Will a compromise on anonymous crypto please US regulators and spur adoption?

Will a compromise on anonymous crypto please US regulators and spur adoption?

It might seem like an inconvenience to ask exchanges to identify their users, but would it push DeFi firms abroad, and do crypto users care?

Analysis


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There is a tension inherent when protocol conflicts with jurisdictional authorities. Cryptocurrencies are designed to be anonymous.

The blockchain and cryptocurrency sectors in the United States have fought with regulators about the need to adhere to Know Your Customer (KYC), Anti-Money Laundering rules (AML), and even economic sanctions regimes.

In a recent speech, a senior U.S. Commodity Futures Trading Commission official said that it would be in the best interest of the industry to verify digital identities. The CFTC is historically friendly to crypto, at least compared to other U.S. government agencies such as the Securities and Exchange Commission. Its views may be worth considering.

In an April 25, 2018 speech, CFTC Commissioner Christy Goldsmith Romero urged “all crypto companies to disassociate themselves from [digital currencies] mixers and technology that enhances anonymity.”

What about decentralized exchanges? Romero stated that central parties maintain these exchanges, and could perform KYC and AML checks if desired. Would forcing compliance drive decentralized finance (DeFi), innovation overseas?

Preston Byrne is a partner in the law firm Brown Rudnick. He told Cointelegraph that software will do what you tell it to.

The real question is whether or not the United States wants to isolate its companies from DeFi, when DeFi is growing rapidly overseas.

John Wagster of Frost Brown Todd, the head of the law firm’s technology industry team, says that whether crypto protocols must comply with AML/KYC and other aspects under the U.S. Bank Secrecy act (BSA), depends on if they are considered “money transmitters” or “money service businesses” according to the applicable federal and state laws. It is not clear whether crypto protocols can comply. He told Cointelegraph that:

“Centralized protocols have the potential to implement AML/KYC, but at the risk that crypto-idealists will abandon products which allow anonymous, permissionless access.”

What about DeFi? Wagster said that “decentralized protocols can implement BSA Compliance, but individual steps will need to be approved by the protocol’s DAO – or another governance mechanism – and some aspects of implementation may require community members or authorized service organizations,” Wagster explained.

The BSA may not be the biggest challenge to crypto companies looking to do business in the United States.

Wagster said that all companies must comply to the Office of Foreign Assets Control in order “to ensure that their platforms aren’t being used by individuals who come from prohibited jurisdictions” like North Korea or Iran, as well as by those designated by Wagster. Some aspects of OFAC can be achieved autonomously by using third-party services like Chainalysis which offers free access to its OFAC interface.

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OFAC sanctioned Tornado Cash in August 2022. The agency had accused that the company was laundering over $7 billion worth of digital currency. Over $455 million was stolen by a North Korean hacking group. According to the U.S. Department of Treasury, mixers like Tornado facilitate anonymous payments “by obscuring their origin, their destination, and their counterparties without any attempt to determine their source”. OFAC has prohibited U.S. companies and individuals from dealing with Tornado Cash.

Some people believe decentralized exchanges could also block mixers, if they put their minds to it. Justin Hartzman is the CEO and cofounder of Toronto’s cryptocurrency exchange CoinSmart. He told Cointelegraph that decentralized exchanges such as Aave, dYdX, and CoinSmart actively blocked addresses which interacted with mixers when the Tornado Cash fiasco occurred. Hartzman explained further:

Blockchain’s transparency makes it easy to determine which addresses have interacted.

Would it be beneficial if crypto companies could resist the technology that enhances anonymity? Maybe privacy coins and anonymous crypto are important to counteract the growing government surveillance.

Byrne said that “the answer to this is in the eyes of the beholder” and that the desire for privacy-enhancing technologies is a question of politics. “I believe the purpose of cryptography is to make it so commonplace, that its existence becomes a given.”

Privacy coins and regulations “don’t mesh”

Hartzman said that regulations will be key to achieving widespread adoption. Privacy coins’ usability is likely to remain “niched”, and therefore restricted. “Blockchain has never been anonymous and I don’t see it moving forward.”

Frost Brown Todd’s Wagster agreed, on his part, that there was an incompatibility:

“Anonymizing technologies and BSA compliance don’t mix.” If BSA compliance is required, a protocol must not allow users to hide their identities.

Wagster continued, “Protocols that seek to attract institutional investors will not likely defend the use mixers as their institutional users won’t get involved with a system in danger of government enforcement actions.” DeFi lenders that allow anonymizers may have to move their business outside of U.S. jurisdiction.

Is it worth saving’mixers?

Does the verification of digital identities, as demanded by the CFTC Commissioner, pose a significant burden to crypto users? Is it worth the fight to get “mixers” such as Tornado Cash or Blender approved?

Hartzman believes that anonymity isn’t a matter of life or death for most crypto users. Most people use crypto for trading and making money, and they don’t even use mixers. Byrne, of Brown Rudnick, said:

The Treasury Department should not have the authority to sanction certain technologies, according to my opinion.

Wagster pointed out that BSA requirements such as AML and KYC, are enforced by U.S. Treasury via the Financial Crimes Enforcement Network “not by SEC or CFTC.”

AML/KYC/OFAC will be a requirement for many centralized crypto protocol providers because these are commonly used in the financial industry and “because institution money managers have a fiduciary obligation to use compliant suppliers.”

Wagster added that some crypto-native DeFi protocol may wish to avoid BSA Compliance, since “compliance goes against the ethos and philosophy of crypto, which favors privacy, monetary freedom, and the government’s desire for money laundering and terrorist funding prevention.”

Mixers can be used for good or bad. CoinSmart’s Hartzman said that people living under oppressive regimes might use these tools to safeguard their wealth and freedom. But “the truth is, hackers are abusing this protocol to steal money from hardworking individuals.”

The importance of compliance regimes can also vary. KYC/AML is one thing but sanctions evasion may be another. The sad saga of Ethereum developer Virgil Griffith illustrates that sanctions evasion is a surefire method to attract the wrath and ire of U.S. authorities.

The Treasury declared in August 2022 that it had worked to expose the components of the virtual currencies ecosystem, such as Tornado Cash, Blender.io and others, which cybercriminals used to hide the proceeds from illegal cyber activity and other criminal activities.

The Department of Justice acknowledged that the majority of digital currency activity was “licit,” but said that cryptocurrency “can be utilized for illicit activities, such as sanctions evasion, through mixers and darknet markets. This includes the facilitation heists and ransomware schemes. It also includes fraud, cybercrime, and other cybercrimes.

Give regulators the things they want!

Would it be better for the crypto industry to give U.S. regulatory agencies what they ask for, i.e. ID verification, as a matter of strategic consideration? It’s been done for years by consumers for other things like opening bank accounts. If developers don’t want it, they can simply move their operations outside of U.S. jurisdiction.

Wagster predicted that some DeFi providers would adopt AML/KYC processes, whether or not they were required to, to avoid unwanted government oversight and to attract institutional funding. Others will stick to their ideologies because that is why they entered crypto.

Hartzman from Toronto cites Canadian regulation as a good example. “All exchanges are required to register with the Ontario Securities Commission/Canadian Securities Administrators, and must undergo rigorous regulatory processes and audits.”

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Hartzman added that the U.S. needs a regulatory structure designed specifically for cryptocurrency.

It seems U.S. regulatory authorities have not yet decided whether cryptocurrencies are securities, commodities or something else. The train wreck of a hearing by [SEC chairman] Gary Gensler pretty much proved to be that the regulators were behind the eight ball when it came to the crypto industry.

Byrne suggested that U.S. regulatory authorities may be too late in the game to make any significant changes on the anonymity issue. While I understand the desire of U.S. regulators to exert regulatory control, commercial reality outside of our borders will start to demonstrate their practical limits sooner than later.