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DEF on IRS “Broker” Rulemaking; Tornado Cash Plaintiffs Appeal; HFSC Hearing on Crypto

DEF Comments on IRS “Broker” Rulemaking

What happened?

On November 7, the DeFi Education Fund (DEF), submitted a comment letter to the U.S. Treasury Department and the Internal Revenue Service (IRS) in response to their highly alarming proposed “broker” rulemaking. As we’ve previously discussed, the rulemaking would include DeFi protocols and frontends as “brokers.”

What does this mean?

First, considering how both lawmakers and regulators have understood the term "broker" for over a century, it seems unlikely that Congress, in this context, meant something other than brokers being agents, acting on behalf of the customers (principals).

Second, the proposed definition for “digital asset middlemen” is vague and overbroad to the point that it could result in treating nearly every participant in the blockchain technology stack as a broker. This interpretation far exceeds the historical and reasonable understanding of the term “broker.”

Third, according to the preamble, the Treasury and IRS intend for these proposed regulations to provide taxpayers with sufficient information to prepare their tax returns. However, the proposed regulations would instead result in taxpayer confusion and make it more difficult to prepare tax returns.

Fourth, the proposed regulations violate the Fourth Amendment’s prohibition on warrantless searches and seizures of a person’s papers and effects because individuals do not voluntarily turn over their personal data to “digital asset middlemen” who themselves neither collect nor have any legitimate business reason to collect that information.

Fifth, the proposed regulations are unconstitutionally vague, and therefore, violate the Fifth Amendment. These proposed regulations would be extremely hard to apply in practice, leaving software developers and other market participants guessing about their meaning and application. This lack of clarity prevents individuals from planning accordingly and does not provide fair warning of any penalties they might incur for noncompliance.

Lastly, the proposed regulations would impose a disproportionate and unbearable financial burden on businesses in the digital asset industry by requiring them to collect and report extensive amounts of information on digital asset transactions. This would result in significant compliance costs for businesses, including the need to develop new systems and processes to track and report this information, hence erecting market barriers to entry and innovation. Equally burdened would be the government itself, as it does not have the resources to process the IRS’ estimate of 14.5 million additional annual tax returns.

If finalized in their current form, the Proposed Regulations would stretch the definition of “broker” beyond what the Constitution allows, require information collection and reporting by individuals and entities incapable of collecting that information, unnecessarily endanger the personal data of millions of Americans, confuse taxpayers, stress government resources, stifle innovation, and cripple American businesses and competitiveness.

In her conversation with the IRS, Marisa Coppel of Blockchain Association, noted the fundamental shortcoming of the proposal, arguing that: "There's obviously a ton of information that needs to be collected in order to do this reporting," adding "...if there's no specific person that either owns or controls the software that users are using in DeFi, there's no way to collect that information."

Tornado Cash Plaintiffs Appeal

What happened?

Self-identified US users of Tornado Cash smart contracts sued the U.S. Treasury Department, Secretary Janet Yellen, the Office of Foreign Asset Control (OFAC) and OFAC Director Andrea Gacki in September 2022 challenging the legality of the Treasury Department’s sanctions designations of smart contracts. They argued that the defendants exceeded statutory authority by adding Tornado Cash to the Specially Designated Nationals and Blocked Persons (SDN) List and that this action violated their constitutional rights to free speech. The U.S. District Court for the Western District of Texas denied the plaintiffs’ petition.

In turn, this week, the plaintiffs filed an appeal in the Fifth Circuit. In the brief, the plaintiffs argue that the Treasury’s designation of Tornado Cash is unlawful for three reasons:

  • Tornado Cash is not a sanctionable "national" or "person." Treasury defined it as founders, developers, and anyone holding the TORN governance token without evidence these disparate token holders share any common purpose, which is required for an unincorporated association.

  • Tornado Cash smart contracts, being immutable and ownerless, are not “property” in the sanctionable sense. Since these contracts cannot be controlled nor modified, the concept of ownership does not apply.

  • Tornado Cash lacks any "interest" in the immutable contracts. An interest requires a legal, equitable or beneficial claim, but Tornado Cash has none here.

What does this mean?

The legal battle over the Tornado Cash designations goes beyond this specific case and reaches any software system. The outcome of this appeal could set precedents for how software can be regulated.

Congressional Hearing on Illicit Activities in Crypto

What happened?

On Wednesday, the House Financial Services (HFSC) Subcommittee on Digital Assets, Financial Technology, and Inclusion convened a hearing to analyze and discuss the illicit abuse of cryptocurrencies. Titled “Crypto Crime in Context: Breaking Down Illicit Activity in Digital Assets,” the hearing brought together industry experts and senior law enforcement officials to provide insights into the evolving crypto regulatory landscape.

In his initial remarks, Chairman French Hill (R-AK) highlighted the urgency of an accurate understanding of digital assets’ role in illicit activities, citing the conflicting reports on the topic since Hamas’ attacks on Israel on October 7th. “Phones and the internet aren't to be blamed for terror financing, and crypto shouldn't be either, We must examine these issues head on and separate fact from fiction,” Hill said.

In their testimonies, many emphasized the unique capabilities of blockchain technology in countering crypto-based illicit activities. Experts pointed out that, unlike traditional financial systems, blockchain ledgers provide a public, immutable record of transactions, enabling law enforcement agencies to trace the flow of funds with greater accuracy and speed. On this matter, Jonathan Levin of Chainalysis stated: “[Financial Intelligence] is highly dependent on domestic services and institutions to report on suspicious activity, insights into international transactions is often measured in complex international collaboration and information sharing arrangements. Cryptocurrencies mark a departure from this era.”

In her testimony, Jane Khodarkovsky, a partner at Arktouros, emphasized the vital role of digital assets in humanitarian efforts, stating that “in Ukraine, humanitarian aid came in the form of crypto. I believe US lawmakers must recognize that.”

Mr. Gregory Lisa, Chief Legal Officer, DELV, commented on the potential pitfalls of excessive regulatory measures in the cryptocurrency sector, arguing that “overreaction, especially overreaction in regulation, will simply serve to drive crypto underground, offshore and beneath the radar. Regulation can work and it should, but overreaction with regulation can undermine exactly what we're trying to do… It can jeopardize our national security.”

What does it mean?

The hearing helped inject what has been a highly charged debate with facts and the testimony of multiple former law enforcement officials who worked to combat illicit finance risks in crypto and will hopefully inform Congress’s approach to this issue. We expect more hearings on this topic, and we should welcome the sober consideration of these issues, which are top of mind for many policymakers.

Please note that due to the Thanksgiving Holiday, there will be no Weekly Update next week. We hope everyone has a lovely Thanksgiving!


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