The War Against DeFi & Crypto Privacy Begins: How Will It Impact The Internet Computer?

The other week on August 8th, the US Treasury Department’s Office of Foreign Assets Control (OFAC) sanctioned Tornado Cash, a popular cryptocurrency mixer used for making cryptocurrencies untraceable from the original wallet.

The US government made this move in reaction to money laundering accusations against North Korean hacking groups that stole money from US persons. As a result of this policy move by the US, a huge debate has begun about the future of DeFi, censorship, privacy, security, and crypto policy.

What Risks Does The Tornado Cash Sanction Pose To The Industry?

The first risk is shutdown contagion. For example, if Tornado Cash, a smart contract cryptocurrency mixing service, can be shut down and sanctioned by a global government, then any decentralized application (DApp) can suffer the same fate, primarily if they’re involved in transactions or are a financial platform.

For example, the US government, European Union, Russia, India, or anyone else can claim that a particular DeFi service was used by a sanctioned person, criminal, wanted suspect, or just simply say that service threatens the country’s national security — and subsequently issue an executive order or lawsuit against the app/service.

This would effectively shut down that service as any users would be unwilling to risk having their assets and money frozen or challenge the legal authority of nation-states. Essentially, these types of actions can bring a ton of FUD to the market and service in general, which would almost be enough to cause significant disruption.

The second risk is censorship. As a result of the sanctioning, other DeFi applications such as Aave and centralized exchanges (CEXs) such as FTX are banning blockchain wallets or users that have had touchpoints with Tornado Cash transactions. This means that blockchains and Web3 are not all that censorship-resistant, especially when it comes to laying down blanket bans over all Tornado addresses, even if the addresses have nothing to do with the North Korean hackers and ransomers.

However, as said above, it hasn’t stopped there, more players have signed on to the sanctions and are abiding by stopping any Tornado Cash addresses such as dYdX, UniSwap, Balancer, OpenSea, and Circle. So this confirms the hypothesis that in general, other companies, projects, and services will follow suit and abide by the sanctions. As a result, the conclusion is DeFi applications are not censorship resistant and face economic policy risk, regulatory risk, political risk, and cybersecurity risk.

It’s important to note here that these censorship concerns are all occurring on the Ethereum blockchain. As a result, there’s been a ton of criticism that Ethereum is in fact vulnerable to censorship and has a loophole in the privacy/security/decentralization tradeoff. But these concerns are already known, but the solution still hasn’t arrived.

The third risk is privacy. Tornado Cash is a cryptocurrency mixer, which means that cryptocurrency holders can send their coins to a smart contract and the smart contract will mix them and thus the end crypto will be untraceable. However, these types of services are dangerous because they combine good and bad actors. Good actors and regular folks may want to use mixers and tumblers for their transactions too (because generally speaking, it’s not hard to track cryptos). However, bad actors are also present in crypto and they just the same will utilize these services. So when a country has no choice but to go after the “bad guys,” the “good guys” will be casualties as well. It’s unfortunately the nature of the game.

This is why people commonly say “blockchains are anonymous, but aren’t private.” This issue of privacy, however, is an issue that certain blockchain and technology stacks like the Internet Computer are better at.

The fourth risk is security. Security can be interpreted in a few ways. For example, the security of being able to control the people coming to your platform — say blockchain and crypto enthusiasts and not rogue nation-states. So if a bad actor or rogue regime wants to use your crypto service, there should be a way to screen these people. Because when a platform is open to everybody, it also faces a risk of being open to everybody, and not everybody is a good person. So this creates a security risk of being “too open for business.”

So as a result of this privacy feature in the Tornado Cash smart contract, it subsequently gave the service a business risk of being not secure and usable for a crime.

The second aspect of security is being secure against regulatory risk and stable as a service. Inherently, because DeFi is largely not KYC’d, it faces a risk of being vulnerable to security risks and targeting. As a result, governments may potentially keep attacking “threatening” DeFi services and DApps that can be used for both civilian and criminal purposes.

How Would Other Blockchains Fair Under Similar Pressure?

Generally speaking, all blockchains or layer 1s can be targeted and disrupted by governments, although it would be extremely difficult to 100% take them down. For example, as long as a blockchain or layer 1 relies on any centralized or public services, or uses fiat currencies like the Pound, Dollar, Euro, Ruble, etc, they can be sanctioned or targeted and hence lose that part of their business. This is why layer 1 blockchains in general should move to decentralized technology systems as the Internet Computer deploys.

For example, Solana and Avalanche rely to a large degree on AWS, and other crypto websites and services rely on CloudWare for their web servers. However, both these things can be disrupted and targeted during a sanction or legal ruling.

That’s why the Internet Computer has established its own independent world computer. It has its own standard operating data centers and protocols that run the network in a decentralized way. So if a sanction were to occur, it would be outside the reach of any individual government.

Nonetheless, even if a system operates its own backend and frontend, it’s still hard to fully escape the reach of real laws. But, what makes the Internet Computer blockchain unstoppable is its decentralization of node operators.

It’s similar to the Bitcoin blockchain, one cannot go in and sanction the blockchain because that would involve going after every miner validating blocks and cutting them off from the financial system. There are debates though that Ethereum moving to PoS makes it less resilient in this aspect. But that’s a rabbit-hole debate for another day. The takeaway is the Internet Computer because of its independent data centers and self-governing protocol, is censorship resistant to attacks that occurred to Tornado Cash. The Internet Computer is a sovereign network. This means that applications running on the Internet Computer are “sovereign applications.” Thus, making them censorship-resistant as well.

Stay tuned for my future analyses on how current events and crypto winter are impacting the Internet Computer. Resiliency is key, and I think the IC is in a stable place.