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This is an important article which highlights how far the US Government is willing to go to try to control private digital transactions. But first, here are some useful definitions for acronyms used in this article.

  • CEX – Centralized Exchange
  • DeFi – Decentralized Finance
  • DEX – Decentralized Exchange
  • ETH – Ethereum
  • IEEPA – International Emergency Economic Powers Act
  • LP – Liquidity Provider
  • OFAC – Office of Foreign Assets Control
  • SDN – Specially Designated and Blocked Persons
  • USDC – USD Coin
  • USDT – Tether
  • WBTC – Wrapped Bitcoin

On August 8th 2022, Tornado Cash, a cryptocurrency mixing service and 45 related Ethereum wallet addresses were banned in the United States by the United States Treasury and added to OFAC’s SDN List. As a result, USD 467MM of assets were blocked. Both their Github repository and website are now down.

What’s more is that the Tornado Cash developer Alexey Pertsev has been jailed in the Netherland (without charge) for up to three months.

Note – Tornado Cash is not the first mixing service to be sanctioned by OFAC. In May of this year, Blender.io was also sanctioned and added to OFAC’s SDN List.

How does Tornado Cash Work?

Coin mixing services and tools are essential additions to the armory of any user concerned about their privacy. 

Mixers allow users to make their cryptocurrency transactions private by concealing the transaction history. This is achieved by pooling the transacted funds with other users’ funds.

Tornado Cash is considered a cryptocurrency mixer known for anonymizing ETH transactions by breaking the on-chain link between source and destination addresses. Its smart contracts accept cryptocurrency deposits that alternate addresses can then withdraw.

The protocol uses a smart contract accepting ETH deposits that can be withdrawn by a different address. The longer the funds remain in the pool before being withdrawn, the greater the privacy protections.

Read Coin Centers Tornado Cash Explainer for a more detailed explanation of how Tornado Cash works.

What is OFAC?

The Office of Foreign Assets Control (“OFAC”) of the US Department of the Treasury administers and enforces economic and trade sanctions based on US foreign policy and national security goals against targeted foreign countries and regimes, terrorists, international narcotics traffickers, those engaged in activities related to the proliferation of weapons of mass destruction, and other threats to the national security, foreign policy or economy of the United​ States. ~ US Department of Treasury

For a more digestible definition – OFAC administers and enforces sanctions against high-profile individuals including major international terrorists, drug-trafficking kingpins, and the financial/political elite of certain countries deemed hostile to American interests. OFAC ensures that Americans cannot legally do business with Cuba, Iran, Iraq, North Korea, and others without special government approval. Sanctioned persons and entities can be found on their SDN List.

What are the consequences of Breaching Sanctions?

It is illegal for any US ‘person’ (any citizen, resident, or company in the US) to engage in trade, economic transactions, or “other dealings” with any person, company, or country on the SDN List. This now includes using Tornado Cash.

The fines and civil and criminal penalties for breaching sanctions can exceed several million dollars and the maximum civil penalty for a ‘non-egregious case’ is $330,947.00. Jail time for violations can carry a maximum sentence of 30 years.

Now the term “other dealings” is quite broad. However, the government guidance states it could include “technical transactions such as downloading a software patch from a sanctioned entity”. At this point, it is probably illegal for US persons to visit the Tornado website.

Blocking immediately imposes an across-the-board prohibition against transfers or dealings of any kind with regard to the Tornado Cash property.

Treasury will continue to aggressively pursue actions against mixers that launder virtual currency for criminals and those who assist them. ~ Brian Nelson

What does this mean for DeFi?

For USDC, USDT, and WBTC, there is a high likelihood that the issuers of these cryptocurrencies would take all of the technical steps to prevent anyone from moving or redeeming these assets. Circle’s USDC can be frozen at the smart contract level, and so can USDT though they have made it clear that they would not be preemptively freezing funds.

WBTC is issued by BitGo whose entities are in South Dakota and New York, which means they must obey OFAC sanctions or face million-dollar fines and possible jail time for their executives. Therefore, there is a high likelihood that they will suspend redemptions of the tainted WBTC, rendering them worthless.

LPs will likely end up as the bagholders for blocked WBTC [and stablecoin] assets if they do not remove liquidity from their DEXes immediately.

What about Ethereum miners and stakers who are US persons?

How sanctions will be enforced is unclear as there is no legal precedent that we are aware of. However, it does not look good for Tornado Cash, Americans, and mixing services.

Our speculation:

  • it is possible that a breach of OFAC sanctions would occur if a miner or validator produces (or validates) an Ethereum block which contains a transaction including one of the Ethereum addresses on the SDN list.
  • Ethereum client software might be updated with an opt-in patch allowing miners/validators to ignore tainted mempool transactions to avoid breaching sanctions. While transaction censorship is not popular, it is likely that it may be done in-house by large US miners and stakers.
  • it may be a risk for any US-based fund invested in Ethereum proof of stake, as voting for blocks containing the illegal transactions could be an illegal activity. In this instance, there is a high likelihood that technical countermeasures (voluntary censorship) would be implemented or move the business outside US jurisdictions.
  • CEXes will be expected to use their Chainanalysis software to block and report all customer transactions which are in breach of sanctions. This means anyone who withdraws from Tornado Cash and tries to withdraw via a US-linked CEX.

Non-US divisions of exchanges are separate legal entities but could be seen as de facto ‘foreign branches’ of the US entity. Exchanges are strongly incentivized to ensure that their foreign-registered group companies comply with OFAC sanctions.

Did OFAC Overstep?

There is a strong legal argument that OFAC overstepped its statutory authority in sanctioning Tornado Cash.

  1. OFAC cannot sanction software – The contracts themselves and the software that controls their operation are not foreign nationals or their property and therefore cannot be the target of sanctions. To the extent anyone has property in those addresses, it is because they have sought the privacy provided by those software tools. That property is their own and no one else has any meaningful control or ownership rights to that property.
  2. Users are not co-mingling with illicit funds; Tornado users deposit and withdraw their own property – If it is an American’s property or a law-abiding person who is not sanctioned, then that property is also not properly the subject of sanctions. Moreover, that property is not mixed, commingled, or under any shared control with any sanctioned person’s property.
  3. OFAC cannot stop users from moving their own funds from one location they control to another – When a person uses the Tornado Cash contracts to protect their privacy, they arguably are not even engaged in the kinds of activities that IEEPA empowers the President to block. It is more like they are moving valuables from a drawer in their house to a safe in their house.
  4. If some Tornado Cash users are sanctioned persons, and they have property at those contract addresses, then that property is legitimately the target of sanctions. BUT…in that case, the address of the smart contract itself is not an appropriate alias for that entity or property because, like the name John Smith, it wrongly subjects many more persons to sanctions scrutiny than sanctions laws intend or allow.

Will the censorship-resistant, permissionless dream survive, or is OFAC’s influence an existential threat?

Final Thoughts

The United States was willing to use its highest level of economic sanctions which are usually reserved for foreign powers and extremely dangerous people against a privacy product in the cryptoverse. This is merely the beginning or the end of the war against privacy, security, crypto-assets, and cryptocurrencies.

If you are a US person, any interaction with Tornado Cash is most likely illegal, including, Gitcoin donations, working for or contributing to the project, running or downloading its software, visiting its website, and depositing/withdrawing from its smart contracts. As of August 8th, all Tornado Cash assets are considered tainted and Tether, Circle, and BitGo will refuse to redeem these tokens.

It is likely that the tokens will be withdrawn from Tornado Cash and dumped into liquidity pools. Liquidity Providers may be left holding the bag and there is a small risk of DEX pools for these tainted assets being blacklisted in their entirety out of an abundance of caution by the issuers (Circle, Tether, BitGo).

US persons running Ethereum mining or staking operations are possibly at legal risk. These businesses may self-censor transactions or move offshore.

DeFi protocols beyond DEXes which interact with Tornado-mixed funds may be at legal risk as they may have US-based staff.

After years of effort, Ethereum is now facing the start of a new age and going through a real test of its resiliency.

By using the tried-and-true strategy of divide and conquer, established authorities have timed their crackdown to weaken a movement they cannot fully control.

If you are a US person with funds in Tornado Cash do not break the law and risk your freedom, the money is not worth it.

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