Tornado Cash sanctions effective, reveal Ethereum weakness: NY Fed

The Federal Reserve Bank of New York has released a report on the effect of sanctions on Tornado Cash, the crypto mixer that was blocklisted by the United States Treasury Department in 2022. Sanctions work, by and large, even in decentralized finance, the report concluded.

The report’s findings also apply to Ethereum. The Ethereum network’s resistance to censorship and cooperation shows “fragility,” the report says.

What sanctions matter to a smart contract protocol

The Treasury’s Office of Foreign Assets Control (OFAC) sanctioned addresses associated with the so-called crypto mixer Tornado Cash on Aug. 8, 2022. The move was a response to large-scale money laundering operations it had enabled by obscuring the movement of crypto funds onchain. It was the first time a computer protocol had been sanctioned.

The report says that use of Tornado Cash dropped significantly after the sanction but gradually recovered. There was a reaction throughout the crypto community as exchanges and other platforms banned Tornado Cash, and industry groups defended it.

The consensus mechanism on the Ethereum blockchain shifted from proof-of-work to proof-of-stake just after the Tornado Cash sanctions were imposed. On Ethereum, proposers (better known elsewhere as validators) receive blocks of transactions from builders.

According to the NY Fed report, users tended to observe the sanctions on Tornado Cash. Large builders also observed the sanctions but to a somewhat lesser extent. Block builders that refuse to heed the sanctions did so out of conviction, not a profit motive. Proposers’ behavior remained largely unchanged, although the report noted that they could have sorted out non-sanctions-compliant blocks.

What sanctions matter to blockchains

The report’s observations of the Tornado Cash sanction behavior expose facts about Ethereum itself, the report says:

“Our results suggest that censorship-resistance is fragile. Although various design choices of Ethereum were chosen to encourage decentralization, we find a fair level of concentration along the settlement chain and high dependence on few actors to facilitate the inclusion of Tornado Cash transactions.”

Tornado Cash continues to operate and has seen a strong resurgence this year. Protocol developer Alexey Pertsev was found guilty of money laundering in the Netherlands in May. Roman Storm and Roman Semenov, the other developers behind Tornado Cash, have been charged by the Justice Department with conspiracy to commit money laundering, conspiracy to commit sanctions violations, and conspiracy to operate an unlicensed money-transmitting business.

Storm is in custody and his trial is currently underway. Semenov is still living free.