Bitcoin Lightning Network at Regulatory Risk After Tornado Cash Saga

Policy advisor Patrick Hansen posted his thoughts on the regulatory risk that the Bitcoin Lightning Network now faces following sanctions against crypto mixer Tornado Cash.

US authorities added Tornado Cash to the Office of Foreign Assets Control (OFAC) sanctions list on August 8. The Treasury Department claimed that more than $7 billion of illegal funds have been laundered through the protocol since 2019.

Since then, Tornado Cash addresses have been blacklisted, the developers have been booted from Github, and the website has been taken down. The team announced the closure of operations on August 13.

The saga has raised questions about personal information and the mandate of the authorities that oversee the crypto space. More so, considering Tornado Cash is a neutral tool consisting of code and not a sanctionable “person.”

Bitcoin Lightning is in danger of being flagged as high risk

Commenting on this, Hansen pointed out that interim Bitcoin Lightning services will be forced to comply with the Financial Action Task Force (FATF) Travel Rule. This states that service providers must share relevant originator and recipient information along with crypto transactions to combat money laundering and terrorist financing.

“VASPs and other financial institutions share relevant originator and payee information along with virtual asset transactions, therefore helping to prevent misuse by criminals and terrorists.”

However, Hansen said that implementing this would be difficult for Lightning nodes to implement in practice. The problem is further compounded by the fact that nodes are potentially classified as regulated payment service providers, which may require additional requirements such as customer authentication.

The problem is that flows through the Lightning network can be seen as high risk under existing anti-money laundering frameworks. But the politicians have not yet decided where they stand on the matter.

Is there hope for privacy after the Tornado Cash saga?

When it comes to overreach, the CEO of Aztec Network (an Ethereum-based privacy team,) Zac Williamsonsaid he remains optimistic that Web3 technology can help protect personal information.

“Despite the dark circumstances of the present, there is reason to be optimistic about the future of web3.“

Williamson said it is possible that Web3 networks can comply with the goals of regulators and still protect users’ privacy.but will not conform to existing regulatory structures.“

He explained that the above scenario could exist if regulators target the application layer, such as ramps and wallets, instead of going after the network level. This was further clarified using the analogy of internet providers not being held responsible for “the data in their cables.”

“There is room for regulation in web3. It is not at the network level. It is at the application level; companies and entities that use web3 to offer services to users and businesses. e.g. cryptocurrency on/off ramps and hosted wallets.“

Despite the heavy-handed approach towards Tornado Cash, Williamson expressed confidence that regulators will gradually accept and legislate financial privacy. After all, continuing on the current path will only lead to innovation going elsewhere.