The Tornado Cash saga highlights legal issues affecting the crypto market

by · August 23, 2022

Things have not been looking so good for the crypto market in recent months and the market seems to be gripped by one bad news after another. To this point, on August 8, the United States Department of the Treasury’s Office of Foreign Assets Control (OFAC) issued legal sanctions against the digital currency mixer Tornado Cash.

According to the regulator, since the platform’s inception in 2019, it has been used for a number of illegal money laundering activities estimated to be worth $7 billion. Of this sum, it is estimated that $455 million was controlled by the infamous Lazarus Group, a North Korean state-sponsored hacking group. In addition, Tornado Cash was also used to launder over $96 million of ill-gotten funds from June’s Harmony Bridge hack and $7.8 million from this month’s Nomad heist.

However, before going any further, it would be best to understand what a cryptocurrency mixer is. Simply put, it is an offering that helps hide potentially identifiable or tainted cryptocurrency funds with others to erase any traces associated with the assets, thereby making it impossible for anyone to trace the tokens back to their original source.

Arrest of creator leads to public outcry

On August 12, Alexey Pertsev, the creator of Tornado Cash, was arrested by Dutch authorities. According to a press release issued by the Dutch financial crime authority – Fiscal Information and Investigation Service – the arrest was made on the basis that Pertsev was involved in “concealing criminal financial flows and facilitating money laundering”.

While Tornado Cash can potentially be used by bad actors to hide criminal proceeds, it can and is also used to facilitate a wide range of legitimate activities. The Dutch police have not yet made it clear what exact rules Pertsev broke, although various media outlets have speculated and given varying explanations as to why he was arrested. The Tornado creator has not yet been charged with any wrongdoing.

Following Pertsev’s detention, a mass of protesters gathered in Amsterdam’s Dam Square on August 20 to voice their dissatisfaction with the handling of the case. And while the protesters did not directly comment on the legal issues surrounding the arrest, they argued that Pertsev’s arrest signaled a dark future for the fast-growing Web3 ecosystem. Not only that, but they also believe it could have a chilling effect on the Netherlands’ existing blockchain ecosystem.

Mark Smargon, CEO of the decentralized payment network Fuse, told Cointelegraph that while he is very disappointed to see a developer arrested for simply writing a piece of code, in order to avoid such scenarios in the future, crypto-financing entities – especially those who see mainstream adoption on the horizon — should be willing to meet regulators halfway to mitigate existing security concerns while ensuring people’s rights to individual privacy.

However, Abraham Piha, CEO and co-founder of Web3-focused firm Tomi, told Cointelegraph that government sanctions like these are scary if you start looking at them objectively:

“Tornado only existed because most blockchains weren’t private enough. If subsequent updates to Ethereum or Bitcoin include protocol integrations like Mimblewimble, will the next step be to block them too? This action is yet another reason to push for Web3, a free web , controlled by users and not by any big brother governments.”

A spokesperson for the crypto-policy think tank Coin Center noted that the non-profit organization is considering taking the case to court as it believes the core argument banning the platform from operating is unjustified. Not only that, but the independent body also believes that the Treasury’s actions may have exceeded its statutory authority.

Was Tornado’s forced shutdown unconstitutional?

In a recent interview with Bloomberg, Jesse Powell, CEO of digital-asset exchange Kraken, argued that the Treasury Department’s actions to shut down Tornado Cash could be “constitutional,” saying that people have a right to privacy and so it will be interesting . to see if the regulatory body’s claims can hold any kind of basis in a court of law. He further stated that the subsequent removal of Tornado’s original codebase was a “completely unnecessary step.”

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Following the sanctions, USD Coin (USDC) stablecoin issuer Circle decided to block all Tornado Cash addresses, to which Powell responded: “To have a digital currency that is so controlled and can be controlled by perhaps unconstitutional government actions is a little scary.”

Kenny Li, co-founder and core developer of Manta Network – a privacy protocol – told Cointelegraph that the Treasury Department’s decision to sanction Tornado Cash is far-fetched and extreme, even though certain individual crypto wallet addresses have previously been subject to the same treatment. But in most cases, he said, it was a clear case of fraud, hacks or a Ponzi scheme:

“In this case, smart contract addresses are blacklisted. Smart contracts are not people. Not only that, but people forget that Tornado Cash is a protocol, not a person or entity, which means it will continue to run regardless of the sanctions. It it’s time we realized that privacy and anonymity are not the same, and Web3 is about privacy.”

As for people moving USDC to other stablecoins following Circle’s decision to block Tornado Cash wallet addresses, Li noted that there has unfortunately been an increase in the number of platforms blacklisting wallet addresses maintained via Tornado Cash.

He pointed out that the move was due to Circle’s status as a regulated platform, thereby obliging it to comply with any sanctions issued by a government body under whose jurisdiction it operates.

Finally, he believes that Circle’s actions to block the movement of millions of dollars worth of USDC could potentially inhibit innovation in this space. Li concluded:

“No one wants their money blocked, especially for activities they are not involved in. That said, there is no certainty that tomorrow Tether will not block addresses that have touched Tornado Cash. Ultimately, this action from the Treasury is likely to lead to a domino effect, most of which has yet to be felt.”

Human rights violations on the way?

One aspect of Pertsev’s detention that has attracted public attention is that since his arrest he has reportedly been denied visits of any kind, including visits from his wife, Ksenia Malik.

In recent correspondence with Cointelegraph, Malik said, “He is being held in prison as if he were a dangerous criminal,” despite the fact that he simply “wrote open source code.”

With Dutch authorities continuing to bar all contact with the outside – not even “a short conversation” – several demonstrations are being organized to support him. Decentralized financial aggregator 1 inch tweeted that the arrest stands to set a dangerous precedent, one that could potentially “kill the entire open source software segment” if developers are still held liable for abuses that occur as a result of the software they create.

Decentralized financial aggregator 1 inch tweeted that the arrest stands to set a dangerous precedent, one that could potentially “kill the entire open source software segment” if developers are still held liable for abuses that occur as a result of the software they create.

Despite the deeply felt sentiments of the open source development community, it is relevant to highlight a recent report by blockchain security platform SlowMist, which found that approximately 74% of all funds stolen from the Ethereum network during the first and second quarters of year made its way to Tornado Cash, with researchers noting:

“The platform accounts for most of the initial funding for these security incidents. There have also been reports of withdrawals from exchanges, trading platforms and personal wallets to fund these security incidents.”

Finally, it should be noted that despite the outpouring of public support for Pertsev, his arrest has not been completely rejected by members of the global financial arena. For example, in a recent interview, venture capitalist Kevin O’Leary stated that platforms like Tornado Cash — which are advertised as “privacy tools” — have created a culture where it’s okay to tinker with federal regulations.

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In his opinion, the arrest of Pertsev was necessary and that it is good to have “sacrificed him” because, in his view, it will help to introduce a high degree of stability in the market in the long term.

Therefore, going forward it will be interesting to see how legal issues like these continue to be addressed by regulatory agencies around the world.