Did Sanctioning Tornado Cash Work?

Sanctions are an effort to throw the weight of the U.S. dollar around to tamp down on activities the U.S. government thinks may be harmful – like money laundering to fund terror groups or rogue nations. The New York Federal Reserve thinks they had a real effect in crypto.

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Sanctions effect

The narrative

The Federal Reserve Bank of New York published a report Wednesday finding that sanctions against Tornado Cash did actually have an effect on the crypto mixer’s usage.

Why it matters

Obviously the big question around Tornado Cash is whether people have the right to transact privately online and how mixers fit into this right. Kind of a secondary question is whether these services are censorship-resistant, as some in the industry have claimed. The New York Federal Reserve took a look at the effect of the Office of Foreign Asset Control’s 2022 sanctions against Tornado Cash.

Breaking it down

When a person or entity is sanctioned, OFAC is banning any U.S. persons – that is, a U.S. citizen in the U.S. or abroad, or resident of the U.S., or an entity that has a similar kind of tie to the U.S. – from engaging with the sanctioned party. After OFAC first blacklisted Tornado Cash, usage plummeted some 90%, TRM Labs reported in October 2023.

In the two years since it was first sanctioned, however, usage has grown back to some extent, Wednesday’s NY Fed paper said.

“While volumes and transaction diversity for larger Tornado Cash pools never fully recover to pre-sanction levels, we observe recovery in the smaller pools which may indicate retail users continue to find the product attractive,” the report said.

Moreover, block proposers include Tornado Cash transactions, but block builders are excluding them, the paper continued.

You can read the paper at this link or my initial write up at this link, but I wanted to highlight two details the paper emphasized.

The first is this suggestion that sanctions compliance really kicked in after an August 2023 court ruling finding that Tornado Cash was indeed an entity for the purposes of OFAC’s definitions. And the second, which is tied to the first, is that the main entities not complying with the sanctions have ideological issues – the true believers in censorship-resistance, in other words.

“We find direct evidence of large builders switching to a cooperative posture following the ruling, giving credence to the idea that clarity around regulation is a pivotal factor to determining whether to cooperate,” the paper said. “With the ruling, we find two builders responsible for over half of the non-cooperative blocks, pointing to significant dependence on a few players to facilitate the settlement of Tornado Cash transactions. This heavy dependence on a few builders reveals a surprising level of fragility in the censorship-resistance of Ethereum.”

As a result, Tornado Cash’s privacy functionality “has deteriorated relative to before,” the paper said, both because the transaction volume and number of different wallets engaging with the mixer have dropped over the past two years.

What’s more, the paper said blocks that contain Tornado Cash transactions generate lower fees than blocks that don’t. Validators that process these blocks are more likely to be “motivated by philosophical reasons” than pure profit, the paper said.

The overall paper is worth a read, as mixers increasingly draw scrutiny from international regulators over their potential uses by groups like Lazarus.

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