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What Happens When You Try to Sanction a Protocol Like Tornado Cash

The U.S. government's unprecedented move to sanction a smart contract on Ethereum continues to produce perverse consequences.

On Monday, the U.S. Treasury Department issued a blanket ban on crypto mixing service Tornado Cash. All American “persons” are barred from interacting with the open-source protocol, in a move that is likely to have widespread implications for the world of crypto.

This article is excerpted from The Node, CoinDesk's daily roundup of the most pivotal stories in blockchain and crypto news. You can subscribe to get the full newsletter here.

Circle, one of the issuing entities behind the USDC stablecoin, immediately banned 38 addresses that had connections to Tornado in their transaction history following the sanction. Anecdotal reports suggest other platforms and companies are also enforcing bans.

Treasury’s Office of Foreign Assets Control has put a massive hole in the center of the crypto economy by making it a felony to interact with Tornado Cash. Not only has it become harder to achieve transactional secrecy on the most-used blockchain, Ethereum, but platforms and people now need to determine their exposure and take steps to mitigate potential regulatory action.

“It’s a bit early to speculate here. This is new territory. We are still seeing what is even possible,” Coin Center Director of Communications Neeraj Agrawal , said via email. The second-order effects of the ban are still playing out, and it remains to be seen whether regulators can enforce such a wide ban or if crypto is capable of complying.

Tornado Cash is an open-source project that enables people to shield their transaction histories from public view. The U.S. government alleges it is also a service that was used to launder more than $7 billion worth of ill-gotten gains since 2019, including by North Korean hackers.

See also: What the Tornado Cash Sanction Means for Privacy Coins

Instead of targeting said hackers or going after identifiable bad actors, the government has imposed a sweeping ban on the protocol. Elliptic, an analytics company, said it has identified some $1.5 billion in illicit funds earned through ransomware, fraud or hacks.

Meanwhile, data firm Chainalysis released a report claiming that use of crypto mixers hit an all-time monthly high in April this year – after $51.8 million was laundered through various platforms.

"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,” Coin Center Executive Director Jerry Brito and Research Director Peter Van Valkenburgh wrote earlier this week.

Tornado is also a key component of the Ethereum “money stack.” It’s not the only way to anonymize transactions on the blockchain, but it was perhaps the most used. It’s likely the vast majority of applications that support ETH have some exposure to the mixing service. (Ethereum co-creator Vitalik Buterin disclosed he used the platform ahead of donating funds to Ukraine this year.)

Moreover, although Tornado now has a criminal designation, the government cannot actually shut the application down. Nor can it stop people from interacting with the code or redeploying it to a new, non-sanctioned address.

Tuesday, a prankster made light of the situation, showing the difficulty the government will have in enforcing its sanction by sending small amounts of ETH from a Tornado wallet to high-profile crypto holders, including Jimmy Fallon and Coinbase CEO Brian Armstrong. Crypto transactions cannot be refused – and those on the receiving end may now be deemed liable for interacting with a sanctioned address.

"Protocols strictly solving for transactional privacy face a challenging path forward, as their narrow focus makes them a target for regulators that primarily seek to curb illicit financial activity," Tor Bair, founder of the privacy-focused Secret Network, told CoinDesk.

"Protocols that haven't been actively thinking about these possibilities from Day 1 are in for a nasty surprise. You cannot build any kind of reliable or sustainable privacy solution without considering every threat and tradeoff," he added.

In a telling sign of how the Tornado ban may shake out across the industry, community members of MakerDAO are working on a contingency plan in case it gets “nuked” by regulators due to its exposure to Tornado. Maker is the algorithmic issuer of the DAI stablecoin, a platform that allows people to mint U.S. dollar proxies by depositing crypto.

Maker founder Rune Christensen began detailing an emergency plan to shut down “core” contracts that underpin the stablecoin, which appears to be garnering majority support. Of particular concern is DAI’s exposure to the USDC stablecoin, which currently accounts for more than a third of its collateralized deposits. Some $3.56 billion USDC is currently held by Maker.

Maker is currently the largest decentralized finance (DeFi) protocol by value, and so its moves here are significant. It’s likely DeFi platforms across the board are working to reduce their exposure to USDC and other offending assets, which sit on their balance sheets like ticking timebombs. Unraveling this could be costly and time consuming, but it’s necessary.

See also: Cloning Tornado Cash Would Be Easy, But Risky

Circle bills its U.S. dollar-pegged stablecoin as the most compliant and trusted on the market, and even before the Tornado sanction Circle had blacklisted nearly 50 addresses to comply with law enforcement demands. USDC has therefore been integrated widely through the DeFi sector.

Directing ire at Circle for following the rules – even if the rules are overbroad and misunderstand how crypto works – is not the solution. But protocols should consider following OG Erik Voorhees' demand and wean themselves off of USDC in favor of more censorship-resistant alternatives.

Although it’s unknown how things will play out over the next days, weeks and months, it is becoming clear that the desires of crypto and the demands of the 21st century modern governments are not compatible. That’s by design.