Last month’s sudden implosion of the popular cryptocurrency exchange FTX has intensified a political war for the soul of crypto that was already raging.
In the coming year, we are likely to see that fight come to a head in US courtrooms and in Congress. The future of finance hangs in the balance.
The battle lines are complicated, but there are two prominent sides. A vocal crowd of crypto skeptics, which includes prominent politicians and regulators, wants to rein in an industry it sees as overrun with fraud and harmful to consumers. The catastrophic demise of FTX has emboldened this group.
Then there are the champions of “decentralization.” Members of this camp tend to believe that cryptocurrency networks like Bitcoin and Ethereum—since they are accessible to anyone with an internet connection and are controlled by public networks instead of companies, governments, or banks—are vital to the future of privacy and financial freedom. They worry that misguided attempts at regulation could imperil those freedoms.
To this group, the collapse of FTX is further proof that centralized control is dangerous—and a reminder of why crypto exists in the first place. Their goal is a blockchain-based financial system that is more accessible and private than the traditional one, which they see as plagued by surveillance and rent-seeking middlemen.
The truth is, policymakers had crypto in the crosshairs long before the FTX debacle. The courtroom fights and congressional debates we will see in 2023 were going to happen regardless. And given the outsize role that America plays in the world’s financial system, the outcomes of these fights will have global implications.
For those who see open blockchains as crucial to the future of finance, the stakes have never been higher. Can they hold their ground and keep decentralized financial systems free from traditional regulatory frameworks? Or will policymakers manage to tame these platforms by imposing some degree of centralization? These questions have lingered over crypto for years. Now we’re on the verge of getting answers.
“The crypto we created”
The details of the FTX collapse are complicated and still coming to light. Its founder and CEO, Sam Bankman-Fried, has been indicted in the US on fraud and money laundering charges. It’s hard to know how much crypto itself is to blame.
Although crypto enthusiasts may now be inclined to distance themselves from FTX, the episode reflects “the crypto we created,” says Neha Narula, director of the Digital Currency Initiative at MIT.
To begin with, she says, the industry is over-reliant on centralized exchanges like FTX. But it’s not just the centralization. “It’s also this token casino economy,” says Narula.
Like many crypto firms, FTX created its own cryptocurrency. What started the chain reaction that unraveled the exchange was reporting in early November by CoinDesk that FTX’s affiliated trading firm, Alameda Research, had a significant portion of its money denominated in that currency, called FTT. As CoinDesk put it: Alameda, which was believed to have more than $10 billion in assets, was resting on “a foundation largely made up of a coin that a sister company invented, not an independent asset like a fiat currency or another crypto.” The revelation set off a series of events that eventually caused FTT’s value to plummet.
In fact, the whole industry has built a “self-referential ecosystem” on top of “ambiguous tokens” created “out of nowhere,” with “very loose arguments for why they should have any value,” Narula says. The FTT token is just one of thousands of cryptocurrencies.
The ambiguity of these tokens is a big reason regulators are now zeroing in on an emerging area of the crypto world known as decentralized finance, or “DeFi.”
Decentralize this
Let’s stick with FTT as an example. In the US, it is not possible to buy FTT on a centralized exchange. That’s because it’s likely that if an exchange were to offer it, it would risk getting in trouble with the Securities and Exchange Commission (SEC).
The SEC’s mission is to protect investors who participate in financial asset markets. It does so by requiring the companies selling these assets to register with the agency and submit comprehensive disclosures about their finances.
SEC chair Gary Gensler has said he believes that many of the cryptocurrencies in circulation are securities and should be regulated as such—implying that organizations offering those assets to US customers are doing so illegally. Since FTT resembles FTX stock in important ways, it likely falls into this category.
But although the government can stop centralized exchanges from listing unregistered securities, it can’t stop exchanges that run completely on a blockchain from letting people trade those securities.
Decentralized exchanges, or DEXs, are central to the fast-growing world of DeFi. The most prominent DEX is Uniswap, which sees more than a billion dollars in daily trading volume. Uniswap is a set of smart contracts—essentially, computer programs that are stored on and executed by the Ethereum blockchain—that allow anyone with an internet connection to buy and sell a wide range of cryptocurrencies, regardless of how regulators might classify them.
DeFi’s proponents have pointed to FTX as the latest evidence that what we need is an alternative, “open,” and decentralized financial system. DeFi applications verify transactions cryptographically, and everything is recorded on the blockchain. There are no corruptible middlemen.
Therein lies the problem, however, with decentralized financial applications—at least in the eyes of policymakers: if there is truly no one in the middle, there is no one to regulate. How can regulators police securities trading on decentralized platforms? How do they make sure illicit funds aren’t being used?
This challenge explains why the hot topic of “DeFi front ends” is on track to boil over in Washington this year.
“Front ends” is the industry term for the web-based user interfaces through which most people access DeFi protocols, since doing so otherwise requires some specialized technical know-how. In the case of Uniswap, a startup called Uniswap Labs built and maintains the front end.
The big question now is whether a DeFi front end should be required to get a license from the government, says Stephen Palley, a partner at the law firm Brown Rudnick and cochair of the firm’s digital commerce group. He doesn’t think so, at least not in every case:
“If I create a website and all that it does is give people the ability to interact with software that somebody else created that exists on a global distributed database—that they could interact with themselves already—how have I created a securities exchange?”
DeFi has exploded in popularity in the past two years, but it is still niche and mostly a thing for traders. It hasn’t yet delivered on its more idealistic promise. Proponents argue that regulating front ends could be fatal to DeFi because it would add the kind of barrier to entry that blockchains were supposed to eliminate.
It seems safe to say that whether regulators gain control of this important DeFi access point will have a profound influence on how the underlying technology evolves from here. Don’t be surprised to see regulators take some kind of action soon, says Palley. This fight is likely to play out in the courts over the next two years, he says. Congress may also get involved.
Tornado warning
DeFi advocates are also facing off against regulators on a separate front, where the main issue at hand is privacy. Nowhere are the stakes higher for the future of the decentralized financial systems than in the case of Tornado Cash.
Like Uniswap, Tornado Cash is a set of smart contracts on the Ethereum blockchain. It lets users deposit cryptocurrency in a pool of other people’s digital money and then withdraw it to a different address, while using advanced cryptographic techniques called zero-knowledge proofs to ensure that there is no public link between the deposit address and the withdrawal address. That means the money is no longer tied on the blockchain to the user’s past transactions, which makes it harder to trace and provides a layer of privacy.
In August, the Treasury’s Office of Foreign Assets Control (OFAC) sanctioned 45 Ethereum addresses associated with the platform, effectively banning Americans from using it and decimating its user base. The agency said it took the action because Tornado Cash had been used to “launder” billions of dollars, including hundreds of millions stolen by North Korean state-sponsored hackers.
OFAC has sanctioned blockchain addresses associated with foreign individuals before, but never has it sanctioned a smart contract. It also doesn’t have the authority to do so, argues Peter Van Valkenburgh, director of research at Coin Center, a policy advocacy group in Washington, DC. As Coin Center points out, many of the contracts OFAC sanctioned cannot be modified, blocked, or turned off by any of Tornado Cash developers; they exist independent of human intervention.
While OFAC has the legal power to sanction people and certain foreign entities, it can’t ban Americans from using a tool like Tornado Cash, Van Valkenburgh says: “The statute that gives OFAC power was never intended by Congress to be used to tell Americans which software tools they can and cannot use.”
Coin Center has filed a lawsuit against the Treasury Department aimed at reversing the sanctions and blocking the Treasury from “enforcing against ordinary their self-evident and basic rights to privacy.” Besides arguing that OFAC does not have the authority to ban software tools, Coin Center also argues that the sanctions violate the Constitution. The popular US crypto exchange Coinbase is funding a similar lawsuit against the Treasury.
After the sanctions came down, GitHub removed the project’s source code, and the project’s website, tornado.cash, was taken down. Separate from OFAC’s actions, Dutch authorities detained one of Tornado Cash’s developers, Alexey Pertsev, and a prosecutor has accused Pertsev of facilitating money laundering.
Pertsev was one of Tornado Cash’s founders. But like most crypto projects, Tornado Cash is open source and relies on a loosely affiliated collective of contributors. Another cofounder, Roman Semenov, did not respond to a request for a comment.
All of crypto is watching the Tornado Cash saga closely, because whatever happens will shape the future of online finance. “A developer should not be treated like a financial intermediary just for writing code and putting it on the internet,” says Narula. There are many steps between doing that and running a service, she says.
At what point does a financial application go from being just code on the internet to being a service? That’s also the question at the heart of the conflict over DeFi front ends.
At stake in both cases is the freedom to use a blockchain-based service without seeking permission from the government. One thing we can expect is that crypto’s true believers will fight with everything they have to keep that freedom in place.
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