In reaction to the sanctions, organisations such as Coin Center have defended the mixer, stating that the smart contract code is not a sanctionable entity.
It is unknown whether privacy coins such as Monero would face similar restrictions in light of this new precedence. A hard fork upgrade on August 13 made it more challenging to trace Monero transactions.
Contrary to the idea that all bitcoin transactions are private by nature, the data on a blockchain is public, and transactions may be traced. Crypto mixers and privacy coins were established to facilitate the open financial system’s anonymity. But each faces unique uphill struggles.
What is a crypto mixer?
A crypto mixer, also a tumbler or blender, is a transaction mixing tool or service anybody can use to conceal a crypto wallet’s source of funds. These technologies were initially built for bitcoin in 2013, but once solutions like Tornado Cash made them available for a range of cryptocurrencies, they became a popular alternative to privacy coins.
Blender.io was the first custodial mixer sanctioned by the Office of Foreign Assets Control of the US Department of the Treasury (OFAC). It didn’t garner the same attention as Tornado Cash since it belonged to the pattern of prior punishments against individuals and organisations.
How Tornado Cash works
Tornado Cash is an Ethereum-based crypto mixer that mixes ETH and ERC-20 tokens using non-custodial smart contracts. Through a zero-knowledge proof contract, users contribute funds to smart contract addresses that arrange them by the amount and efficiently mix the deposits.
Tornado Cash. Source: tornado.cash
For instance, suppose you wish to combine 11 ETH. Because deposits are categorised by amount, you send 10 ETH to the 10 ETH mixer and 1 ETH to the 1 ETH mixer. Once funds are given to each mixer, the zero-knowledge proof verifies that you provided a deposit to each one without revealing which one was initially yours. This provides the equivalent of a withdrawal authorisation slip for each mixer.
Legal obstacles
On August 8, 2022, OFAC added a list of Tornado Cash-related addresses to the same list of sanctioned addresses, including Blender.io. OFAC used the same language for Blender.io as it did for Blender.io, but failed to recognise their significant custody distinction. Coin Center asserts that Tornado Cash has two distinct components: the decentralised group of governing members, Tornado Cash Entity and the immutable smart contract coin mixers Tornado Cash Application.
The Tornado Cash Entity cannot modify or update the Tornado Cash Application due to the destruction of the original developers’ administrative keys. Smart contracts exist so long as the Ethereum blockchain is operational. Therefore, even if the Tornado Cash website is down, anybody can develop a replacement front end — or communicate with the smart contracts directly — that gives users access to the same mixers.
The issue is that OFAC included these immutable addresses for smart contracts on its list of penalties. Consequently, there are currently innocent Americans with funds in these mixes. If they attempt to transfer the funds, they will violate the law and face penalties. And because the application is not a legal business, it cannot petition OFAC to remove the sanctions.
Coin Center claims that OFAC did not cite the legal authority to add the smart contract addresses to the sanctions list since the Tornado Cash Application is not an organisation, triggering constitutional concerns. In response to OFAC’s notification, firms agreed to filter individuals associated with these IP addresses. Aave, a decentralised financial application, prohibited any user that received Tornado Cash payments in a dust assault.
Privacy coins’ features
Privacy coins are digital currencies that employ various techniques to conceal IP addresses, wallet balances, and the movement of transactions. Z-cash and Monero are the two most popular privacy-centric cryptocurrencies. Z-cash is a cryptocurrency that protects transaction data primarily through zero-knowledge proofs. They vary from crypto mixers in transforming financial privacy into a product rather than a benefit.
Z-cash and Monero. Source: Investing
Since this early setback, Z-cash has never returned to the highs of the 2017 bull cycle and presently stands second in total market capitalisation behind Monero. While Monero prices were able to hit 2017 levels in 2021, they could not surpass their all-time high.
Monero is a privacy-centric cryptocurrency that provides financial anonymity via privacy-enhanced blockchain encryption. Every transaction uses one-time stealth addresses to conceal the balances of public addresses.
Privacy obstacles
The protocol for Monero was improved on August 13. The earlier version of Monero provided a layer of anonymity, but its entire untraceability was questionable. In 2018, detractors said that the process of elimination might discover the signature ring’s inputs. And in 2021, CipherTracer purportedly patented a transaction-tracking technology used by the Department of Homeland Security (DHS).
Even if CipherTracer uncovered actual flaws, the scope of their repercussions remains unknown. They did not reveal their tactics or degree of success. Since it prevented CipherTracer from being accessed by anybody unwilling to pay, this earlier version nevertheless provided some financial anonymity.
In Canada, efforts were undertaken to trace the sources of funding for the trucker freedom convoy. The authorities sanctioned 34 cryptocurrency wallets associated with the movement, and Monero addresses were included on that list.
By raising the number of transactions in a ring signature, the Monero team expect this upgrade will solve any possible security loopholes. Even if the anticipated Monero chain enhancements are essential, the principles of tracking the likely source of funds remain the same after the fork. If the update is successful in eliminating these backdoors, there is a danger that OFAC might take similar action against Monero.
The developer’s prospective capacity to benefit from these smart contracts renders him accountable. The Dutch financial crimes agency FIOD detained a Tornado Cash developer suspected of using the application to launder money. It is unknown if he was arrested for his attempts to launder money or for his association with others who did so.
Adoption obstacles
Though major privacy coins like Monero and Z-cash are actively trying to improve transaction privacy, they haven’t obtained the same level of acceptance as leading layer-1 blockchains such as Ethereum. Many rivals, notably Secret Network and Oasis Network, believe that privacy coins do not provide a privacy layer that can be utilised to create Web3.
In 2020, Secret Network was the first privacy-based blockchain to offer the programmability of smart contracts. It resides in the Cosmos ecosystem and works towards a Web3 privacy goal. Multiple applications have been released, including the decentralised messaging service Altermail and the decentralised exchange SiennaSwap.
However, Secret Network and its rivals confront the typical difficulty of a crowded market. They have a long way to go before overcoming the market domination of Monero and Z-Cash. The prospect of punishment has spurred many members of the Z-Cash community to investigate the possibility of programming their smart contracts.
Digital financial privacy future
Amid the battle for financial privacy, the state has used two distinct instruments thus far. They employed the regulatory sanctions hammer with crypto mixers. If one financial privacy method is too popular with criminals or difficult to trace, their strategy may be to eliminate it.
Advocacy groups such as Coin Center may challenge such measures in court, but this may take years. In the meanwhile, the sanctions are probably harming innocent Americans.
They may continue their cat-and-mouse game with developer upgrades via investigations for other privacy solutions.
However, user adoption is a crucial aspect of this game. As more users use mixers or privacy coins, tracing transactions becomes progressively more difficult. It is comparable to the traditional police pursuit into a tiny alley. If the suspect approaches a busy procession, they can brush themselves off and blend with the crowd.
If a privacy coin, mixer, or base-layer privacy solution obtains widespread adoption, its resistance to censorship might increase. State officials would struggle to garner political support for sweeping punishments or the necessary technologies to circumvent privacy protections. And the possible repercussions of Tornado Cash punishments on Ethereum validators may draw millions more into this discussion.