysis in this space. They are by far the most successful when it comes to winning U.S. government contracts, but that doesn't mean that there aren't other big players. A Liptic is a competitive company that has been raising

a Series B of something like $28 million. And just today, it was announced that they had received an additional $5 million from Wells Fargo's strategic investment arm, and the elliptic product that they were really interested in was basically something that provides a, quote, bill of health for crypto exchanges. So it allows banks to be confident that cryptocurrency exchanges are actually conducting the sort of K-Y-C-know-your-c customer checks that they're required to, and it allows banks better insights into the regulations that they're supposed to be regulated by in the first place. The upshot of this potentially is that banking relationships could become much easier for exchanges and other core parts of the crypto industry infrastructure. It has been notoriously hard to be banked

if you are a crypto exchange or a crypto business. So the benefit, the upside of this better regulation, better formalization of all of these processes is that companies can actually function. So if you take a step back and look at the net of this, there is an inevitable push to reign in the wild west nature of cryptocurrencies. And basically, you can kind of read all of this as saying that if these technologies are going to exist, if they're going to be real, if they're not going to just fade away, as we might have hoped, and obviously I'm speaking here from the perspective of regulators, if they are going to be here and be a force, we are going to make sure that they fall in line with our regulatory regimes, that they do not allow people to work outside the

system that we have created. Now, within that there are going to be many battles, right? These are gray areas that are much more complicated than many other financial technologies. So you can expect there to continue to be some amount of back and forth and confusion and challenge along the way. But regulators are making it clear that there is a new sheriff in town, it's the old sheriff of them, and that they're going to get their law on. I want to shift now, though, to a slightly different side of this privacy debate, one that relates to the emergent phenomenon of central bank digital currencies and the U.S.'s role within that new area. The part of the crypto industry

that is paying attention to CBDCs and the development of these types of digital currencies around the world, really, the concern has to do with financial surveillance and the ability for governments that are issuing digital fiat effectively to effortless. surveil all transactions going forward. This conversation has accelerated since both Facebook announced Libra, and additionally, China responded aggressively to Libra in the context of their own forthcoming digital yuan. China is clearly trying to move into the leadership position in this new arena of economic warfare and put out a digital currency before anyone else can. And this has many people, many governments worried. News last week that I think we talked about here, Japan is pushing, pushing,

pushing the Fed to actually get their digital dollar strategy together to ward off the influence of China in governments around the world. Just last week, after months of being dismissive, we saw the first indications from the Fed that there was actual more attention being paid in this domain. Fed Governor Lail Braynard gave a speech at Stanford where she explicitly acknowledged, that the Fed was researching digital currencies. Now, just this week, Fed chairman Jerome Powell was testifying before Congress and was asked about digital currencies. Specifically, he was asked whether the Fed had any, quote, visibility into China's progress around CBDCs. He said, yes, we certainly have that, but they're in a completely different institutional context. For example,

the idea of having a ledger where you know everybody's payments, that's not something that would be particularly attractive in the United States context. It's not a problem in China. So people in the crypto industry have picked up on this very quickly as an indicator that if the U.S. is to pursue a digital dollar type project, it would be somewhat privacy preserving, at least given lip service to that. This is really interesting because Christopher Giancarlo, the ex-CFTC chair who's known around these parts as Crypto Dad, also recently announced what he calls the digital dollar project. And it is a collaboration with Accenture to actually design or push the Fed to design a digital dollar. And in an interview with CoinDesk's Michael Casey at Davos, he said explicitly that the reason that he was

so passionate about this project is that he believes that in the fight for the battle of the future of money, if you have on the one hand corporations like Facebook who have an incentive to see every transaction because they want to use that data for their own business purposes, and on the other hand, authoritarian governments like China who want to see every transaction data because they use it for their own authoritarian purposes, having someone like the U.S. that is constitutionally prevented from tracking data in that way, that has a constitutional mandate not to surveil their citizens in that way, is a very improved third option. We didn't get much from Jerome Powell, but what we did get seems to be,

in line with that argument that if there were to be a digital dollar, and this is a big if, the Fed has made clear that their position is different because the dollar is in the world leadership position, the world reserve currency position with still a very strong, robust cash system. But if the Fed were to pursue a digital dollar, it seems to be the thinking that it would have to have some amount of privacy protection built in. Now, skeptics and cynics will say that it doesn't matter what the Constitution says if the ability to surveil is there. You can expect government agencies to do it. What's more, we certainly have evidence that right now government agencies care very much

about the ability to surveil electronic communication. There is an ongoing battle between Apple and Attorney General Barr around end-to-end encryption in apps like WhatsApp and Facebook Messenger that is not finished and is certainly not very encouraging in terms of our government's beliefs about privacy. However, at least the lip service being given to this idea is more reassuring than it might otherwise have been. And I think that's why people in the crypto industry were so interested and, frankly, a little surprised to see these comments coming out of the Fed chair just this week. So what's the net takeaway about the state of privacy? Well, honestly, we have a bunch of

divergent conditions, frankly. On the one hand, there is no doubt that we are seeing more aggressive enforcement and a way that is promised to not only continue but accelerate. I think that the emergence of Libra, the continued persistence of Bitcoin, all of these factors combined, regulators are finally accepting that these are forces that are here to stay. Cryptocurrencies are not going away. Because of that, you can expect them to bite back and make sure that those projects, those companies that are built in this ecosystem are playing by their set of rules. That could come with pretty severe impingments on personal privacy. On the flip side, we're seeing that the emergence of China in particular as a force in the digital currency space is making perhaps the U.S. regulatory regime

think about its role as a more liberty-providing or liberty-supporting version of a digital currency provider. That's a notable thing, even if we're not quite ready to be clear that it's a positive thing or a sentiment that we exactly trust to come to being when applied. So that's the state of it for now. This is going to be one of the most important conversations, I think, not just this year and not just in our industry, but across industries. We are living in fundamentally new times when it comes to the question of privacy versus surveillance and the best thing we can do is to stay engaged, to make sure we do not go passively, quietly into the good night, to demand that privacy is an issue that our government takes seriously. There are

few legacies of the U.S. government that are more profound and more at the core of who this country believes itself to be than individual liberty. And we could very easily find ourselves in a scenario where those values are threatened simply by the greater availability of data across all spectrums, but in the one that we're talking about now, the financial realm. So let's make sure that that doesn't happen. That is the breakdown for today. I hope you enjoyed it. Let me know what you think. Hit me up on Twitter at NLW, and I will be back tomorrow breaking down the news. See you then.