Tornado Cash Sanction: What Does it Mean for the Future of DeFi?

On August 8th, U.S. Secretary of State Antony Blinken announced that the United States would be sanctioning Tornado Cash, a decentralized application on the Ethereum blockchain that makes it possible to transfer cryptocurrencies anonymously. This has caused outrage within the cryptocurrency community, both for its reasoning and implementation, and could foreshadow a serious government crackdown. Let’s look at the context for this sanction and what it could mean for the future of decentralized finance.

Tornado Cash was released in 2019 and was one of the first fully decentralized applications on Ethereum to allow for private transactions. It accomplished this by accepting user funds, mixing them together in one address, then allowing users to withdraw their funds on a different Ethereum address. This effectively mixed the Ethereum such that it could not be traced back to the original owner. With every transaction on Ethereum being publicly visible by default, Tornado Cash offered a way for privacy-preserving individuals to both utilize and invest in cryptocurrencies while keeping their transactions from being visible by anyone.

To date, Tornado Cash has helped mix over $7 billion in user funds. While the majority of these are probably fully legitimate and legal transactions, there have been some notable hacks that have used the service to launder stolen money. For example, the Axie Infinity Ronin Bridge hack, which occurred in April 2020 and saw over $400 million in cryptocurrency stolen, was laundered through Tornado Cash. Additionally, the Harmony Bridge hack and Nomad hack also led to funds being laundered through the protocol. To make matters worse, the FBI has attributed the Ronin and Harmony hack to Lazarus Group, a North Korean organization that has been sanctioned since 2019.

The use of Tornado Cash by Lazarus Group was the United States’ main explanation as to why they decided to sanction Tornado Cash. To sanction a decentralized application, they took all addresses associated with Tornado Cash, including their smart contracts and donation address. This means that anyone who interacts with Tornado Cash could face criminal charges for violating U.S. sanctions.

Many in the cryptocurrency space are criticizing the move as “throwing the baby out with the bathwater,” meaning that they are banning a technology that was primarily helpful because it served a few bad purposes. Additionally, due to the decentralized nature of Tornado Cash, its smart contracts will be permanently running and able to be used, and its website is hosted on decentralized storage services and cannot be taken down. The only way any government could ever fully disable Tornado Cash is by taking down the entire blockchain and the hundreds, if not thousands, of servers that are hosting the decentralized application. Additionally, since the code is open source, it is freely available for anyone to copy, and there could be hundreds of clones of Tornado Cash created tomorrow, each with slight variations. The sanctioning of a dApp will only lead to a never-ending cat and mouse game between privacy advocates and the government.

After the sanction came out, Circle, the parent company of the USDC stablecoin, froze all USDC on Tornado Cash and blacklisted associated addresses from using USDC. This has also caused massive controversy, as it proves that one of the largest and most trusted stablecoins can freeze anyone’s account at any given moment. The stablecoin is fully centralized and under the control of a United States-based company. Some industry experts fear that if USDC is forced to freeze more assets it could cause a domino effect that collapses DeFi. For example, USDC collateralizes loans on Aave, is used for trading on Uniswap, and makes up some of the peg for the Dai stablecoin. If the government decides to sanction these three pillars of DeFi next, and USDC complies, it would cause the entire DeFi industry to crash overnight, as funds are frozen, mass liquidations occur, and trading in a decentralized manner becomes impossible. This is arguably one of the greatest threats to the future of decentralized finance.

As long as the Ethereum blockchain is running, Tornado Cash and any other sanctioned protocols will never truly die. The 2020s are proving to be incredibly critical in the field of cryptocurrency regulation, and we are bound to see more restrictions and sanctions coming soon. Whether or not this will have serious consequences on the market remains to be seen, but one thing remains true: these applications can never be fully censored once they are published, and that alone significantly increases the value proposition of Ethereum and other layer 1 blockchains.

By Lincoln Murr

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