Tornado Cash Sanctions Prove DeFi Regulation Is Inevitable

Last week’s decision by the U.S. Treasury Department’s Office of Foreign Assets Control to sanction the cryptocurrency mixer Tornado Cash was the first major action against such a service, and could well prove to be a transformational event on DeFi’s road to mainstream recognition.

That’s because the impacts of that decision have had such magnitude that DeFi leaders will have no option but to recognize that regulation is the only way for the industry to grow beyond its current niche audience.

Last week, the OFAC slapped Tornado Cash with heavy sanctions as a result of it enabling malicious actors, including a group of North Korea-linked hackers, to process illegal transactions totaling over $1.5 billion. The sanctions come with severe consequence’s, as they mean that all U.S. individuals and entities are now barred from using Tornado Cash, and face criminal penalties if they choose to do so anyway.

Tornado Cash is a so-called mixer service that people can use to hide the source of their crypto transactions. All funds sent to the protocol are directed into a larger pool that mixes all of its user’s tokens, before they can be withdrawn again. In this way, it becomes impossible to tell where those funds came from.

While advocates say Tornado Cash has legitimate privacy use cases for a decentralized Web3, the platform has also become a favorite tool of cybercriminals, who have used it to launder billions of dollars worth of stolen funds. This includes more than $455 million of the over $600 million that was stolen from the Ronin blockchain network that hosts the popular Axie Infinity “play-to-earn” game.

In addition to the sanctions, the U.S. Treasury Departments OFAC also blacklisted multiple wallet addresses belonging to Tornado Cash. The sanctions further block any assets held by the platform that fall under U.S. jurisdiction, and prohibit U.S. citizens and companies from transacting with it.

While the sanctions will almost certainly make it more difficult for criminals to use Tornado Cash to launder stolen funds, they also signal a new chapter in the story of DeFi, which is an alternative and completely unregulated financial system – there can be no escape from regulation.

Miller Whitehouse-Levine, policy director at research and advocacy group DeFi Education Fund, told the Wall Street Journal that the sanctions will have “deep implications” in the future. “The industry’s impression is that the U.S. government is pivoting from focusing on punishing bad actors to policing the protocols,” he said.

DeFi Regulation To Accelerate

With Tornado Cash now sanctioned and its servers and source code taken offline as a direct consequence of that move, it seems inevitable that regulatory scrutiny on the DeFi sector will increase.

Traditionally, the leading DeFi protocols have brushed off calls for regulation, simply shrugging their shoulders and saying that it’s impossible to regulate the sector due to its decentralization. However, a rethink could well be in order if DeFi is to grow and fulfill its potential as a genuine alternative to traditional finance that can appeal to the masses.

One of the first steps in this will be the acceptance of regulator’s motives, which entails rejecting the popular opinion that governments simply want to shut down DeFi. Rather, their primary intention is to simply suppress financial criminals, without killing off the game-changing potential of DeFi to “bank the unbanked”.

We have proof of these positive intentions. Earlier this year, the Financial Action Task Force published a report that highlighted how cross-chain bridges have successfully helped to grow DeFi. However, the same report also pointed out that this innovation is aiding criminals in moving funds across networks more swiftly, complicating authorities’ efforts to prevent money laundering. As we can see, regulators’ main focus is on preventing crime, not stopping DeFi from doing what it’s doing.

Given the attention DeFi has attracted, it seems clear that developers in the space will have no choice but to acknowledge they’re going to need to come to an understanding with DeFi regulators on matters pertaining to compliance. If they don’t, and their projects fall under the regulator’s crosshairs, they will almost certainly be presented with serious challenges due to their inaction.

DeFi developers have long argued that it’s impossible to truly regulate DeFi. They say that regulation involves subjecting a centralized authority to certain rules, and punishing them for non-compliance. Because DeFi does not have any centralized authority, they claim it isn’t possible to regulate DeFi.

However, the sanctions placed on Tornado Cash prove that DeFi protocols can indeed be severely punished, and it seems unlikely that the service will recover – even if it does manage to come back online.

The good news is that there are already some initiatives in the DeFi sector that are happy to work with regulators. They include projects like Phree, which is attempting to build compliance protocols in anticipation of forthcoming regulation.

Phree acknowledges that regulating DeFi is difficult and that protocols cannot be subject to rules and punishments. However, in order to breathe DeFi does require onramps and offramps into the traditional world of finance. People need a place to be able to exchange their crypto for fiat, and it’s these services that can be subject to rules that must be complied with.

To that end, Phree is building a compliant DeFi ecosystem-as-a-service platform and a licensed asset manager that developers can use to create transparent and permissionless protocols that will attract more mainstream investors. Basically, it will be able to enforce that DeFi users undergo KYC and AML before interacting with these protocols. By doing this, Phree believes it can address the challenge of what happens if funds go missing due to a “rugpull” or a hack that takes advantage of smart contract vulnerabilities.

Initiatives like Phree have led to the realization that there is a big opportunity in DeFi. The world’s biggest financial institutions see compliance as a must-have before they can inject liquidity into a DeFi project, even if they see the potential of it. Serious investors will not sink their money into a protocol that ends up on a U.S. blacklist as a result of some North Korean hacker abusing it. As such, it’s likely that DeFi projects that continue to ignore calls for regulation will fall by the wayside, while those that do agree to subject themselves to greater controls will prosper amid the growing interest of traditional financial players.

There’s reason to believe DeFi will embrace regulation soon. Already, Phree has struck partnerships with the likes of PwC Switzerland and Mastercard and is planning to launch its platform next year. When that happens, we can expect it to give birth to a number of compliant, yet still decentralized protocols.

More than anything else, the Tornado Cash sanctions show us that the prospect of regulation in DeFi cannot be ignored. While compliance will scare away the crypto diehards who refuse to accept any kind of governmental interference, the vast majority of users will continue to follow the money trail. After all, one of the greatest attractions of DeFi is the opportunity to make more money. As institutional investors look for newer investment avenues, it’ll be the most compliant DeFi protocols that are best positioned to attract this new money.

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