DeFi is facing a ‘full frontal assault’ from regulators

The US Treasury’s Financial Crimes Enforcement Network recently published a proposal regarding the mixing of what they call “convertible virtual currencies” or CVCs.

Cryptocurrency transactions can be “mixed” via certain services in an effort to hide origins and quantities from any forms of surveillance.

The proposal is not a bill, the chief legal and policy officer at Polygon Labs Rebecca Rettig explains, but is a set of rules that the regulatory agency has proposed. The rules aim to curb money laundering and address the obfuscation of illicit flows of funds via crypto mixing mechanisms.

But the risks of such a proposal may outweigh the benefits, Rettig says. Now, she explains on the Empire podcast (Spotify/Apple), the Treasury Department is “looking for feedback.”

“They will take in all the comments,” she explains. “They’ll have to take them into account. They have certain balancing factors, right? Benefits versus risks.”

The rules ask US-based financial institutions and agencies “to implement record-keeping and reporting requirements,” Rettig says, relating to crypto transactions that involve mixing.

“On its face,” Rettig says, “that’s not crazy, right?”

But the real problem, Rettig says, is the breadth of the proposal’s definition of “mixing.” As it stands, it could capture “all smart contract based applications, definitely DeFi apps, but probably even ones that expand out from DeFi.”

“That’s really problematic,” she says.

A “full frontal assault” from regulators

Jake Chervinsky, in his new role as chief legal officer at venture fund Variant, says the crypto industry faces a “macro challenge.”

“Regulators want to identify the parties who are transacting. They want full insight and surveillance over the financial system.” Crypto mixers, Chervinsky explains, are a tool that people can use for privacy, “so that the government cannot surveil their transactions.”

“What we are seeing is sort of a full frontal assault from regulators, specifically anti-money laundering regulators,” he says, to figure out “who are the people who are transacting” and how to “circumvent this type of technology.”

“How do they stop people from using them — to make them as low liquidity and as difficult for people to use to protect their privacy as possible?” he asks. One answer is to criminalize technology, he explains, as demonstrated with sanctions against Tornado Cash.

Since the Patriot Act, which has been in effect for more than 20 years, Chervinsky says the Treasury department has been able to designate primary money laundering concerns. “They can designate an institution, a jurisdiction, a type of account — or a class of transactions.”

You might get in trouble with us…

Chervinksy notes that the department has never designated a class of transactions before. “This is a novel action that the Treasury Department is taking one step further, going after crypto, than they’ve ever done in any other type of context.”

“What it says is, ‘Hey, you regulated financial institutions, do you really want to touch these things?” he says. “‘Cause if you don’t paint within the lines, you might get in trouble with us.’”

“And that is really a signal to them to simply cut these things out. And that’s, often, how the government works.”

Chervinsky explains that the definition of CVC mixing “is way more broad than something like Tornado Cash or another privacy preserving protocol. It includes basically anything in DeFi.”

Rettig says “the industry needs to come together” and respond to the proposal with comments. FinCEN is “asking for examples of legitimate business purposes for mixing,” she says. “They specifically asked for it.”

“They need it to balance against what harm they would be doing by implementing this rule against the legitimate business purposes for mixers,” she says.

“We need to talk very publicly and also then submit to FinCEN all the legitimate ways that mixers are important to preserving privacy.”

Start your day with top crypto insights from David Canellis and Katherine Ross. Subscribe to the Empire newsletter.