A Milestone in Cryptocurrency Market: OFAC Tornado Cash Move

OFAC (Office of Foreign Assets Control), affiliated to U.S. Department of Treasury, has recently added Tornado Cash, a mixer application, to sanctions list, which was a move that can break many grounds for both crypto market and OFAC. Since the application subject to sanction is a smart contract, the market started to question the applicability and the legal infrastructure of the sanction.

A think-tank in the U.S., Coin Center, has published an extremely detailed research on the legal dilemmas arising from adding a smart contract to sanctions list with the existing regulation infrastructure. Since it is very likely that OFAC can be sued about the matters stated in the research, we have simplified and summarized the subject legal issues for you.

The potential subject discussed in four different parts here is extremely important since it can cause U.S. to make a serious update in sanction regulations, and also permanent changes in technical infrastructure of smart contracts.

(Tornado Cash: Hides the information of sender in cryptocurrency transfers between two wallets. Such services are called mixer.)

Part 1 — Pragmatism and Violation of Rights

Coin Center bases its mechanism of defense on the argument that Tornado Cash should be defined as two different formations. The first formation is the legal entity of Tornado Cash (DAO formation), the formation having the characteristic of a corporation that created the smart contract; and the second formation is the smart contract itself that directly performs the transactions, that is the Tornado Cash application. The reason for separation of these two formations is that the smart contract performs the transactions without needing an approving party, that is, in a totally decentralized way without the approval of DAO. The lack of legal control mechanism of the legal entity on the smart contract distinguishes these two formations from each other.

That differentiation stated by Coin Center was emphasized by FinCEN, another entity affiliated to the Department of Treasury, in 2019. In the statement of FinCEN, two categories that cover mixers were defined: ‘anonymized service providers’ and ‘anonymized software providers’. If a person provides a service on behalf of herself/himself, another person or an entity, receives payment from a customer, masks the received money and sends it to the receiver; that is within the scope of the definition of service provider, is classified as ‘money transmitter’ and is subject to FinCEN regulations. However, there is a definition where the anonymous software performing similar transactions is not classified as ‘money transmitter’, and where such software performs trade operations.

In the declaration of FinCEN, the part that distinguishes Tornado Cash application from the legal entity of Tornado Cash allows the case to be interpreted as a case having firm foundations. However, since OFAC is not affiliated to FinCEN, it is not obliged to observe the guidance published in 2019.

So, what makes that differentiation important?

According to the laws, the ‘persons’ that can be added to the sanctions list by OFAC are: individuals and entities. Since smart contract is neither an individual nor an entity, it does not adapt to the legal infrastructure. Therefore, while adding Tornado Cash to the sanctions list, by registering both the legal entity and smart contract as a single entity, OFAC wanted to eliminate the lack of infrastructure in this matter, and acted in a pragmatic way. Due to the lack of information regarding the executives of the legal entity, that is Tornado Cash DAO, Coin Center does not make any comments on whether any sanctions can be imposed on DAO. It is stated that if there are executives and beneficiaries, and if they have been somehow involved in money laundering, they can be added to the sanctions list. The most important point emphasized here is that the application part of this, that is the smart contract, cannot be subject to sanctions.

In case Tornado Cash is considered as two separate formations, there will be two important violations of rights:

• Third parties do not have the right of objection regarding a person or entity that is added to the sanctions list. Since only the person or entity in the sanctions list can object, imposing sanctions on the application part of Tornado Cash makes it impossible to object since a smart contract cannot object.

• In OFAC’s website, it is stated that the purpose of OFAC sanctions is improving the behaviors of persons or entities, not punishing any person or entity. So, in case the reason for adding to the sanctions list disappears (e.g. if the company changes the business model or disengages with persons related to criminal acts), OFAC removes that person or entity from the list. But since this is about a smart contract, this contract just executes the function it is programmed for and since it cannot be modified, there is no possibility of removal from the sanctions list. Therefore, it is pointed out that the purpose of this sanction is solely punishing it. (More detailed explanations on punishment are given in part 4.)

Blender.io /Tornado Cash

OFAC’s classification of Tornado Cash under a single roof is maybe not a deliberate move. In May 2022, OFAC added a similar mixer service, Blender.io, to the sanctions list. That move was rapidly accepted and forgotten without creating big reactions in the market. Since Tornado Cash provides a similar mixer service, it is possible that OFAC implemented the assumptions and regulations implemented for Blender.io to Tornado Cash as well.

Although the services provided by two platforms are similar, those services have extremely different structures. Blender.io provides mixer services as a centralized organization. So, the customers that will be accepted by the platform can be specified, and if required, some of the transactions can be omitted and parties can be refunded. In other words, the company affiliated to Blender.io has a clear authority on the platform. Therefore, adding the platform to the sanctions list means imposing sanctions directly to the company and that is a legal act. It is possible for Blender.io to get out of the sanctions list in case the executives change the business plan, are subjected to more stringent regulations, and cooperate with OFAC. However, since the smart contract of Tornado Cash is decentralized, this is a completely different case. Smart contract provides mixer services by interacting with any wallet without any approvals. Therefore, since Tornado Cash legal entity has no effect on directing the smart contract, like in Blender.io case; addition of Tornado Cash to the sanctions list under a single roof became a subject of debate. For this reason, it is arguable whether OFAC made this move to eliminate the inefficiency in legal infrastructure; or with a copy-paste style implementation, without being informed about the difference between Blender.io and Tornado Cash.

Part 2 — Excess of Power

International Emergency Economic Powers Act (IEEPA), which was regulating the foreign property sanctions in Obama period, allows adding the properties outside the U.S. and the interests arising from properties to the sanctions list. Since Tornado Cash is an application whose smart contract has an open source code with a copy owned by each Ethereum Node, which can be used and reproduced by any person, it is not owned by any specific person. Coin Center properly exemplifies this as ‘It is no more the property of the Tornado Cash Entity than the Phillips-head screwdriver in every American’s home toolbox is the property of its inventor, Henry F. Phillips’.

Also, in IEEPA, it is stated that it is obligatory to have a property that is capitalized by a country or nation. It is stated that since a smart contract does not belong to any country or nation and does not have the status of a property like in the example above, it is out of OFAC’s right of authority.

The concept of property in the law should not only be considered as physical property, but also be viewed notionally, like intellectual property. Therefore, focusing on the intellectual property part of OFAC, Coin Center states that Tornado Cash application can be defined as a property owned by Tornado Cash legal entity. However, Coin Center states that in this case the process was conducted in a different way, and normally the intellectual property-related sanctions are related to whether the sanctioned person or persons can provide licenses for that property or whether such persons can trade with the entities in the countries characterized as enemy states within this framework. However, in Tornado Cash case, there is an open-source code, this code is copied on Ethereum nodes, none of the Americans have paid, or will pay for codes; and therefore the software developer has no economic interests on the code. This case is considered to be similar with prohibition of Americans to read a book they already own because U.S. added an author to the sanctions list.

Part 3 — Constitution Advantage

Although the laws have specific descriptions in general, they are open to interpretation. Such interpretations can be both comprehensive and incomprehensive. In case there is a conflict with the Constitution in comprehensive interpretation via extending the meanings of terms, the Constitutional Avoidance Canon law in the U.S. requires acceptance of incomprehensive interpretation of law for eliminating such conflicts. This can turn into a big advantage for Tornado Cash.

We have already said that in the first two articles, the sanction was limited to only ‘person’ (individual and entity) and property of application field, and Tornado Cash cannot be considered within this framework. When the scopes of entity and property mentioned here are extended, the freedom of speech sections in 5th and 1st articles of the Constitution are violated. If these violations are explained to the court persuasively, the court should interpret the definitions of person and property incomprehensively in accordance with Constitutional Avoidance Canon law. In that case, since Tornado Cash application will most probably not be classified as one of above, it can be possible that the sanctions are removed.

Part 4 — Disruption of Technology

According to the 5th article of U.S. Constitution, for the federal government to deprive a person of her/his life, freedom or property, it should notify that person before acting, allow that person to defend herself/himself and the verdict to be returned by an unbiased decision maker, that is the court.

There are American users who have assets in Tornado Cash application, and who cannot withdraw their assets since they do not want to be involved with sanctioned parties. Since OFAC’s decision of sanction prohibits U.S. citizens from using the application, it poses a limitation of freedom, and also causes a limitation of property for the users who cannot withdraw their assets in the platform. Coin Center states that the 5th article was violated since OFAC did not issue a notice prior to the sanction, and no Americans were interrogated and questioned.

However, Coin Center also suggests that the government is used to such accusations and has specific defense methods that previously worked.

• It is possible for the government to get the approval of court by stating that it is aimed to prevent the sanctions list candidates from taking precautions since the case is a matter of national security, therefore no prior notices are issued.

• The Americans having assets on the application can communicate with OFAC, get a license for themselves and withdraw their balances without getting involved in sanctions. In that case, there is no limitation of property.

• Since it is considered as a matter of national security, OFAC’s detailed internal and extensive interrogations and investigations can be put on par with a public case. This way, the unbiased decision maker article is also not violated.

Coin Center states that there are questions on whether OFAC conducted an extensive investigation regarding the possible damage of Tornado Cash, and that if such investigations were conducted, they should be submitted to the court, otherwise it could pose a constitutional violation. But the most critical article here is the subject of license in part 2.

As stated in the first part of this article, OFAC’s purpose is not punishing, but improving the behaviors. Therefore, all the sanctions are theoretically temporary. For that reason, the matters of limitation of freedom or limitation of property are not permanent, they are temporary. However, since there is no possibility that Tornado Cash can improve the behavior of its smart contract, this is a permanent sanction. Since that can cause a constitutional violation, it is considered that OFAC can allow the use of contract with license. In that case, each American, who wants to use the contract, will have to get a license from OFAC and inherently, anonymous and decentralized nature of platform will be ruined for Americans. This scenario can turn into a routine implementation where OFAC adds any smart contract to the sanctions list and make licensing obligatory, when necessary, and this is a process that significantly threatens the right to stay anonymous, which is extremely important for crypto.

Since OFAC’s sanction on smart contract means prohibition of using a project with an open-source code, Coin Center states that this limits the freedom of publication and therefore can mean violation of 1st Article of Constitution which assures the freedom of speech. However, in that case, the government might defend itself by stating that the contract is not restrained, only the communication with the Ethereum wallets used by contract is restrained. If that is the argument, it can be easily concluded that Tornado Cash sanction is an unsuccessful-ineffective decision in terms of protection of national security. Because this code already has copies, and it can be executed with a similar service and same code through other wallet addresses. Therefore, the prohibited persons or entities can still continue using this service. For this reason, according to Coin Center, the real reason behind this OFAC move is adding all kinds of smart contracts having similar codes and services to the sanctions list. Statements of an authority in the Department of Treasury on Tornado Cash sanction, declaring that this sanction gives signals for similar services, support the theory of Coin Center. However, in this scenario, the case is beyond sanctions and the matter is getting bigger and bigger. Since prohibition of similar contracts means direct prohibition of a specific technology category, it can cause various other matters to be involved in the case as well.

In conclusion, it seems that whatever action OFAC takes, it will face serious accusations such as violation of 1st article of Constitution or prohibition of a technology. Taking into consideration that many software with open source codes were deleted or taken into hidden status, it can be stated that the arguments required for a defense accusing OFAC of harming technological development are formed themselves.

In case of a trial, OFAC might need to find far more different rationales than the arguments that brought success in previous pleas. If OFAC really made this move without detailed investigations on Tornado Cash, and only with the assumptions in Blender.io case, it is very likely that the court’s verdict is in favor of Tornado Cash. However, whichever scenario is valid, we can easily say that we are witnessing the beginning of a very important process that will be precedential, and perhaps, will constitute the new building stones for crypto market.

Prepared By: Berkay Aybey

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