Q9 Markets | Constitutional Rights or Criminal Wrongs?

12 August 2022

Q9 Capital: www.q9capital.com

Weekly 12.08.2022

Constitutional Rights or Criminal Wrongs?

• Ethereum completes final dress rehearsal before the Merge
• Coinbase reveals $1.1bn loss for Q2
• Constitutional questions raised about privacy and speech after US sanctions Tornado Cash

Ethereum spiked again (+17%) to $1.9k after developers successfully “merged” a proof-of-work testing environment called Goerli with a proof-of-stake chain, in the third and final dry run before the real “Merge” happens next month. The number of addresses holding over 1k ETH hit a 7-month high as whales continue accumulating before the main event. The price of Ether has more than doubled since its June low.

Source: Glassnode

Markets jumped mid-week after the US consumer-price inflation (CPI) data showed inflation has cooled. The core CPI was unchanged at 5.9% versus the expected 6.1%. Equities are taking the news positively with the hope that the Fed may need to be less aggressive in their rate hiking cycle. The Nasdaq now sits at its highest level since early May and has rallied more than 20% from its recent low.

Source: New York Times

Crypto also took the news positively. Bitcoin rose +5.9% this week to $23.9k. Most DeFi names, Layer-1’s and GameFi tokens had a positive week, with Avalanche (+22.2%), Chainlink (+21.9%) and Solana (+10.3%), all standout performers.

Insert COIN

Coinbase (COIN), a major proxy for the state of the wider crypto market, released its quarterly earnings on Thursday. Revenues for the firm fell 61% in Q2 as crypto prices fell and trading volumes slumped. The exchange reported an after-tax loss of $1.1bn, compared with the $1.6bn net profit it registered in the middle of the crypto boom a year ago — but analysts believe the company’s balance sheet leaves it well positioned to survive a prolonged crypto winter.

As part of a wider effort to trim its budget, the exchange said it would be cutting back on its marketing spending, and laid off about 18% of its staff in June — about 1,100 employees. But the firm received a major boost from its recently announced partnership with BlackRock. Shares have been volatile in recent days, but have jumped ~25% since the alliance was penned.

Coinbase is going to have to get smart about how it makes revenue in the future as spot trading volumes have declined as clients HODL, not generating income from transaction fees. The exchange could start charging fees for market data and colocation, develop more investment and asset management products, and increase distribution by white-labeling its services. It could also support high margin options markets like rival exchanges Binance and FTX.

Coinbase Total USD Reserves

In other crypto company news… Singapore based crypto lender Hodlnaut became the latest firm to halt withdrawals citing extreme market conditions. Jame DiBiasio at DigFin has a good take on the fallout and liquidity issues surrounding crypto lending products. You can read it here. Crypto futures exchange CoinFLEX has filed for restructuring in Seychelles as part of its plan to improve its financial situation. German crypto exchange Nuri GmbH has filed for insolvency in Berlin, according to a court filing.

Tornado Warning

The US Treasury has blacklisted cryptocurrency mixer Tornado Cash, raising key constitutional questions about privacy and speech.

The Office of Foreign Asset Control (OFAC) — a watchdog agency of the US government — sanctioned Tornado Cash on Monday, prohibiting US persons and entities from interacting or transacting with the privacy tool, making it the second crypto mixer sanctioned by OFAC after the designation of Blender.io in May.

The Treasury barred its use by all US persons as a matter of national security, claiming Tornado Cash has been used to launder more than $7bn in virtual currency and is used by North Korean hackers to layer stolen funds. Korea’s state-sponsored Lazarus Group has laundered about $450mn through the service.

The action against Tornado is the Treasury’s most significant action in the crypto space to date. Since the announcement, the Tornado website, email accounts, and GitHub have also been suspended. Circle, the issuing entity behind the USDC stablecoin, immediately banned 38 addresses that had connections to Tornado in their transaction history. Anecdotal reports suggest other platforms and companies are also enforcing bans.

What is Tornado Cash?

Tornado Cash is a mixer — a decentralized protocol designed to pool funds in an effort to obfuscate the origin of any given transaction.

Blockchain ledgers are completely open to public view, meaning that any state or individual can view and track every single transaction that has occurred between wallets going back to the dawn of crypto. Tornado Cash is designed to preserve privacy on the blockchain. Its technology breaks the link between the sender and receiver’s addresses on transactions sent to the Ethereum blockchain.

The Treasury says Tornado Cash “indiscriminately facilitates anonymous transactions by obfuscating their origin, destination, and counterparties, with no attempt to determine their origin. Tornado receives a variety of transactions and mixes them together before transmitting them to their individual recipients. While the purported purpose is to increase privacy, mixers like Tornado are commonly used by illicit actors to launder funds, especially those stolen during significant heists.”

But there are many valid use cases of privacy protocols: ie, donating to a cause that might get you in trouble if done publicly such as the war in Ukraine. Vitalik Buterin has said that he has used the mixer for this very reason, citing the need for privacy from Russia’s government. As a Russian citizen who actively supports Ukraine, its unwise to hand over the full details to the government of every transaction he’s made and its full amount.

Tornado Cash co-founder Roman Semenov defended its use as a privacy tool in an interview with CoinDesk in January. “Since all their crypto portfolio is visible to the public, the holders of significant amounts of crypto are very vulnerable to becoming victims of kidnapping, torture and blackmail… We think that it’s a very serious threat, and the privacy protocols are very important to ensure their personal safety. The banks don’t disclose your personal holdings to anyone who asks, and we think it should be the same way with crypto.”

Celebrity Endorsements

An anonymous prankster has taken to trolling celebs by sending ETH from Tornado Cash to their wallet addresses, implicating them in a potential regulatory mess. Affected wallets include those controlled by Snoop Dogg, Logan Paul, Brian Armstrong, Jimmy Fallon, Dave Chapelle, Steve Aoki, Beeple, clothing brand Puma, and many others. Each received 0.1 ETH.

The gag effectively points out the absurdity of such sanctions for users receiving funds from blacklisted addresses that they have no power to decline. In reality, it is impossible to stop other people from sending crypto to your wallet address if it is publicly known, even if the sender is sanctioned. As it isn’t possible to block an incoming transfer on-chain, exchanges and other parties will most likely have to block the addresses.This may not be easy for celebrities and businesses with public wallets that aren’t operated by an exchange or similar type of business.

Will the authorities take action?!

Is it Unconstitutional?

The US state views this as an important move to stem the flow of criminal funds. However, critics view this as a criminalisation of privacy, unconstitutional and equivalent to banning cash.

The ruling certainly raises many questions. Is writing open source code illegal now? Is code speech? Is this a violation of the first amendment? Is this a sign of more things to come?

The sanction is also unusual because a smart contract is a robot, not a person. The Treasury’s action seems to be the sanctioning of a tool that is neutral in character and that can be put to good or bad uses like any other technology. Science and technology has no ethics or morality, but the objects they create can be used both for “good or evil”. Take, for example, the radio: should this technology have been banned because it was used in WWII to broadcast German propaganda?

“It is also not just any specific bad actor who is being sanctioned. Instead it is all Americans who may wish to use this automated tool in order to protect their own privacy while transacting online who are having their liberty curtailed without the benefit of any due process.” Coin Center Executive Director Jerry Brito and Research Director Peter Van Valkenburgh wrote earlier this week. Critics say the Treasury Department used the sanctions laws to create a limitation on spending money — for everyone, not merely with some person who has been found guilty of a crime or even suspected of terrorism.

And while Tornado’s code is functional — mixing ETH transactions so they are harder to trace — publishing the code on its own is protected speech, even if that code can be used unlawfully. This is a limit on any American who wishes to use their own money and a freely available software tool to maintain their own privacy — including for otherwise entirely legal and personal reasons.

Coin Center wrote that the Treasury’s action is a prior restraint on speech and essentially a ban on using an open source software tool:

Moreover, while limitations on speech are often constitutional when applied after the fact (e.g. defamatory speech can be penalized), prior restraints on speech are typically unconstitutional. OFAC sanctions, unlike a defamation claim, operate as a regime of strict liability, meaning that no prosecutor or judge needs to make any public showing of fact to add a name to the sanctioned persons list, and transactions with anyone on that list are banned–a prior restraint–irrespective of the specific details of any particular transaction or the motivations of the transacting person. The Constitutionality of that regime as it is typically applied has not, to our knowledge, been challenged on First Amendment or due process grounds. This particular usage of OFAC raises heightened constitutional concerns because it is, again, not a ban on one non-US person’s ability to use the financial system, it is instead a ban on effectively every American’s ability to use a particular open source software tool.

Immutable by Design

The sanction is not great for the privacy movement in general, but we’ve all known it’s been coming and was just a matter of time. The pretext for censorship is the usual go-to among minders: hackers and baddies in North Korea, but this will have broader consequences for the population at large. It’s new territory: the second-order effects of the ban are still playing out, and it remains to be seen whether regulators can actually enforce such a wide ban or if crypto is capable of complying.

The open nature of crypto was conceived to cut out governments and intermediaries, unlike the traditional financial sector that would use banks and other financial institutions to act as gatekeepers against such transactions.

If crypto is successful over the years and governments have issues trying to shut down rails for all sorts of reasons then they’re essentially going to lose some power and control over the financial system. They’re not going to want to give that up in any such way. Regulations, taxes, monitoring, sanctions et al are coming… but this all points to one thing… crypto is now too big for governments to ignore.

Although it’s unknown how things will play out, it is becoming clear that the desires of crypto and the demands of the 21st century modern governments are not compatible. That’s by design.

In the News…

• BlackRock launches private trust offering direct bitcoin exposure
• Coinbase faces SEC probe over crypto yield, staking products
• Potential Ethereum proof-of-work fork unlikely to succeed, says Vitalik Buterin
• Slope wallet provider saved user seed phrases in plain text, Solana security researchers find
• Bank of Thailand to pilot retail CBDC by year-end
• Galaxy Digital’s quarterly losses more than double to $554mn
• Voyager CEO dumped $31mn stock as shares hit record highs
• Revolut Singapore launches crypto services
• Virginia Pension Fund diversifying into yield farming
• Tiffany & Co. NFT sale sells out, jeweler rakes in $12.5mn in ETH