Sen. Warren’s bill signals that crypto is headed for a clash with national security interests

The anti-money laundering bill sponsored by Senators Elizabeth Warren (D-Mass.) and Roger Marshall (R-KS) claims to close loopholes in the risk of cryptocurrencies being used for illegal activity that even the Biden administration agrees is small. But the ill-conceived bill is a useful harbinger for the crypto community of a coming conflict between the community’s desire for blockchain privacy and law enforcement’s responsibility for national security.

Warren recently said she led an “anti-crypto army,” and her misguided Digital Asset Money Laundering Act tarnishes cryptocurrencies by unfairly tying them to illegal activities. The reality is that even the Biden administration agrees that illicit crypto use is small – see the recent US Treasury Department report on “Illicit Finance Risk Assessment of Decentralized Finance”, which found that “illicit activity is a subset of the overall activity within DeFi area.”

Chris Grieco is General Counsel at Rain Cards, and a National Security Fellow at the National Security Institute at George Mason University. He has previously worked in the Department of Justice and the White House Counsel’s Office and for the House Judiciary Committee.

The unspoken secret among law enforcement and national security personnel is that they love crypto in its current form. Instead of trying to track wads of cash, or requesting documents from a traditional financial institution, the blockchain is open for anyone to follow. Move money from one crypto wallet to the next and everything is traceable and “on the chain.” This is especially true with advanced tracking tools that law enforcement and others are increasingly using, such as those at TRM Labs or Chainalysis.

Law enforcement’s attitude is likely to change in the near future as private blockchains make tracking and tracing nearly impossible. Blockchain technologies are evolving, and as more use cases emerge, the need for financial privacy on the blockchain continues to grow. Americans expect a degree of financial privacy unknown in other parts of the world, with law enforcement requiring varying degrees of due process to access financial information. This is true even with the generous loopholes in the third-party doctrine, and the minimal privacy protections for transactions under $10,000 provided by the Bank Secrecy Act (BSA). As recent outcry against a potential Federal Reserve-led central bank digital currency has shown, Americans expect to be able to conduct their financial affairs outside of government oversight or permission.

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As blockchain becomes a more widespread technology, people demand a greater degree of privacy for their transactions. You wouldn’t put your credit card purchases on your Instagram page, and the same logic applies to digital assets. You wouldn’t let the world know what you bought with your crypto wallet if you were given the option between an open blockchain and a private blockchain. Promising startups like Zcash and Aleo blockchain are building privacy-enhancing features into their offerings – allowing anonymity for blockchain transactions.

But in a world where blockchain transactions are truly untraceable, the significant anti-money laundering (AML) rules and regulations have built up since the 1970s, and the expanded counter-terrorist financing (CFT, or counter-financing of terrorism) processes have been put in place. place since the 2000s, can become toothless. The status quo among the crypto, law enforcement and national security communities will turn into open conflict.

There are indications that law enforcement is concerned about this, but the true reckoning has yet to come. Late last year, the Biden administration sanctioned Tornado Cash, a blockchain mixer that, in the most pessimistic view, allowed users to “launder” their crypto with others and extract “pure” nearly untraceable crypto. The legality of the Ministry of Finance sanctioning an unauthorized computer program is a question that can be left for another day. Astute observers have noted that the Tornado Cash sanctions were much more about combating the Lazarus Group, the notorious North Korean hacker group that were allegedly frequent users of Tornado Cash, rather than a concerted attack on crypto protocols or the average user. That’s little consolation for Tornado Cash users who no longer have access to their money because the Treasury Department has deemed it “tainted” by passing through the Tornado blender and requires an OFAC license to continue using the asset. And there are many Web3 developers who saw the Tornado Cash enforcement as a direct attack on their work, especially as one of the Tornado Cash developers spent nine months in a Dutch prison and is currently under house arrest awaiting trial.

Future privacy-focused blockchain technologies will make privacy the starting point rather than the exception. If everyday purchases are locked behind a cryptographically protected, unbreakable privacy barrier, so too will illicit purchases, terrorist financing, and the myriad of dark money-backed actors like crypto-pessimists that Senator Warren has argued from the start be the only real use cases for crypto. While this may alarm enforcers who have grown accustomed to having access to traceable blockchain transactions, and have already gone to war with technology companies over warrant-proof encryption, blockchain advocates rightly point out that cash and fiat transactions still have a much higher percentage of illegal transactions than crypto does. Even if this were not the case, Americans still have financial privacy rights that supersede any financial surveillance regime.

The Ministry of Finance’s actions against Tornado Cash show the coming clash between everyday crypto users and the financial sanctions apparatus, an issue highlighted but not fully understood in the report on “Illicit Finance Risk Assessment of Decentralized Finance”. In it, the agency notes that “[s]several participants in the virtual asset industry are exploring measures to increase the privacy of virtual asset transactions… [w]Although the US government supports privacy-enhancing technologies that simultaneously allow or even promote compliance with AML/CFT obligations, the use of non-public blockchains by entities that do not comply with AML/CFT obligations or services that may fall outside applicable regulations. increase AML/CFT risk.” But Treasury fails to appreciate that many privacy-focused blockchains may fall outside existing legal authorities for AML/CFT, and extending these rules to privacy-focused blockchains may be technologically difficult and legally problematic given various constitutional protections.

This coming conflict between on-chain privacy and financial surveillance will not be easy to resolve. Most of the rules and regulations for AML/CFT are built on obligations from centralized intermediaries such as banks and financial institutions. But crypto reduces or completely eliminates the need for most financial intermediaries, and requiring a borderless, permissionless and immutable computer program like a blockchain to comply with country-specific laws will present a difficult challenge for global financial enforcers, not just US bureaucrats.

AML and CFT enforcers have improved significantly at international coordination and cooperation in recent years, with the US largely leading the way. But expanded enforcement against privacy-focused blockchain technologies is likely to run first into US constitutional objections and further strain the existing legal foundations of various parts of the Bank Secrecy Act and the existing AML/CFT regime. As many have already pointed out, it is difficult, if not impossible, for decentralized financial protocols to comply with the BSA, a point that is largely lost on the recent financial report on the subject.

It may take time, but US constitutional protections are a stronger bulwark against financial surveillance than the safeguards offered in most other countries. Perversely, as the Biden administration continues to push blockchain developers overseas with its messy enforcement and policy decisions, the U.S. Constitution combined with America’s leading role in the global banking system and AML enforcement may mean that U.S. enforcers, constrained by constitutional protections, offer the best option for privacy-focused blockchain technologies in the long term.

While this fight is still a few years away, should policies like Warren’s proposed legislation be passed into law, it may very well be the proverbial straw that breaks the BSA camel’s back by hastening this clash. Enforcing constitutional guarantees against expanded financial surveillance like Warren’s, whether by existing crypto protocols or future privacy-focused blockchains, may ultimately require strategic litigation by the industry.

The good news is that Warren’s legislation is unlikely to go anywhere, especially in an increasingly politicized crypto environment. But that doesn’t mean serious national security thinkers and crypto advocates can ignore this growing problem. The industry must grapple with the idea that bad actors can and will exploit untraceable blockchains in the future, and must continue to provide solutions that protect privacy and national security interests.