Explained | What does Tornado Cash sanction mean for future of DeFi

US Secretary of State Antony Blinken said on August 8 that the Biden administration would sanction Tornado Cash, a Decentralized Finance (De-Fi) programme on the Ethereum blockchain that enables the anonymous movement of cryptocurrency.

The move has sparked fury in the crypto world because of both the logic behind it and the manner in which it was being carried out. The move may signal a significant government crackdown on the space.

ALSO READ: MAS to explore the economic potential of DeFi

Let us examine the circumstances behind the sanction and what it could mean for the future of decentralized finance, an emerging financial technology based on secure distributed ledgers akin to those used by cryptocurrency.

One of the first completely decentralized apps on Ethereum to support private transactions, Tornado Cash was released in 2019.

It first accepted user payments, combined them into one address, and then let users withdraw their money and move it to a second Ethereum address.

The mix of Ethereum addresses meant that the original owner could not be identified.

Tornado Cash provided a mechanism for those who valued their privacy to use and invest in cryptocurrencies without having their transactions made public on Ethereum, which makes every transaction public by default.

Over $7 billion in user money has been mixed with the aid of Tornado Cash so far.

However, some major hacks have utilized the site to launder stolen money even though the bulk of these transactions were entirely genuine and legal.

For instance, Tornado Cash was used to launder the proceeds of the Axie Infinity Ronin Bridge attack, which took place in April 2020 and resulted in the theft of more than $400 million in cryptocurrency.

Additionally, the Nomad attack and the Harmony Bridge compromise both resulted in money being laundered via the protocol.

To make matters worse, the Lazarus Group, a North Korean entity that has been sanctioned since 2019, is responsible for the Ronin and Harmony hack, according to the US Federal Bureau of Investigation (FBI).

The key justification offered by the US for its decision to sanction Tornado Cash was its use by the Lazarus Group.

To sanction the decentralized application, the government took control of all Tornado Cash addresses, including the addresses for its smart contracts and contribution address.

This implies that anyone who deals with Tornado Cash may face criminal charges for violating American sanctions.

Many in the crypto industry are condemning the decision as "throwing the baby out with the bathwater," which refers to the idea that it is unfair to outlaw a technology because it also serves certain undesirable ends.

Furthermore, since Tornado Cash is decentralized, its smart contracts will always be active and usable, and its website is maintained on decentralized storage systems and cannot be taken down.

Any authority would have to shut down the entire blockchain as well as the hundreds or perhaps thousands of servers hosting Tornado Cash in order to altogether disable it.

Additionally, because the code is open-source and free for anybody to copy, hundreds of copies of Tornado Cash can be made, each with minor differences.

Banning the decentralized app will result in a never-ending game of cat and mouse between privacy activists and the government.

Following the announcement of the ban, Circle, the stablecoin's parent firm, immediately froze all the USDC, or digital dollar pegged to the US currency, accounts on Tornado Cash and blocked any connected addresses from utilizing USDC.

The fact that one of the biggest and most reputable stablecoins has the ability to freeze anyone's account instantly has also generated a great deal of criticism.

The stablecoin is completely centralized and governed by a firm with headquarters in the United States.

Some industry leaders worry that if USDC is compelled to freeze more assets, it would kick off a chain reaction that may destroy DeFi.

For instance, USDC is used to trade on Uniswap, collateralize loans on Aave, and provide part of the peg for the Dai stablecoin.

The whole DeFi sector would collapse overnight if the government decided to ban all three DeFi pillars as its next move, and USDC complied.

This is because trading in a decentralized fashion would no longer be viable and money would be frozen.

This is one of the biggest risks to the future of decentralized finance.

Any authorized protocol, including Tornado Cash, will never completely perish as long as the Ethereum blockchain is active.

In terms of crypto legislation, the decade is proving to be very crucial, and more limitations and penalties are unavoidably on the horizon.

It is unclear if this will have a large impact on the market, but one thing is certain: once they are released, these apps cannot be completely controlled, which alone considerably improves the value proposition of Ethereum and other Layer 1 blockchains.