In November 2022, the famous crypto exchange FTX collapsed suddenly, amplifying debate over the very meaning of crypto's existence. In 2023, this fight is set to extend into U.S. courts and Congress. The controversy over the future of finance continues.
The battle lines are complex, but two opposing camps stand out in the middle. Skeptics — prominent politicians and regulators among them — want to rein in the crypto industry. They believe fraud is rampant in crypto and that consumers are suffering financial harm as a result. Watching FTX's catastrophic end, they have grown even more emboldened.
And on the other side are the advocates of 'decentralized finance'. Those in this camp tend to believe that crypto networks like Bitcoin and Ethereum are essential to the future of individual financial privacy and economic freedom. Crypto is accessible to anyone with an internet connection and is controlled not by companies, governments, or banks but by public networks.
The decentralization camp worries that flawed regulation could undermine the freedom of the crypto industry. They interpret the FTX collapse, on the contrary, as evidence of the dangers of centralized control and as a reminder of the need for crypto's existence. Their goal is to build a blockchain-based financial system that is more accessible and privacy-preserving than conventional financial arrangements. In other words, they dream of liberation from the traditional financial system in which intermediaries like banks surveil users and impose middleman fees.
In fact, policymakers had crypto in their sights well before FTX's collapse. The courtroom fights and legislative debates over crypto expected to unfold in 2023 are therefore an inevitable sequel. Given the central role the United States plays in the global financial system, the outcome of this battle over crypto will clearly ripple through the world's financial sector.
For those who view the use of open blockchains as critical to the future of finance, this debate matters more than ever. Can they hold their ground and sustain a decentralized financial system that is free from traditional regulation? Or will policymakers tame crypto platforms via legislation and centralized control? The questions surrounding crypto have gone unresolved for years. Now we'll soon see the answers.
"The crypto we created"
The details behind FTX's collapse are complex. New facts about the bankruptcy keep emerging. U.S. prosecutors recently indicted FTX founder Sam Bankman-Fried on charges of fraud and money laundering. Against this backdrop, it isn't easy to gauge how much blame for the FTX fiasco lies with crypto itself.
Even as the most fervent crypto backers are eager to distance themselves from FTX, Neha Narula, director of MIT's Digital Currency Initiative, says the FTX affair reflects the character of "the crypto we created."
Narula pointed out the problem that the current crypto industry relies excessively on major exchanges like FTX. The issue isn't only this centralization. "It's also a problem that the crypto market has the characteristics of a casino economy run on tokens," she says.
Like countless other crypto companies, FTX issued its own cryptocurrency. The affair began in early November when the specialized crypto outlet CoinDesk published an article. The article revealed that much of the capital held by FTX's sister firm Alameda Research was made up of a cryptocurrency called FTT. According to CoinDesk, a significant portion of the roughly $10 billion (about 13 trillion won) in capital held by Alameda consisted of 'coins issued by an affiliated company rather than independent assets such as fiat currency or other cryptocurrencies.' The revelation ultimately triggered a plunge in FTT's value.
Narula pointed out that the crypto industry relies on a self-referential ecosystem of countless vaguely-substantial cryptocurrencies that have sprung up suddenly without offering sufficient justification for why they are valuable. FTT was just one among thousands of such cryptocurrencies.
The ambiguity of crypto tokens' value is the biggest reason regulators are focusing on decentralized finance — the new domain of the crypto world today known as 'DeFi'.
Going decentralized
Let's continue with FTT as an example. In the United States, you cannot buy FTT on centralized exchanges. That's because any exchange selling it would have to be overseen by the U.S. Securities and Exchange Commission (SEC).
The SEC's mission is to protect investors participating in financial-asset markets. Companies selling assets must register with the SEC as institutions and submit comprehensive disclosures about their financial condition.
SEC Chair Gary Gensler has stated that many of the cryptocurrencies circulating in the market are securities and therefore must be regulated. In other words, Gensler's position amounts to treating organizations selling crypto assets in the U.S. as operating illegally. Because FTT's characteristics resemble those of FTX stock, it is likely a target for regulation. Yet while the U.S. government can prevent unregistered securities from being listed on centralized exchanges, it cannot stop people from trading these securities on exchanges that run purely on the blockchain.
Decentralized exchanges, or DEXs, sit at the center of the rapidly growing DeFi world. The most prominent DEX is Uniswap, whose daily trading volume easily exceeds $1 billion. Uniswap is a computer program stored and executed on the Ethereum blockchain, allowing anyone with an internet connection to buy and sell a wide variety of cryptocurrencies outside regulators' control.
DeFi advocates argued that the FTX affair is, in fact, the reason an alternative, 'open', decentralized financial system needs to be adopted. DeFi apps verify transactions via cryptography, and it's all recorded on the blockchain. Thus there are no middlemen — and no risk of middlemen being corrupted.
Yet from the perspective of policymakers, decentralized finance apps present considerable problems. The absence of intermediaries also means the absence of anyone to regulate. How can regulators manage securities trading on decentralized platforms? Is there a way to check whether illicit funds are being laundered?
That's why, in 2022, the U.S. Congress was embroiled in debates over DeFi 'front ends.' 'Front ends' refers to the web-based user interfaces most people use to access DeFi protocols. In Uniswap's case, one startup has been building and managing the front end.
Stephen Palley, a partner at the law firm Brown Rudnick and co-chair of its Digital Commerce Group, says, "The question now is whether operators of DeFi front ends must be licensed by the government." He does not believe that every DeFi front end should be licensed.
He put it this way: "Suppose I launched a website. The site I created simply has the function of letting people exchange information with a particular piece of software. That software was developed by someone other than me, has a globally distributed database, and is already designed to interact with its own database. In that situation, can I really be said to have built a securities exchange?"
DeFi has attracted a lot of attention over the past two years, but the market is still not very large, and most participants are short-term investors. The bright future DeFi promised has not materialized. DeFi supporters argue that regulating front ends would, on the contrary, strengthen the very entry barriers the blockchain was meant to eliminate — and would thus destroy the DeFi ecosystem.
Whether regulators regulate major DeFi front ends will have enormous influence on how the underlying technology evolves. Palley added that regulators could announce relevant measures soon. He also predicted this debate will continue in courts and Congress for about the next two years.
Tornado Watch
Another major issue on which DeFi supporters are clashing with regulators is privacy. The regulation of Tornado Cash has become one of the most important points of contention for the future of decentralized finance.
Like Uniswap, Tornado Cash runs on top of the Ethereum ecosystem. Users deposit their crypto into Tornado Cash's digital currency pool and can then withdraw from a different address; during this process, Tornado Cash uses advanced cryptographic techniques called 'zero-knowledge proofs' to ensure that the link between the deposit address and the withdrawal address is not publicly revealed. That is, because information about the user's past transactions and the money on the blockchain no longer remains, tracing funds becomes difficult.
Last August, the Office of Foreign Assets Control (OFAC) under the U.S. Treasury sanctioned 45 Ethereum addresses associated with the platform, effectively banning U.S. citizens' access. OFAC said it took action because Tornado Cash has been used to 'launder' billions of dollars in funds, including hundreds of millions of dollars stolen by North Korean hackers.
OFAC has previously sanctioned blockchain addresses linked to foreign individuals, but this was the first time smart contracts were sanctioned. Peter Van Valkenburgh, a research director at the crypto advocacy group Coin Center in Washington D.C., argues that OFAC lacks the authority to ban smart contracts. As Coin Center notes, although OFAC has regulated Tornado Cash's contracts, these contracts cannot be modified, blocked, or released even by Tornado Cash's own developers. These contracts exist independently of human intervention.
Van Valkenburgh points out that while OFAC has legal authority to sanction specific individuals or foreign entities, it cannot bar all U.S. citizens from using a tool like Tornado Cash. He added, "The federal statute empowering OFAC is being used to designate which software tools citizens may not use. That is not the legislative intent Congress had in mind."
Coin Center filed a lawsuit against the Treasury demanding that the sanctions be rescinded, arguing that citizens' privacy had been violated. Coin Center argues that OFAC lacks the legal authority to forbid use of a software tool and that the sanctions go against the spirit of the Constitution. The well-known crypto exchange Coinbase is similarly funding another lawsuit against the Treasury.
Following the authorities' sanctions, GitHub deleted the project's source code, and the project website tornado.cash was taken down. Separately from OFAC's action, Dutch authorities detained Alexey Pertsev, who had participated in developing Tornado Cash. Prosecutors charged Pertsev with aiding and abetting money laundering.
Pertsev was one of Tornado Cash's founding members. But like most crypto projects, Tornado Cash is run by loosely connected open-source contributors. Another co-founder, Roman Semenov, did not respond to requests for comment.
The crypto industry is closely watching the progress of the Tornado Cash controversy. Whatever the conclusion, it will shape the future of online finance. Narula says, "A crypto developer should not be treated as a financial intermediary simply for writing code and putting it on the internet." She added that there are countless steps between crypto development and actually operating a service.
So at what point does a finance app transition from internet code to financial service? That, precisely, is the question at the heart of the conflict over DeFi front ends.
The freedom to use blockchain-based services without obtaining permission from the government is on the line in both debates. By our forecast, crypto believers will likely fight with everything they have to defend that freedom.
