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Treasury Risk Assessment; Banque de France; Wahi Insider Trading Case; POLITICO Op-Ed on Innovation

Treasury’s DeFi Risk Assessment

What happened?

Yesterday, the Treasury Department released their “DeFi Risk Assessment,” a report that explores illicit actor’s abuse of DeFi and related issues.

The report argues that regardless of decentralization, if a so-called “DeFi service” functions like a financial institution, it must comply with AML/CFT regulation—which includes the Bank Secrecy Act (BSA) that requires financial institutions to keep records of transactions and report them to the federal government. Confusingly, the assessment also recognizes gaps in the existing framework that are unable to address DeFi’s “disintermediated” nature.

As a result, it recommends “strengthening AML/CFT supervision… and enforcement of virtual asset activities.” This would include “closing any identified gaps in the BSA” to address its inability to encompass DeFi protocols. The assessment also recommends the US government to promote “responsible innovation of compliance tools for the industry”—such as real time analytics and rigorous code tests—and continue to “conduct research and engage with the private sector.”

What does this mean?

At a high-level, we believe that the assessment forgets at times that the existing BSA framework was developed based on how the global economy worked in the 1970’s and is a means to an end, not an end in and of itself. DeFi protocols allow people to engage in transactions in new ways, and an effective AML/CFT response must acknowledge the fundamental functional differences between TradFi and DeFi.

With that said, we will be submitting our input on the assessment.

Banque de France Discussion Paper

What happened?

On Wednesday, the Banque de France published a discussion paper distinguishing between “decentralized” and “disintermediated” finance and argues that “disintermediated finance” is a more appropriate term for DeFi, suggesting that it exhibits a “high level of concentration” and centralized governance. The paper then proposes regulatory options to potential risks and challenges associated with "blockchain infrastructure, ‘services’ application layer, and mechanisms allowing users to access these services"

First, it proposes minimum security standards for public blockchains—computer code certification, a minimum number of validators, and a cap on how much control or influence a validator has. Furthermore, the paper proposes transferring “financial functions”—trading, lending, borrowing, etc.—to private blockchains that are managed by “trusted private or public players,” while recognizing this may inhibit innovation.

Second, the paper proposes a mandatory certification mechanism for smart contracts, which would require an audit of the code, as well as review of the nature of provided services and governance—interaction with non-certified smart contracts would be prohibited and certification could be revoked, the paper states that “such a ban would apply to both individuals and firms, whether they are trading platforms, DASPs, institutional investors, banks or non-financial companies.”

Third, the paper proposes creating statutes for “service providers,” which could involve incorporating and becoming subject to supervision. The paper goes on to include DAOs by subjecting them to supervision—though, the report says it would refer to ongoing work being done by the Legal High Committee for Financial Markets of Paris.

Lastly, the paper proposes strengthening supervision of intermediaries facilitating users’ access to DeFi—the paper refers to front-end websites as these “intermediaries”—and goes so far as to propose extending the EU’s Markets in Crypto Assets (MiCA) regulations to include them.

What does this mean?

The Banque de France’s proposal to identify DeFi front-ends as intermediaries could subject them to the same regulations imposed on traditional financial intermediaries. This proposal misunderstands the relationship between front-ends and DeFi. A front-end does not intermediate a transaction itself, it acts more as a “translator” from human to blockchain similar to the way email services function. When sending an email, a person writes the email using the Roman alphabet to coherently write words and sentences. But those characters are not what is actually “sent” over the internet. When that email is sent, the message is “translated” into packets of data that can be “understood” by the network, in this case, the internet. Likewise, DeFi frontends “translate” human-understandable activities into a form that blockchains can understand.

Plaintiffs File Motion for Partial Summary Judgment in the Tornado Cash Case

What happened?

On Wednesday, April 5th, plaintiffs in the Joseph Van Loon et al v. Department of the Treasury et al case filed a motion for partial summary judgment that argues that the U.S. Department of Treasury’s decision to sanction Tornado Cash smart contracts was unlawful and should be invalidated under the Administrative Procedure Act (APA).

To recap, Coinbase funded a lawsuit filed last year by six plaintiffs who contested the sanctions on Tornado Cash smart contracts in hopes that the smart contracts would be removed from the sanctions list.

According to the motion, this case is based on two key statutes. The International Emergency Economic Powers Act (IEEPA) that allows the Treasury to take action with respect to “any property in which any foreign country or a national thereof has any interest,” and the North Korea Sanctions and Policy Enhancement Act of 2016 (North Korea Act) that allows the Department to “block and prohibit all transactions in property and interests in property of a person designated.”

The plaintiffs presented four arguments why they believe the Treasury's decision is unlawful:

  1. They argue that the Department incorrectly designated Tornado Cash as an entity. According to the motion, the protocol, which is essentially a software code, cannot be considered a foreign “national” under the IEEPA or a “person” under the North Korea Act.

  2. Even if Tornado Cash was a “national” or a “person,” the Department wrongly considers its smart contracts as “property.” The plaintiffs point out that at least 20 of the smart contracts are “ownerless, immutable smart contracts—open-source software that is no longer capable of being altered, removed, or controlled by anyone.” Thus, they assert that these smart contracts are not “property.”

  3. In addition, even if the protocol’s smart contracts are “property,” the Department fails to provide any evidence that the purported Tornado Cash person has any “interest” in those smart contracts.

  4. Lastly, the plaintiffs argue that the Department’s decision violates the free speech clause of the First Amendment. According to the motion, the Department’s action “is not narrowly tailored” and is “unconstitutionally overbroad.” The plaintiffs claim that with the blanket ban, socially valuable uses of the protocol, like donating to Ukraine, will no longer be possible.

What does this mean?

As we have previously discussed at length, the Treasury’s decision to sanction the protocol raised serious and far reaching questions. Tornado Cash is a decentralized and open-source software protocol that allows users to protect their financial privacy. We will keep a close eye on this case and provide updates accordingly.

Potential Settlement in Wahi Insider Trading Case

What happened?

The Securities and Exchange Commission (SEC) is reportedly close to settling an insider trading case involving a former Coinbase product manager, Ishan Wahi, and his brother, Nikhil Wahi. Details of the potential settlement were included in a joint court filing submitted on Monday.

Both the SEC and the defendants have requested a postponement of the upcoming April 6 deadline to the summer to finalize the settlement. The delay requires approval by the SEC Chair, Gary Gensler, and the commission's bipartisan panel of four additional commissioners.

As a refresher, Ishan Wahi pleaded guilty to criminal wire fraud charges brought by the Justice Department in February. At the same time, however, Wahi sought to dismiss the insider trading charges, arguing that the tokens in question do not constitute securities. This development appears to represent a departure from that stated position.

What does this mean?

A settlement in this case could have broad implications for the digital asset industry as it represents the first major crypto-related insider trading case. Moreover, the charges revolve around nine tokens listed on Coinbase that the SEC claims are unregistered securities. Some or all of those tokens remain listed on other major exchanges, including Binance, Gemini, and

A precedent set in the Wahi case could potentially be applied in enforcement actions against these and other firms pursuant to a determination that these tokens are unregistered securities. However, if the settlement merely stipulates that the tokens in question are indeed securities, the industry will remain starved for guidance as to the SEC’s evolving analysis on this pivotal question.

This development also comes on the heels of an ongoing SEC investigation into multiple aspects of Coinbase's business. Notably, on April 3rd, Coinbase filed an amicus brief advocating for dismissal of the case. Whether the terms of Wahi’s settlement involve cooperation in the investigation of Coinbase remains a subject of speculation.

Why Chilling Crypto Curtails American Competitiveness

What happened?

A POLITICO article by Brandon Possin, foreign service officer at Tokyo’s U.S. Embassy, brought to light the implications of chilling digital asset innovation in the US. Possin argues that U.S. agencies’ approaches to digital asset development has an impact on the power of the American dollar, arguing that “just as the dollar has projected U.S. economic power in the analog world, digital assets pegged to the dollar, called stablecoins, project the dollar into the digital economy.” While “U.S. national-level banking and technology regulations are becoming more obsolete by the day,” foreign actors such as China have trudged forward, building out the government-backed Blockchain-based Services Network.

The U.S. is not blind to these risks—a September 2022 report on Responsible Advancement of U.S. Competitiveness in Digital Assets by the Department of Commerce indeed emphasized that “well-implemented, digital asset-based systems could introduce competition into international payments and offer underserved communities greater access to the financial system,” and by extension, that “challenges and opportunities make U.S. leadership in ensuring the responsible development of digital assets a policy imperative.”

What does this mean?

As American leadership in the digital asset space dwindles, foreign actors enter the void. China’s promotion of the digital yuan and eCNY through the People’s Bank of China’s mBridge Ledger not only promotes the displacement of the U.S. dollar’s influence, for example, but also raises questions of large-scale surveillance through CBDCs based on permissioned systems. This expansion also continues through the private sector, as Ant Group (AliPay’s parent company) moves its blockchain-based cross-border remittance platform into Hong Kong, Philippines, and Pakistan.

In 2022, the share of development work from the American time zones collapsed to below 30% for the first time. The executive agencies’ outright hostility to the industry and refusal to allow it to function within a regulatory perimeter is in no small part responsible for this phenomenon.


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