Implications of the Tornado Cash Scandal
VYSYN Weekly Release #111: Tornado Cash sanction increases the appeal of digital assets and encourages adoption
The U.S. government's latest move to sanction the open-source code underlying the Tornado Cash privacy protocol may have unintended consequences. The seemingly honest attempt to stop bad actors is poised to backfire, undermining the privacy of innocent users. At the same time, however, the sanction is highlighting the core principles of the digital asset industry and spurs the mainstream adoption of digital assets.
This edition of the VYSYN Release will offer a comprehensive analysis of the Tornado Cash sanction and the effect it will have on both the crypto and non-crypto tech ecosystems. We will also consider the crypto community's response to the sanction and what it will mean for the digital asset industry.
U.S. government sanctions privacy protocol Tornado Cash
The U.S. government recently clamped down on the Ethereum-based, open-source, privacy protocol Tornado Cash alleging that it is being used to conduct illegal activities. Tornado Cash helps crypto holders maintain their anonymity by scrambling information trails on the blockchain.
Contrary to popular belief, while crypto transactions are pseudonymous, they are not anonymous. When someone conducts a crypto transaction, the transaction record is immutably etched into the blockchain, leaving crumbs that allow investigators or bad actors to trace the identity of the parties involved. This level of transparency led to an increase in the demand for more privacy solutions, including crypto mixers like Tornado Cash.
However, as the popularity and use of cryptocurrencies grew, crypto mixers became a go-to tool for criminals to anonymously cash out the proceeds of their crimes. A recent report from Chainalysis pointed out that the use of crypto mixers for processing transactions has increased significantly in 2022. The report noted that about 23% of all transactions conducted using mixers were sent from illegal addresses, up from the 12% recorded in the whole of 2021.
As per the Chainalysis report, one of the major drivers of this uptick in illicit transactions using mixers is the increased activity of hackers. The hackers had reportedly used Tornado Cash to launder the over $600 million stolen from Axie Infinity's Ronin bridge. Thus, in an attempt to crack down on criminals, the Treasury Department's Office of Foreign Affairs Control (OFAC) placed Tornado Cash and related smart contract wallet addresses on their Specially Designated Nationals (SDN) list. This is the first time lines of code have been sanctioned.
The agency argued that Tornado Cash has played a central role in the laundering of more than $7 billion worth of digital assets, adding that any Americans who interact with those addresses now may face criminal penalties. In the official statement, OFAC called Tornado Cash "a significant threat to the national security" of the United States, alleging that it has been used repeatedly by North Korean hackers to launder money from multiple million-dollar thefts.
The sanction on Tornado Cash has elicited a chain reaction, with several centralized entities responding to the Treasury's decision. For one, Github, the software development platform owned by Microsoft, deleted the accounts of Tornado Cash developers following the sanction. Additionally, the popular stablecoin issuer, Circle has frozen over $4 million worth of USDC linked to a total of 82 Tornado Cash addresses.
The crypto community reacts to the sanction
The decision by OFAC to sanction Tornado Cash drew backlash from the crypto community, with several experts remarking that the sanction is a governmental overstep that runs contrary to their core values of privacy and autonomy. Experts noted that the sanction will have adverse effects, attracting unintended consequences. In a recent tweet, the crypto lawyer Collins Belton called it "the most significant legal action that has occurred in crypto" and warned that it could elicit "absolutely gargantuan ripple effects."
While the Treasury argues that Tornado Cash was used to launder more than $7 billion worth of ill-gotten gains, the data analytics firm Elliptic puts the figure closer to $1.5 billion. The firm noted that out of the $7 billion worth of digital assets sent via Tornado Cash, $5.5 billion were legal transactions.
The service has proven to be useful for those who live under oppressive governments. Ethereum's founder, Vitalik Buterin, recently revealed that he used Tornado Cash to donate to Ukrainian causes without putting the recipient organizations under extra scrutiny.
Several industry experts acknowledged that while the government must crack down on criminals, on this occasion, rather than targeting hackers and identifiable bad actors, the government imposed a sweeping ban on an open-source protocol. According to Jerry Brito, executive director of the crypto policy non-profit Coin Center, the unprecedented crackdown on a piece of technology is not only irregular but may also infringe on the constitutional rights of Americans. He said, "It appears to be the sanctioning of a tool that is neutral in character and that can be put to good or bad uses like any other technology. It is not any specific bad actor who is being sanctioned, but instead, it is all Americans who may wish to use this automated tool in order to protect their own privacy while transacting online who are having their liberty curtailed without the benefit of any due process."
The crypto community has drawn attention to a perceived logical flaw in the sanction, which claims that anyone who interacts with a Tornado Cash contract in any way is doing so illegally. Therefore, since individual users can not reject incoming transactions, mischievous crypto users have dared the Treasury to take action upon an entire community by sending small amounts of ETH to prominent public figures via TornadoCash. Thus, if the receipt of assets from Tornado Cash is prohibited, then the owners of these accounts have now violated the new sanction.
Some prominent crypto lawyers are also preparing for a legal battle against the sanction. These legal experts believe that the OFAC has overstepped its authority and are currently floating the idea of challenging the sanction on constitutional grounds. Coin Center's director of research, Peter Van Valkenburgh said, "Banning software publication is banning speech. Even laws that unreasonably chill speech are constitutionally suspect, and can be challenged even before enforcement."
Tornado Cash sanction will strengthen the digital asset industry
The Tornado Cash sanction will set a precedent, not only for the digital asset industry, but the technological sector. Despite the seemingly fatal effect the sanction will have on crypto regulation, it could boost interest in the industry.
In the meantime, the sanction has highlighted two of the biggest qualities of the digital asset industry, resistance to censorship and permissionless transactions. Although Tornado Cash now has a criminal designation, it is impossible to shut down the code on a technological level. The government can neither shut the application down nor completely stop people from interacting with the code or sending it to a new, non-sanctioned address. Currently, Tornado Cash is still up and running, and has continued to process transactions, with over $7.6 billion worth of assets deposited.
In addition to being unstoppable, the code underlying Tornado Cash is permissionless, thus, it can be accessed at all times. This permissionless nature of crypto transactions makes it possible for users to conduct transactions at all times without the approval of a central authority. This reinforces the underlying principle upon which the digital asset industry is built - decentralization. Over the past decade, millions of users have flocked to the digital asset industry because it allows decentralized financial transactions hidden from surveillance by authorities.
While the Tornado Cash sanction was issued to curtail the activities of criminals, it will have several unintended consequences for innocent users, as it undermines their privacy. The sanction will increase the demand for decentralized solutions as an alternative to existing traditional financial systems. The digital asset industry has seen a surge in the demand for further decentralization and protection of user privacy. Therefore, to harness this demand and accelerate mainstream adoption of digital assets, developers must create a balance between privacy and transparency.
About VYSYN Ventures
VYSYN Ventures is a longstanding venture capital company that specializes in funding and supporting disruptive startups in the blockchain and cryptocurrency industry. We have provided early-stage support to several projects that have grown to USD market capitalizations of hundreds of millions and even billions. Our incubation program focuses on providing capital allocations, versatile marketing support, and tech assistance.