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12th August 2022 > > The Tornado Cash fall-out.


The Tornado Cash fall-out begins.

Market Snap

Market Wrap

After twice threatening a breach of $25k, a psychologically important level that has nothing to do with technical analysis, the shorts that got liquidated two days ago have saddled up again. Bring it on I say – a series of short-squeeze induced run-ups might be enough to change the still negative narrative around the price of BTC.

Curious Cryptos’ Commentary – The Tornado fall-out

The CCC reported on 10th August that “The Office of Foreign Assets Control (OFAC) has announced that it has sanctioned Tornado Cash, claiming that North Korea has laundered hundreds of millions of dollars from hacks of crypto projects, and has used those proceeds to fund its weapons programmes.”

Apart from the obvious benefit that this might inhibit North Korea’s nuclear weapons ambitions, this sanction raises several other issues, about which it might be useful to understand.

The first of these is the defence being put forward by many people, that Tornado Cash is simply a tool. This view can be summed up as “coin mixers don’t launder money, money launderers launder money.”

This clearly echoes the political dividing line in the US between advocates of gun control, and the pro-gun lobby, and it concerns me that supporters of cryptos, and those against cryptos in any shape or form, can increasingly be distinguished from one another simply on the basis of their party-political affiliation. This is not good.

A rather more nuanced view has been put forward by Matthew Green, a computer science professor at John Hopkins University, who said:

“This is the first time I've ever seen a piece of software get shut down. And that's kind of unique.”

Here he is making a reference to First Amendment protected speech, a complex discussion that can probably only be usefully had in a room full of lawyers.

The second issue is that as well sanctioning Tornado Cash, there is a long list of Ethereum public addresses that have also been blacklisted. It seems unlikely to me that any readers of the CCC are about to execute an ETH transfer to or from a North Korean hacking group, but how far down the chain does this blacklist go? In other words, if a wallet interacts with a blacklisted wallet, does it then become blacklisted itself?

If so, does this now mean that due to sanctions, not all ETH are fungible with one another?

The third issue relates to miners – if they process a block that contains a transaction to or from a blacklisted address, are they now also in breach of the sanctions? If so, being a miner based in the US becomes far too risky a proposition. Indeed, being a miner anywhere in the world could still leave you with problems, if the US authorities cleave to the view that you have facilitated the operations of gangsters and terrorists.

A fourth, very predictable, issue is the sudden proliferation in just days of many other mixers, such as:

Note that BUSDX has been around for a while, but I believe the mixer was launched yesterday, but happy to be corrected if I am wrong.

Personally, I wouldn’t go anywhere near such a facility – and I am certainly not recommending you use it - but having just been launched as a dApp (decentralised application), are the legal authorities about to get into the most mammoth whack-a-mole game ever, with little to zero prospect of identifying the person(s) behind each one of these iterations of privacy technology?

There are also knock-on effects for centralised crypto platforms. dYdX – a purveyor of perpetual futures for BTC and ETH – has frozen many accounts as a reaction to the sanctions, but reportedly many of these accounts have never interacted with Tornado, nor is there any evidence of a North Korean, or of a drug baron connection.

Centralised stablecoin issuer Circle and its native stablecoin USDC, have frozen all USDC held in Tornado Cash smart contracts, regardless of evidence of nefarious behaviour or otherwise.

And this last point raises the prospect of a second Terra-like fiasco.

To recap, the first Terra fiasco involved an algorithmic stablecoin TerraUSD (UST) which had previously been backed by USD cash equivalents assets. Given the high quality of the collateral, and the over-collateralisation, the algorithmic part was irrelevant. Unfortunately, the creators of UST thought the maintenance of the USD peg was due to their own brilliance in building the algorithm, so a decision was made to sell the USD cash equivalent collateral and buy BTC instead. This decision coincided with a sharp downturn in the price of BTC, leading to an extremely rapid unwinding of the peg, a massive devaluation in the market price of LUNA, the sale of the BTC collateral, and wholesale destruction of billions of dollars of value when the whole system collapsed.

MakerDao (disclosure – I have been a long-term investor in this project) also has an algorithmic stablecoin at its centre (DAI) backed by crypto assets, 50% of which are USDC.

A proposal has been made to sell the USDC due to the risk of funds being frozen, and invest in ETH instead, raising the risk of a de-peg and putting the algo under some extreme stress and pressure. If it fails in this task, the MakerDao ecosystem may go the same way as Terra.

I cannot predict what might happen in that situation, but I should not have been so greedy at the time when this investment was up 1,000%. Ho hum.

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