The Commodity Futures Trading Commission goes after DeFi. On September 7, 2023, the CFTC announced it has filled charges against three U.S. companies in relation with three DeFi projects, Opyn, 0x (ZeroEx) and Deridex, and has reached a settlement with each of them.

Because of their loose similarities with traditional financial market instruments and actors, Deridex and Opyn have been charged with failing to register as a swap execution facility or designated contract market, failing to register as a futures commission merchant and failing to adopt a customer identification program.

ZeroEx, Opyn and Deridex are also charged with illegally offering leveraged and margined retail commodity transactions in digital assets.

The orders require that Opyn, ZeroEx, and Deridex pay a fine of $250,000, $200,000, and $100,000, respectively, and cease and desist from violating the Commodity Exchange Act and CFTC regulations. “Somewhere along the way, DeFi operators got the idea that unlawful transactions become lawful when facilitated by smart contracts,” the CFTC writes in its press release. Its Director of Enforcement, Ian McGinley, warns that “the Division of Enforcement will […]

aggressively pursue those who operate unregistered platforms that allow U.S. persons to trade digital asset derivatives”.

Despite the hostility of the CFTC’s position, one must salute its clarity, a feature in the uncertain waters of blockchain compliance in the U.S.

Dissenting Opinion From Within The CFTC

Not everyone at the CFTC agrees with these three actions, as shown by the dissenting statement of CFTC Commissioner Summer K. Mersinger. The latter disagrees with the merits of the CFTC actions as well as the confrontational nature of its rhetoric and messaging.

Mersinger distinguishes these cases from the Ooki DAO case, where a former centralized exchange which became decentralized to avoid legal liability was pursued for violation of the Commodity Exchange Act and CFTC rules. The CFTC stance was that decentralization will not erase prior unlawful centralized activities. Since all of its enforcements in the crypto space were historically targetting centralized exchanges, the recent DeFi cases, holding developers of decentralized marketplaces liable, are unprecedented and surprising.

Short of engaging with the public and innovators, the CFTC went straight to enforcement. It had in the past pledged for extensive stakeholder engagement regarding innovation, notably in its 2022-2026 Strategic Plan, underscoring that regulation in the space “requires striking a balance between protecting market participants and supporting innovation.” The novel approach is therefore hostile to DeFi market participants by its lack of understanding of the technology and lack of a balanced approach, perceived as making defi outright illegal: “today’s actions do not promote responsible innovation – they shut it down, banishing innovation from U.S. shores,” regrets Mersinger.

DeFi Is Now Effectively Illegal In The U.S.

As a result of these settlements, outside of the purview of the judiciary branch, developers may now be liable should they create code that is not only for unlawful purposes, but also if their code made for lawful purposes is used for unlawful ones, which could fall outside of their control. Combined with the recent Tornado Cash founders’ indictments, pursuing the founders of a popular blockchain privacy tool who had little control over the usage of the code they wrote, the U.S. has established itself as a jurisdiction to avoid for blockchain based innovation, especially in the decentralized finance and privacy space.

This illegality is also apprehended by the broader crypto community, as can be seen in this tweet by Gabriel Shapiro, General Counsel at Delphi Labs and seasoned crypto lawyer:

The merits of the CFTC approach is subject to much controversy, from the lack of alleged victims or harmed individuals to its understanding of the technology. The lawfulness of the CFTC position is questioned given that it appears to contradict judicial decisions, especially the one regarding Uniswap where the judge dismissed the case, saying that the developers were not liable for the harmful usage by third parties of their lawful code.

One wonders how civilians can constructively anticipate the scope and interpretation of laws and regulations, and therefore their own obligations when the government doesn’t even agree internally, as shown by the Mersinger’s dissent. Only time will tell what is the crypto long game played by the U.S.

Roman Storm and Roman Semenov, who co-founded Tornado Cash, have been charged by the U.S. for their involvement in creating and developing this blockchain privacy tool.

The co-founders are facing counts of conspiracy to commit money laundering, conspiracy to violate sanctions, and conspiracy to operate an unlicensed money transmitting business, according to the Department of Justice indictment, unsealed on August 23, 2023. The two first charges carry each a maximum prison sentence of twenty years, while the last one only 5 years.

This indictment comes a year after sanctions were imposed by the U.S. Treasury on Tornado Cash and the arrest in the Netherlands of their third co-founder, Alexey Pertsev, for alleged money laundering related to his involvement in the project. Pertsev, released after nearly 9 months of jail, is awaiting trial.

Roman Storm Day Trip To Jail

Storm, located in the U.S. was arrested by the FBI and the IRS. According to his lawyer, Brian Klein, Storm’s arrest came at a surprise since he was cooperating with the authorities and denies any criminal conduct. Storm was shortly after released on bail.

Brian Klein, an all-star crypto criminal defence attorney, previously represented Virgil Griffith, an Ethereum developer who has been convicted of sanctions violations. As a result of a conference in which he spoke in North Korea without permission, Griffith has been sentenced to over five years of prison in 2022.

Roman Semenov, The First Sanctioned Crypto Developer

Concurrent to the unsealing of the indictment, the U.S. Department of the Treasury’s Office of Foreign Assets Control sanctioned Semenov for his role in allegedly providing material support to Tornado Cash and to the Lazarus Group, what the U.S. considers to be North Korean state-sponsored hackers. The Treasury claims that the Lazarus Group provided using Tornado Cash revenue to North Korea to support its ballistic missile and nuclear weapons program, to which the U.S. is opposed.

All property and assets of Semenov in the United States or controlled by U.S. persons must be blocked and reported to OFAC. Shortly after the announcements, Semenov’s Ethereum addresses listed by the Treasury were blacklisted and USDC
USDC
belonging to these addresses are now frozen.

It is said that Semenov is currently in Dubai. UAE is known not to extradite individuals to the U.S. However, it is yet to be seen whether there will be an international arrest warrant against Semenov, whether this will lead to his arrest and whether an extradition request will follow. Absent any extradition treaty between these two nations, the extradition request can still be filed by the U.S. with slimmer chances of success, perhaps even under the United Nations Convention against Transnational Organized Crime, to which both nations are a party thereof. It’s worth noting that North Korea has also ratified this convention. In an attempt to increase cooperation between the two countries, the UAE and the U.S. have signed in February 2023 a bilateral mutual legal assistance treaty, to enhance evidence sharing, judicial cooperation and assistance in criminal investigations and prosecutions in some specific fields.

Presumed Innocent Unless Proven Guilty

The case has not been judged yet and therefore the allegations in the indictment are merely accusations. As a result, the defendants are presumed innocent unless and until proven guilty in a court of law, as opposed to a court of public opinion. The facts laid in the indictment are only part of the case against the defendants. We should expect more information to be released as the case proceeds up until the actual trial. The prosecution never lays out all its cards at an early stage as part of its usual strategy to gather more information and put pressure on the parties to plead guilty or incriminate themselves and others.

U.S. authorities have waited more than a year after the sanctions imposed on Tornado Cash and the arrest of Pertsev to sanction Semenov and arrest Storm, less than a week after the decision of the Texas district judge in favor of the sanctions by the U.S. treasury. It is unclear how long the indictment remained sealed and why the authorities acted on that specific day.

In what could be seen as a strategy deployed by the U.S. government on multiple fronts, the Texas decision laid the ground for a novel argument raised by the authorities against the co-founders, namely that they were operating an unlicensed money transmitting business.

All analysis of the case at this stage are premature and subject to change as it proceeds. Nonetheless, crypto twitter and crypto lawyers have been dissecting all the materials published, among a wave of outrage and disconcert following this unexpected development regarding Tornado Cash.

All Eyes On The Indictment

The crypto space seemed on hold yesterday after what was deemed by Collins Belton, a seasoned crypto attorney, as “arguably the most significant legal action that has occurred in crypto.”

Amongst many others, Jake Chervinsky, Chief Policy Officer at the advocacy group Blockchain Association, defends code as speech and qualifies the indictment as a direct attack against the open-source development space.

This case may have consequences beyond the faith of the Tornado Cash founders because of the novel argumentation of the operation of an unlicensed money transmission it puts forward. One such consequence could be the self censorship of developers who will not write code for privacy centric blockchain software by fear of liability. Rebecca Rettig, Chief Legal and Policy Officer at Polygon Labs, points out that this case is materially not about free speech nor are Storm and Semenov accused of simply having written code. Rather, the case is about their alleged centralized service’s involvement in a “scheme.”

Peter Van Valkenburgh, Director of Research at CoinCenter, an advocacy group that has a case pending against the OFAC sanctions on Tornado Cash, was quick to identify that factual allegations of unlicensed money transmission conflict with FinCEN’s longstanding 2019 Virtual Currency Guidance that an “anonymizing software provider is not a money transmitter”.

Even within the government, it seems that offices disagree. Patience is key since only time will tell the future of public blockchain privacy software.

MORE FROM FORBESBlockchain Privacy At The Mercy Of Bad ActorsBy Fatemeh Fannizadeh

The sanctions against Tornado Cash, a privacy tool for blockchain transactions, have shaken people’s confidence in the future of privacy on the blockchain. The main argument brought by the U.S. Treasury to justify these sanctions is the protection of national security interests, which are said to be threatened by criminal organizations using Tornado Cash to launder their money.

As a result, it seems that one criminal organization, notably North Korean affiliated hackers named the Lazarus Group, can by its unilateral use of a publicly available blockchain based application, taint the entire code and prevent its future legitimate use by good actors.

Too much power is given here to criminal actors to further harm the general population. North Korean hackers should not be able to reduce the privacy and freedom to transact of U.S. persons and entities, contrary to what is happening right now in the crypto world.

The trade-off between isolating criminal organizations and fighting against them to protect and defend public interests should not involve disproportionate harm to that public. This circular reasoning currently justifies restricting freedoms for the pursuit of justice. Put in other terms, can a peaceful citizen threaten national security by exercising his or her rights and freedoms enshrined in the constitution?

Preemptive Actions To Create Alternative Unsanctioned Applications

To preserve population’s right to privacy in this battle initiated by OFAC’s sanctions against Tornado Cash, either the lawsuits against the sanctions win in court or appeal, or the underlying facts justifying the Treasury’s decision change as to render these sanctions unnecessary.

One approach would be to analyze each of the arguments used to justify the sanctions against Tornado Cash by the Treasury in the case recently judged by the Texas district court to see whether they can be emptied of their substance through technological means that address the issue at hand. This does not mean simply avoiding the application of the law, but equally addressing the concerns and legitimate interests that the laws and authorities are looking to protect.

One aspect that developers and mechanism designers can further think of is how to create a sustainable ecosystem without fees collected by the DAO on each transaction, which was something that the Texas court held against Tornado Cash. Would it be possible, for instance, to decouple the fees from the transactions or find other mechanisms for fees to be segregated if the transactions are not legitimate, or protect the pool receiving these fees from being held responsible for the entire sanctioned actions?

Otherwise, what prevents this reasoning from being applied further to the entire Ethereum blockchain as well? Transaction fees are disbursed to the cryptocurrency miners or validators of the underlying blockchain on which Tornado Cash runs. Aren’t those fees paid by ill-gotten funds and wouldn’t that also be an instance of money laundering by Ethereum, which could be considered by the courts as an entity? After all, the Texas district court deemed Tornado Cash to be an association. This may be a stretch but these extrapolations help assess whether a specific reasoning is sustainable.

With that in mind, there are Ethereum block builders who refuse to process transactions related to Tornado Cash. Generally, what is known as OFAC compliant blocks has been estimated to amount to more or less 50% of the overall network.

Many other angles deserve independent in-depth creative analysis that hopefully inspire many builders and technologists. For the time being, it remains to be seen if the Coinbase-backed Tornado Cash case, as well as the other parallel cases, will succeed in defining Americans’ right to use public blockchain tools.

MORE FROM FORBESTornado Cash Is An Association, Says Texas CourtBy Fatemeh Fannizadeh

A Texas judge decided in favour of the sanctions of the Office of Foreign Assets Control against the blockchain privacy tool Tornado Cash. As a result of the sanctions, using this tool has become illegal for US persons and practically impossible for others.

The Coinbase-backed case claimed that the Treasury exceeded its statutory authority by overstepping the requirements of the International Emergency Economic Powers Act, a law used by OFAC to justify its sanctions against Tornado Cash. The plaintiffs also argued that the sanctions are not in line with the Free Speech Clause of the First Amendment. The court dismissed all of the plaintiffs’ motions. Here is why.

The Treasury Was Within Its Right To Sanction Tornado Cash

The government argued that Tornado Cash is an entity, which has a property interest in the smart contracts, and therefore can be designated and sanctions enforced against. The court agreed with this reasoning in three steps.

The Association Of Tornado Cash

Tornado Cash is “an entity that may be designated per OFAC regulations,” writes the court. Specifically, it finds that Tornado Cash is an association within its ordinary – and not regulatory – meaning. That entity is composed of Tornado Cash founders, developers, and a DAO (all TORN token holders), together promoting and executing the common purpose of Tornado Cash in order to profit from these activities.

The Contractual Nature Of Tornado Cash Smart Contracts

The court adds that the Treasury acted within its given power, saying “OFAC’s determination that the smart contracts constitute property, or an interest in property, is not plainly inconsistent with the regulatory definition of those terms.” That being said, the court also notes that these terms have been defined by OFAC itself in its implementing regulations, giving them a broad reach.

Contracts are an instance of property as defined by OFAC, and the question of whether smart contracts are to be considered “contracts” is a contentious point among the parties. “Not every smart contract can be considered a contract” writes the judge, but in this specific case it is considered that the smart contracts represent a unilateral offer to provide services. The judge relies on one analogy commonly used to explain smart contracts by comparing them to vending machines, which also do not require outside human intervention. As vending machines are a form of unilateral contracts, so should Tornado Cash smart contracts be, it concludes.

The Financial Interest Of Tornado Cash DAO In The Smart Contracts

Although widely argued against, the court nonetheless finds that Tornado Cash as an entity has a beneficial interest in the smart contracts because of its expectation that they continue to generate revenue for the DAO. This revenue stream in TORN tokens relates to a specific type of transactions called relayer-enabled transactions. Despite this type of transactions being optional should the user want to benefit from the added privacy they bring, it formed around 84% of all Tornado Cash transactions.

The Plaintiffs Failed To Claim And Prove Any Violation Of Their Free Speech

The court rejects any violation of free speech by the sanctions since code is available and can be lawfully analyzed and used “to teach cryptocurrency concepts,” but not executed nor transacted with. The judge states here that the plaintiffs did not claim, let alone sufficiently demonstrate, that any of them has felt inhibited to use the open-source Tornado Cash code in a lawful manner. Additionally, the judge considers that the plaintiffs have failed to cite any case sustaining that free speech protects the right of individuals to donate money to social causes of their choosing through any particular bank or service they opt for, such as Tornado Cash. Finally, the judge highlights that the plaintiffs have not explained how these specific sanctions prevent them from using other alternative on-chain privacy tools.

This judgment, although dismissive of the claims against the Treasury, gives concrete grounds for privacy-focused lawyers and technologists to build a stronger case in favour of their right to privacy. To influence the outcome of the judicial process, privacy advocates now know what to argue to correct the underlying facts, the legal principles and their interpretations on which this court’s reasoning is based.

Next Step, An Appeal To The Fifth Circuit

A loss for the plaintiffs but also for privacy and the decentralized open-source space, this may however just be a bump in the road. Coinbase’s Chief Legal Officer Paul Grewal expressed their support of an appeal to the Fifth Circuit. This does not come as a surprise given that the stakes are high and it should have always been assumed that the dismissed party in district court would play their remaining cards and appeal.

The plaintiffs are not only acting on their own account but can be assumed to defend the interests of all cryptocurrency users in the U.S. and beyond. They must now argue against the reasoning of the judge, while also taking into account and crafting other strategies that could be deployed alongside the potential appeal.

MORE FROM FORBESTexas Judge Sides With The Treasury Against Tornado Cash In Crypto CaseBy Fatemeh Fannizadeh

The United States District Court for the Western District of Texas sided with the U.S. Treasury on August 17, 2023, in a lawsuit disputing the legitimacy of sanctions added by the Department of the Treasury’s Office of Foreign Assets Control against Tornado Cash in its Specially Designated Nationals and Blocked Persons list in August 2022.

All arguments put forward by the plaintiffs in this lawsuit backed by Coinbase have been dismissed by the court in a 25-page document.

Stepping back, Tornado Cash is a privacy focused blockchain tool that enables users to transact on the blockchain while protecting their privacy, the latter being a pain point of Ethereum or Bitcoin that publicly leak more information about an address history of transactions than would a traditional financial actor such as a bank. In short, the court’s decision now makes it nearly impossible for Ethereum users in the U.S. to feel confident in their right to use privacy tools like Tornado Cash when transacting with cryptocurrencies.

Tornado Cash Is An Equal Access On-Chain Privacy Tool

The Treasury blames Tornado Cash for facilitating money laundering to the tune of what they claim to be over $7 billion since the software’s creation in 2019. Although money laundering is only one use case for mixers and other privacy tools, roughly half a billion of the allegedly laundered funds were attributed to the Lazarus Group, an infamous collective of hackers affiliated with the Democratic People’s Republic of Korea.

The decision to sanction Tornado Cash as a whole has been highly controversial and disputed, especially given the popularity of this platform among regular users of cryptocurrency. Multiple lawsuits against the sanctions followed, notably by Coin Center, a leading U.S. cryptocurrency advocacy group. The outcome is still pending in District Court.

Shortly after Tornado Cash was sanctioned, one of its core developers, Alexey Pertsev, was arrested in the Netherlands. He spent eight months in jail before his conditional release in April 2023. He is awaiting trial.

A few months before Tornado Cash, in May 2022, U.S. Treasury issued its first-ever sanctions on a virtual currency mixer called Blender.io for processing over $20 million of Lazarus Group’s Axie Inifinity hack proceeds.