The importance of financial privacy and decentralisation

“He that would make his own liberty secure, must guard even his enemy from oppression; for if he violates this duty, he establishes a precedent that will reach to himself.” – Thomas Paine

We open today's article with a quote from philosopher & libertarian Thomas Paine to remind readers that it is important to be aware of what's happening in the world even if it doesn't affect you directly, YET. Cryptocurrencies are not simply the best performing asset class of the last decade but they are also important privacy-enabling, financially open and accessible networks. If we wish to have a free financial system, we must push back against surveillance that ultimately lowers our financial privacy and liberty.

What is Tornado Cash?

Tornado cash is a mixer that allows people to have privacy in their Ethereum transactions. Ethereum works on an 'Account' based model which means if someone gets your account details in order to pay you, they can also see your entire transaction history and balance. They can also look into the balances of everyone you send to, or receive from, as well as all the NFTs you may have purchased. While we like the open nature of blockchains, this level of openness is very invasive and could be a terrible inhibitor for Ethereum's ambition of becoming a global "Ultra sound" money.

Tornado cash breaks the chain of surveillance by having multiple people put their funds into a 'mixing bowl' and then withdrawing their amount back out. Anyone watching the blockchain will not be able to connect the sender with the recipient.  

Any technology can be used for good or bad purposes. Take for example a hammer, which can be used to build something or to attack someone. Tornado cash can be used to create privacy by good or bad actors.

What happened to Tornado Cash?

Source: Chainalysis

To quote directly the US Treasury as to how they justified these sanctions, "Today, the U.S. Department of the Treasury’s Office of Foreign Assets Control (OFAC) sanctioned virtual currency mixer Tornado Cash, which has been used to launder more than $7 billion worth of virtual currency since its creation in 2019. This includes over $455 million stolen by the Lazarus Group, a Democratic People’s Republic of Korea (DPRK) state-sponsored hacking group that was sanctioned by the U.S. in 2019, in the largest known virtual currency heist to date."

While you don't want money laundering by bad actors you also have the issue of hurting those that are using the tool for legitimate purposes. There is also concern because this is the first time in history a piece of open source code has been sanctioned. There have been outcries that this is sanctioning free speech, and rightfully so as code has been previously seen as speech by the US Courts.

Communication does not lose constitutional protection as “speech” simply because it is expressed in the language of computer code - Digital Law online.

To make matters worse, not all of that money was technically laundered, according to a crypto analytics firm, Elliptic. Roughly $7.6 billion worth of crypto has indeed passed through Tornado, but only $1.5 billion of those funds were illegally obtained (and, thus, laundered), Elliptic said in a report. 
Chainalysis, another blockchain monitoring firm, also reported that nearly half of that $7.6 billion sum came from DeFi (none of which, according to their research, is not necessarily illicit).

We even had Ethereum co-founder, Vitalik Buterin out himself as a TC user to send funds to the Ukrainian people in the middle of their war effort as a means to gain privacy on what should be a private donation, as well as provide security for those receiving the funds.

The unforeseen fallout of protocol sanctions

Shortly after the OFAC sanctions announcement, an on-chain protest of sorts was conducted and 0.1 ETH approx $170 USD at the time was sent from Tornado Cash by an anonymous user to well known public wallet addresses, such as basketball star Shaquille O'Neal, crypto billionaire Justin Sun and the like.

This has massive ramifications as it shows a clear lack of after thought for how sanctioning technology will ultimately backfire and in worst case scenarios cause systemic issues, for example the aforementioned crypto billionaire Justin Sun has stablecoin loans sitting on dApps such as Aave, who have accepted the OFAC sanctions and blocked all wallet addresses with tainted "ETH" from interacting with it's front end interface to add collateral and pay down loans, this could create liquidation cascades if this issue compounds.

The good news is that for now, it's just the dApp front end complying with OFAC sanctions and this isn't occurring at the protocol level but should this start to occur, the whole "Decentralised Finance" and "permissionless" narrative starts to fall apart, creating potential holes in the Ethereum investment narrative.

USDC bends the knee

Circle immediately froze the USDC in those accounts that had been hit with the sanctions hammer, effectively bricking the stablecoins usage for all TC participants and again, completely innocent users have been hit with the fallout and had their liquidity completely frozen at a moments notice.

The whole situation is awfully reminiscent of how our current traditional financial system works. Putting the gravity of war aside for a moment, the Russian invasion of Ukraine was met with sweeping sanctions which was further compounded by US companies adhering to these requirements and removing all services for Russia, for example Mastercard and Visa decided to suspend their network services in Russia.

The severity of both traditional finance and on-chain finance ramifications for everyday people not having access to payment networks forces them into a nasty game of economics they are ill equipped to navigate. 

This is why US Dollar hegemony is a double edged sword both on-chain and in TradFi, the liquidity it provides and global acceptance truly helps the world's financial systems run smoothly but at the same time, with the click of a button you can be completely frozen for non-compliance.

We want to be extremely clear though, this isn't advocating for war, money-laundering and other horrible illicit activities but a call for rationality as the world truly needs open and permissionless financial systems. What if non-compliance means dissenting against social order for the greater good?
Taken to the extreme, what happened in 1940s Germany was completely legal, what happened throughout the Americas with the Atlantic Slave Trade was also completely legal. The people of the world need a free money market solution to ensure they can act morally without threat of being de-banked for going against the state.

What does this mean for Defi?

One point that needs to be well understood, Tornado Cash is open source software and its purpose is financial privacy. Whilst the protocol does have bad actors using the protocol, this doesn’t mean the entire user base are doing the wrong thing. Consider a bank that has serviced money laundering and terror financing, they may face fines and the individuals or nation states using the bank will be sanctioned further but a legitimate user of the same bank in Iowa won’t face these sanctions. However legitimate users of Tornado cash are being sanctioned via the Tornado Cash contract address. Ethics and freedom aside, this action by OFAC will most likely galvanise the cryptography ethos and further highlight the importance of financial privacy. Although the short term impact is fear, uncertainty, and doubt, the medium to long term impact will be the wider crypto community coming together and building private, secure and decentralised dApps, protocols, L2s, side-chains and blockchains.

How does this impact the future of Ethereum?

This move by OFAC is a wake up call for the Ethereum community as the very ethos of financial freedom is at risk. This battle will take some time to play out but here are some of the implications. The upcoming Merge from "Proof Of Work" to "Proof of Stake" will provide more attack vectors for OFAC to attempt to sanction and control the Ethereum network. If we start to see Regulatory capture of the Ethereum network, Ethereum could take the 'nuclear option' and fork/split into a 'freedom' chain and a 'regulation' chain. We'll be watching closely on how the regulatory powers and ethereum community play this one out. 

We love the freedom of DeFi built onto top of Ethereum, but if this goes pear shaped, Bitcoin's deliberate design choice of maximum decentralisation will appear very wise. And if Bitcoin can build DeFi faster than Ethereum can build decentralisation, then it is entirely possible that this is the beginning of the end for ETH.

How this affects you 

This issue of centralised financial infrastructure and administrators dictating how their users can access, use and withdraw their funds is not just an issue limited to crypto but also seen here in bricks and mortar banks. The image above was from a Bank in Britain highlighting how tenuous the relationship between “your money” and the bank that controls and permissions access to your funds.

This reminds me of the fable of the frog brought to boil, that when placed in normal water and the heat is only ever so slightly brought up over time, the frog won’t leap out of the pot but instead boil to death. It’s concerning that the everyday person is the frog and doesn’t realise the slight changes occurring around them that degrades their financial freedom.

 

Despite all of its shortfalls and clear issues, cryptocurrencies may be one of the last bastions of financial and economic liberty but the issues highlighted above should be understood before they start affecting YOU.

No Advice Warning 

The information in this newsletter is general only. It should not be taken as constituting professional advice from the author - Stormrake PTY LTD.

Stormrake is not a financial adviser and does not provide financial product advice. You should consider seeking independent legal, financial, taxation or other advice to check how the information relates to your unique circumstances. Stormrake is not liable for any loss caused, whether due to negligence or otherwise arising from the use of, or reliance on, the information provided directly or indirectly, by this newsletter.

 

Disclaimer 

All statements made in this newsletter are made in good faith and we believe they are accurate and reliable. Stormrake does not give any warranty as to the accuracy, reliability or completeness of information that is contained here, except insofar as any liability under statute cannot be excluded. Stormrake, its directors, employees and their representatives do not accept any liability for any error or omission in this newsletter or for any resulting loss or damage suffered by the recipient or any other person. Unless otherwise specified, copyright of information provided in this newsletter is owned by Stormrake. You may not alter or modify this information in any way, including the removal of this copyright notice.

Copyright © 2022 Stormrake Pty Ltd, All rights reserved