Sauron Remains Undefeated

I'm delighted to co-author this note with my friend Brent Donnelly, president of Spectra Markets and FX trader extraordinaire.

Brent is a senior risk-taker and FX market maker. His latest book, Alpha Trader, was published last summer to great acclaim (by me, among others!) and can be found at your favorite bookseller. I think it’s an outstanding read, and not just for professional traders. He publishes a daily (!) note on FX, which you can subscribe to here, and a weekly note on crypto, which you can subscribe to here.

You can contact Brent at bdonnelly@spectramarkets.com and on Twitter at @donnelly_brent. As with all of our guest contributors, Brent’s post may not represent the views of Epsilon Theory or Second Foundation Partners, and should not be construed as advice to purchase or sell any security.

Last April I wrote a note titled In Praise of Bitcoin, which got a fair amount of attention for the first of its two assertions, that Wall Street was transforming Bitcoin into Bitcoin!^TM — just another securitized and sanitized game in the Wall Street casino, with all the revolutionary potential of a bumper sticker.

Bitcoin!^TM doesn’t stick it to the Man … Bitcoin!^TM IS the Man.

But the second of that note's assertions didn't get nearly as much attention, even though I think it's the more important of the two.

The US Treasury is the Eye of Sauron — a gigantic panopticon tower that sweeps the world with its unblinking gaze, seeking out the owners of power, i.e. money.

The US Treasury can’t see Bitcoin. It can, however, see Bitcoin!^TM, and it will not rest until all of crypto has been transformed into Wall Street's securitized and sanitized casino game.

What Treasury did to Tornado Cash and its developers is just the beginning.

Here's Brent to explain ...

The US Treasury sanctioned Tornado Cash on August 8. This has triggered a massive wave of concern, outrage, anger, navel-gazing, disbelief, fear, beard-scratching and scrambling from the crypto community, even as the historic move garners minimal coverage outside the crypto media. The US Treasury press release is here.

Here are some key points:

1) What is Tornado Cash?

Tornado Cash is a non-custodial decentralized privacy solution built on Ethereum. It is a currency tumbler or crypto mixing service. It increases the confidentiality of transactions by breaking the link in the chain between the recipient and recipient addresses. The idea is to obscure transactions by sending some crypto in and other crypto out so that withdrawals are not traceable.

If you have done any anti-money laundering training in your career (I have done plenty!) you would not be wrong to say that sounds a lot like layering, the second stage in the money laundering process. In fact, most descriptions of layering include the word “mixing” or “tumbling.” For more background on Tornado Cash, see this article which covers most of the main points. The article was written in June, before the sanctions.

Most analysis of Tornado Cash (the entity, and the application) focuses on the illegal aspects of Tornado Cash because laundering money has been the headline use case. There are, however, also legitimate uses, for example if someone in a country run by a dictator wanted to donate anonymously to the opposition party without risking jail, or a person in a nation that doesn’t respect women’s rights wanted to donate to a women’s rights organization without fear of retribution, etc. Simply, people that don’t want their crypto holdings and transactions known for whatever reason could use Tornado Cash to obfuscate them. While the obvious uses case is for criminals to launder hacked crypto, there are other use cases.

2) Violating sanctions is a big deal.

The immediate effect of the announcement was a scramble by anyone remotely connected to Tornado Cash to stand down or risk fines and jail. The most notable tertiary impact was that GitHub (the 83 million user developer hub owned by Microsoft) removed the accounts of Tornado Cash, and three developers who helped write the code (Roman Semenov, Roman Storm, and Alexey Pertsev.) These ripple effects create an avalanche of questions around free speech and government power.

"Thirty years of hard legal work to establish First Amendment protections around software distribution, blown up in a day by Github and Microsoft”

Matthew Green, cryptography professor at Johns Hopkins University

The sanctions from the Treasury don’t specifically name any individuals but a company like Microsoft is not going to take sanctions risk. Aave, dYdX and other big DeFi names also blocked addresses associated with Tornado Cash. Circle, the issuer behind the USDC stablecoin, froze 81 addresses linked to Tornado Cash and around 75,000 USDC. This freezing and blocking triggered venom from the financial freedom and privacy-oriented commentariat but most real-life crypto participants are more interested in self-preservation and making money than risking jail time to lead a utopian revolution in monetary privacy.

Meanwhile, Dutch authorities arrested a Tornado Cash developer, further opening this can of worms and adding to the outrage. Kyle Davies, Su Zhu, Alex Mashinsky, Do Kwon and others still walk free (for now).

Here’s Jake Chervinsky, Head of Policy for the Blockchain Association:

3) US Treasury seems to be sanctioning a protocol, not an entity.

While there is a Tornado Cash website and entity, the application or protocol is essentially sanctioned too as the wording of the Treasury’s action is broad. Sure, someone could cut and paste the Tornado Cash code and build a new app called F5-Cash, or whatever. But the cat is out of the bag and Tornado users are not just going to switch over to F5-Cash! They know any similar application that gathers critical mass risks being similarly sanctioned.

Many question the effectiveness of sanctions but if nothing else they send a stark message and they shut down a known money laundromat. For a deep dive on the legal aspects of this, the constitutional challenges, and the nuances between Tornado Cash (the entity) and Tornado Cash (the code / application / protocol), this is the best read.

Treasury knows they will be challenged in court on this, and they are saying: “Bring it on.”

4) Crypto world is rallying around OG crypto philosophy now that “number go up” vibes have fizzled.

Ideas like “code is free speech” are being tossed around though I’m sure Treasury will say they are not sanctioning the code per se—people are free to cut and paste it as they see fit.

Some are getting that same funny/spooky feeling of authoritarian creep they felt with the sanctioning of the Canadian Truckers. Rule of law is important! Tools which are potentially fine in the hands of a government you trust, may not be fine in the hands of one you do not trust.

Then again, the arrested developer built a public money laundering service, not a Minecraft mod. If you view electronic freedom and the right to monetary privacy as absolute, you are surely up in arms about Tornado Cash sanctions. If you see those as privileges subject to a series of ongoing tradeoffs between protecting the financial privacy of innocent people while prosecuting criminals and state-sponsored terrorists, maybe not.

Since crypto advocates have offered a mountain of vitriolic responses to the Tornado Cash sanctions, and I like to hear both sides of every story, I asked Travis Kimmel for his thoughts.

Travis is sometimes described as a crypto hater, but I think he’s more an informed, unbiased pragmatist who has come to his own conclusions and decided crypto is a dead-end technical path. A differing opinion doesn’t always make someone a hater. I am less pessimistic than Travis on crypto, but I find his views a useful antidote to the much more plentiful religious crypto zeal.

Here is what he said when I asked him about the Tornado Cash sanctions:

“The challenge is this: I'm generally a fan of EFF (and a frequent donor), but the framing of "they're arresting people for writing code oh my god" is just not genuine. They're arresting people for making a publicly accessible money laundering service, because that sh*t ain't good for society and isn't legal. To me the arguments about privacy are just abstractions that are not empirically valid.

Is privacy of money a social good? Well… yes, at some level, but it’s not black and white.

And our current policy framework reflects this: money should be anonymous and frictionless and all that at the base layer of society. Nobody should give a sh*t where I’m buying coffee, or how much, or any of that. The cash economy.

But should people care if I’m buying a house? Yeah, I mean… they kind of have to. Coffee is small enough that the risk of ‘illegitimate transactions’ is smaller than gain experienced by it being frictionless. But as we move up the transaction scale, at some level that changes.”

There is a utopian desire for financial privacy in crypto-land, but financial privacy is not a fundamental human right in the United States. There are laws here that limit financial privacy. That’s why AML and KYC exist. If you don’t like the sanctions because you don’t like AML and KYC, you are fighting a battle in a war you can’t win.

Then again, it’s reasonable to argue that the simple act of seeking financial privacy (or allowing others to seek financial privacy) has been criminalized here, which does seem wildly aggressive and overreachy.

Some are making free speech arguments because code is deemed to be speech. And in the US, money is sometimes speech, when that money is being funneled into Washington. I’ll leave these arguments to the constitutional lawyers.

5) 1ETH = 1ETH?

While crypto always seems to emerge unscathed (or stronger) no matter how much it feels like the regulatory walls are closing in, the walls can only close in so far before things go crunch. If users (and particularly US institutional investors) look at what happened to Tornado Cash and start pondering existential risks like arbitrary address blocking ... well, that creates new uncertainty around the premise that 1ETH = 1ETH.

At the very least, it seems undeniable that the US Government is not going to allow a private, libertarian monetary system to be built on top of the USD.