Governments Scramble To Manage, Regulate, and Throttle Crypto

On January 15, 2022, the Canadian government closed its borders to unvaccinated American truckers and began requiring domestic truckers to show proof of COVID vaccination when crossing northward, infuriating drivers and snarling North American trade. Within two weeks, thousands of "Freedom Convoy" protesters filled the capital city of Ottawa, demanding the requirement be lifted. Officials responded by branding them "extremists," even "terrorists," and quickly began treating them as such. On February 4, the Canadian government pressured the crowdsourcing service GoFundMe—the truckers' seemingly decentralized source of financing—into abruptly stopping further transfers.

Ottawa was just getting started. On February 14, the federal government invoked the Emergencies Act, which let it freeze any bank account or legal financial instrument that could be traced to the truckers. So convoy supporters turned to bitcoin, the decentralized, peer-to-peer, blockchain-enabled digital currency whose whole raison d'etre—maintaining a separation between currency and government—seemed designed for moments like this.

Or not. Most bitcoin transactions—75 percent, according to an October 2021 working paper published by the National Bureau of Economic Research—are conducted through cryptocurrency exchanges. These, being legally licensed businesses (at least in theory), are vulnerable to the same interference as old-school financial institutions. The Canadian government demanded that the exchanges block all crypto wallets that could be linked to the protesters, and it initially seized the contents of some outright. "We will be forced to comply," tweeted Jesse Powell, then-CEO of major crypto exchange Kraken. "If you're worried about it, don't keep your funds with any centralized/regulated custodian. We cannot protect you. Get your coins/cash out and only trade p2p."

States around the world are chipping away at the freedom-enhancing qualities of the purportedly permissionless virtual currencies that have proliferated since the pseudonymous Satoshi Nakamoto unleashed bitcoin in January 2009. Governments are cracking down on third-party exchanges, seeking to hoover up all transaction data to enforce tax and other laws; they are trying to classify virtual currencies as "securities" in order to tighten the regulatory grip; they are sometimes banning software and digital addresses used to transfer ownership of them. Most ominously of all, some governments are trying to get into the crypto business themselves.

War on Crypto Anonymity

By the end of 2021, according to the industry tracking service Chainalysis, global adoption of crypto had "grown by over 2300% since Q3 2019 and over 881% in the last year." Institutional investors in 2021 traded $1.14 trillion worth of cryptocurrencies on the leading exchange Coinbase alone. Digital currency commercials so dominated the 2022 Super Bowl that advertising insiders dubbed it the "Crypto Bowl." And while the market capitalization of the crypto space plummeted to $957 billion as of early October 2022, down from a $2.8 trillion high in November 2021, that's still nearly triple the value at the start of October 2020.

The industry has grown too big for governments to ignore. In August 2022, the U.S. Treasury Department's Office of Foreign Asset Control (OFAC) made it a crime for any American to receive or send money using digital addresses associated with Tornado Cash, a crypto "tumbling" service that pools both source-identifiable and fully anonymous cryptocurrency together in order to make it harder to forensically trace ownership of particular virtual currency from sender to eventual recipient. Tornado Cash, the government claimed, had illegally laundered more than $7 billion, some of it stolen.

In response, pranksters began sending tiny bits of the digital currency ether to many prominent figures via Tornado Cash addresses, to hit home the absurdity of treating the mere interaction with a service as a crime. (The U.S. Treasury did trouble itself to say it would not go after mere recipients of Tornado-tainted ether.)

This wasn't the first time OFAC had made interacting with such a tumbler illegal for Americans, but Tornado Cash's distinct nature raises unique questions about the government's claimed power over increasingly sophisticated crypto markets and the sometimes autonomous software that such markets have come to use.

While some tumblers are essentially custodial entities with actual human beings controlling the exchange of digital currency tokens, Tornado Cash uses "smart contracts," a form of self-executing code. This kind of decentralized finance (DeFi) usually involves ethereum (the second-largest cryptocurrency per market capitalization), which was designed to enable the development of decentralized apps on top of a blockchain. Some of the addresses that OFAC sanctioned were code, untethered to individual people.

Because of this architecture, explain Jerry Brito and Peter Van Valkenburgh in an August 2022 paper for the crypto-focused think tank Coin Center, the people who created the "Tornado Cash Entity" have "zero control over the [Tornado Cash] Application today" and "can't choose whether the Tornado Cash Application engages in mixing or not, and…can't choose which 'customers' to take and which to reject." This implies that there is no actual individual who should be legitimately punishable for whatever specific crimes the app might be thought to have facilitated.

Potential First Amendment implications arise from the difference between a human provider and a blockchain-enabled piece of software. If OFAC can bar citizens from using "an ever expanding list of specific open source protocols and applications that are 'blocked,'" Brito and Van Valkenburgh ask, "then isn't that a restriction on the publication of speech?"

"Merely blocking one application is not the intent," the Coin Center authors argue. "The intent is to send a message that any example of this software is to be avoided…to chill speech such that Americans not only avoid interacting with these specific contract addresses, but avoid interacting with any protocol that is substantially similar to the code in those addresses. It's a ban not just on a specific application, but on a class of technology."

This interpretation is supported by an unnamed Treasury official, who told the Financial Times in August 2022 that the department "believe[s] this action will send a really critical message to the private sector about the risks associated with mixers writ large" and that the crackdown was "designed to inhibit Tornado Cash or any sort of reconstituted versions of it to continue to operate." In September 2022, Coinbase bankrolled a legal challenge to the Tornado Cash ban.

Governments are trying to steer cryptocurrency transactions into legally regulated entities with human operators that can be more easily controlled. In May 2021, Marathon Digital Holdings, which at the time used 6 percent of the total worldwide computing power applied to bitcoin "mining" (the computerized process for creating new units of the currency), began accepting only transactions arising from OFAC's list of legally approved entities. But what state pressure can accomplish, market pressure can still reverse—just a month later, after a backlash from customers allergic to state meddling, Marathon began dealing with all comers again.

States could, and might yet, use the carrot of regulatory permissiveness or even subsidy to encourage miners to accept blocks only from registered nonanonymous users, destroying crypto's core attributes of pseudonymity and permissionlessness. (Though governments should remember that mining is a highly movable operation. Restrictions or outright bans just ensure that citizens of other countries are the ones benefiting from it.) The flood of Wall Street money that helped make many initial crypto holders rich brought with it the attendant danger of respectability—the more "legitimate" an industry becomes, the less liberatory it can be.

White Papers, Red Tape

Governments' reactions to cryptocurrencies have varied widely. El Salvador made bitcoin legal tender in September 2021 (though survey data in mid-2022 indicate that most citizens and businesses are still not using or accepting it), while many other countries ban bitcoin mining and/or the use of crypto as payment. Regulations commonly focus on intermediary businesses that offer custodial, trading, or other services, with the goal of gathering up as much information as possible about their customers.

These efforts, operating under the rubric of AML/CFT (for "anti–money laundering/combating financing of terrorism"), are central to officials' worries about crypto: They cannot tolerate spaces where people can exchange value without the police accessing every detail. The U.S. Treasury Department's Financial Crimes Enforcement Network (FinCEN) considers even private peer-to-peer buyers and sellers of crypto as licensable money service businesses, with all the requirements and criminal/civil penalties pertaining thereto.

A G-7 body called the Financial Action Task Force wants to unify every nation's regulations to ensure no crypto-asset company on the planet evades governments' prying eyes. But as of June 2022, the group was lamenting that the "vast majority of jurisdictions have not yet fully implemented" its demands to standardize the market in an enforcement-friendly way. The global regulators griped that so far "only 11 jurisdictions have started enforcement and supervisory measures" for what they call the "travel rule," which requires the private sector to obtain and report "originator and beneficiary information," as they put it—meaning, squeal on all their customers to financial authorities.

In the U.S., the President's Working Group on Financial Markets (PWG) was already regretting the lack of international standardization in November 2021. "Illicit actors can exploit these gaps by using services in countries with weak regulatory and supervisory regimes to launder funds, store proceeds of crime, or evade sanctions," a PWG report lamented.

The past couple of years have seen a proliferation of blandly repetitive white papers and statements from governments and international bodies and financial institutions about the promises and perils of virtual currencies. Such cud chewing gives hints, though never total clarity, about where state interference in crypto markets might be heading.

In March 2022, President Joe Biden issued an executive order instructing various federal agencies to come up with policies, protocols, and regulations for cryptocurrencies. The specifics remained hazy under clotted bureaucratic prose about "encourag[ing] regulators to ensure sufficient oversight and safeguard against any systemic financial risks," demanding "coordinated action across all relevant U.S. Government agencies to mitigate these risks," and working "across the U.S. Government in establishing a framework to drive U.S. competitiveness and leadership in, and leveraging of digital asset technologies."

More concretely, the administration slipped into 2021's Infrastructure Investment and Jobs Act a provision that widens legal reporting requirements for dealing in crypto on behalf of other people. Entities that receive more than $10,000 of value in crypto now must collect and report to the government the name, date of birth, and Social Security number of the person they got it from.

This fresh demand is already the object of a lawsuit from Coin Center, which argues the requirement constitutes "a mass surveillance regime on ordinary Americans" in violation of the Fourth Amendment, and that it would often be impossible to satisfy given the way blockchain interactions work. As Coin Center explains on its website, the government is trying to sidestep Fourth Amendment obstacles to financial and telecom snooping via the "third party" exemption—maintaining that users lose their protections against unreasonable search and seizure the moment they volunteer sensitive info to a financial institution or telecom company. But there is no third party in peer-to-peer transactions, just sender and receiver. "If the government wants us to report directly about ourselves and the people with whom we transact," Coin Center argues, "it should prove before a judge that it has reasonable suspicion warranting a search of our private papers."

In autumn 2022 the fruits of Biden's March order began to fall in the form, generally, of more vague white papers. The Treasury Department in September released a 56-page report recommending that "regulatory and law enforcement authorities should, as appropriate, pursue vigilant monitoring of the crypto-asset sector for unlawful activity, aggressively pursue investigations, and bring civil and criminal actions to enforce applicable laws with a particular focus on consumer, investor, and market protection." It also said "regulatory agencies should use their existing authorities to issue supervisory guidance and rules, as needed, to address current and emerging risks in crypto-asset products and services for consumers, investors, and businesses." In other words, the agency says the government should enforce the law and tell us how the relevant laws apply to behavior in crypto markets; no great revelations for an industry fearing the next regulatory or enforcement shoe that might drop.

More threateningly, the Justice Department that same month announced the launch of a new Digital Asset Coordinator Network—"over 150 designated federal prosecutors from U.S. Attorneys' Offices"—and suggested, given how hard it was to investigate crypto crimes, that the relevant statutes of limitation be doubled from five to 10 years.

Insecurity About Securities Law

Much of the regulatory chatter and action in crypto over the past few years has been not in the bitcoin or ether tokens that have delivered wild speculative profits to people who got in at the right times, but rather in "stablecoins": digital currencies pegged to assets such as commodities, government currencies, or algorithmically adjusted baskets of other cryptocurrencies. People use stablecoins as an easier-than-cash means to buy crypto or to invest in or use DeFi projects.

In October 2021, the market cap of the more prominent stablecoins equaled $127 billion—a 500 percent year-to-year rise. DeFi's ability to move value and make investment decisions via automatic, unregulated programming makes it harder for the government to rely on the old system whereby it drafts financial intermediators such as banks and brokers to spy on their customers.

"Stablecoins could well fuel the coming Internet phase known colloquially as Web3. As smart contracts automate back-end management functions, ordinary citizens will benefit," attorney Paul Jossey enthused in a July 2022 paper for the Competitive Enterprise Institute. "In the future, cars will rent themselves, computers will lend their excess storage, and decentralized applications will share videos via predefined criteria—stablecoins will enable these and countless other and currently unimaginable transactions."

Even before the May 2022 collapse of the prominent algorithmic stablecoin Luna, much of the recent regulatory attention in crypto has focused on these widely used tokens. In October 2019, the G-7 warned that stablecoins could "increase vulnerabilities in the broader financial system through several channels." These channels include damaging banks' market share and exacerbating "bank runs in times when confidence in one or more banks erodes." By giving people more choice in where to store their value, stablecoins could also result in "diluting the effectiveness of the interest rate channel of monetary policy." Any escape from state money and state eyes is seen as too threatening to bear.

In its November 2021 PWG report, the Biden administration flatly recommended the end of stablecoins as we've known them, insisting that Congress "should require stablecoin issuers to be insured depository institutions" and impose federal risk-management standards on all custodial wallet providers.

There is no shortage of federal financial laws standing at the ready to ensnare stablecoins in their web—the Glass-Steagall Act, the Electronic Fund Transfer Act, the Dodd-Frank Act, the Bank Secrecy Act, and the Gramm-Leach-Bliley Act, for starters. Federal agencies rubbing their hands in anticipation of ruling the crypto domain include the Department of Justice, the Securities and Exchange Commission (SEC), and the Commodity Futures Trading Commission (CFTC) as well as OFAC. Even the Federal Deposit Insurance Corporation has been advising banks not to deal with crypto.

FinCEN considers stablecoins "convertible virtual currencies," and the companies that administer them are thus required in the agency's eye to register as legal money transmitting businesses. This would put them on the hook for complying with anti–money laundering programs, reporting when their clients engage in transactions larger than $10,000, and filing "suspicious activity reports" about actions the government wants custodians to consider suspicious.

But there's still a gap between the written regulatory letter of the law and the lived-in experiences of existing crypto. As the PWG explained, "there may be some instances where U.S. sanctions compliance requirements (i.e., rejecting transactions) could be difficult to comply with under blockchain protocols."

With so much potential enforcement hung up on how the new innovations of crypto can or should be crammed into pre–21st century regulatory definitions, various bills to provide definitional certainty are working their way through Congress. One bipartisan bill co-sponsored by Sens. Cynthia Lummis (R–Wyo.) and Kirsten Gillibrand (D–N.Y.) would define digital assets as commodities and therefore put them under the regulatory purview of the CFTC (which most in the field find more congenial than the SEC), unless they were being sold to raise capital for a company, in which case they would count as securities and the SEC would compel disclosure and provide oversight.

Sen. Pat Toomey (R–Penn.) has introduced a bill that would require stablecoins to publicly disclose their backing and redemption policies while otherwise sparing them from the SEC, and another to eliminate taxation on bitcoin transactions (or capital gains appreciations) of less than $50 in value.

Toomey, who did not run for reelection and thus will be out of the Senate in January, sees potential bipartisan support for rationalizing the regulatory structure around crypto in order to encourage more innovation and more U.S.-based development. But the banking industry "leans a little against this whole space; they see it as potentially disruptive to their business model," Toomey says, though "I don't feel like they have been mounting a very aggressive and systematic campaign" against it.

The Toomey and Lummis/Gillibrand bills will almost certainly not pass this session of Congress, so it's still up to the courts to decide a question being hashed out across several lawsuits and enforcement actions: Do most cryptocurrency instruments legally qualify as "securities" and therefore require SEC supervision? The most prominent SEC case wrangling with that question is aimed at a token called XRP, issued by a company called Ripple.

The SEC asserts that XRP was sold in a manner indicating the company "promise[d] to undertake significant entrepreneurial and managerial efforts, including to create a liquid market for XRP, which would in turn increase demand for XRP and therefore its price." The SEC believes that is sufficient to classify the product as an illegally unregistered "security."

Ripple insists that the XRP tokens, marked on a decentralized cryptographic ledger, have been used by millions of people who never had any dealings with the company itself, and thus the parties could not be said to be in a common enterprise, a key definitional consideration flowing from the 1946 Supreme Court case SEC v. W.J. Howey Co.

If the SEC wins the Ripple case, all sorts of crypto tokens will also see themselves as obligated to operate under the SEC's complicated and expensive rules or risk prosecution.

SEC Chair Gary Gensler is prepared to claim full power over crypto. In May 2022, he griped to the House Appropriations Committee that he needed more money and staff to effectively police virtual currencies, insisting the SEC is "really out-personed" at the moment. In September 2022, Gensler scared the crypto world by telling The Wall Street Journal he thinks ethereum should be treated as a security, meaning every buyer and seller should be hemmed in by, and potentially prosecuted for violating, decades' worth of federal securities regulations.

Central Bank Coin?

As governments struggle to come to grips with the profusion of private electronic currencies, they are increasingly beginning to wonder: If we can't beat 'em, why not join 'em? A brave new world of central bank digital currencies (CBDCs) lurks around the corner.

Among the countries that have either launched or announced their intentions to launch a CBDC are China, Russia, Uruguay, Ecuador, India, Jamaica, Ukraine, Sweden, South Korea, the United Arab Emirates, Venezuela, the Bahamas, and the eight nations affiliated with the Eastern Caribbean Central Bank. With the alarming amount of knowledge about and power over every transaction that a CBDC could deliver, those dedicated to crypto's liberating promises might wish the state kept on just trying to beat them instead.

A February 2021 paper from JPMorgan Chase found that about "60% of central banks are experimenting with digital currencies, while 14% are moving forward with development and pilot programs." The bank foresees a tangle of future jurisdictional issues, "as policymakers will call for harmonization of legal and regulatory frameworks governing data use, consumer protection, digital identity and other policy issues."

Or, as Federal Reserve Chair Jerome Powell testified to Congress in July 2021, "You wouldn't need stablecoins, you wouldn't need cryptocurrencies, if you had a digital U.S. currency."

Deploying a CBDC as a stablecoin killer makes sense from the government's perspective. As the economist Noah Smith noted in his newsletter in December 2021, "rather than the current environment of unchecked inflation and competitive devaluation, the [DeFi] matrix imposes a new kind of discipline on national currencies, as billions of people make individual choices regarding which currencies to hold—or not hold." States are not comfortable with us choosing to abandon sovereign currencies.

The Fed insists it has no intention of actually replacing cash, but merely wants to improve the speed and efficiency of our overall payments system—banking the unbanked; making the transfer of value easier, faster, cheaper, and so forth.

"The Federal Reserve's initial analysis," the central bank insisted in a January 2022 report, "suggests that a potential U.S. CBDC, if one were created, would best serve the needs of the United States by being privacy-protected, intermediated, widely transferable, and identity-verified."

That last point is the danger zone. To use cash, you merely have to convince your counterparty that the cash is cash; you do not have to convince them you are you. In a digital system whose capacities to surveil and control are nearly unlimited, identity verification looks frightening indeed.

When it comes to China—which has been working on a retail CBDC since 2014, and in the past couple of years has rolled out trials of its own e-currency in more than 10 cities, with at least 261 million Chinese citizens using it—economists, international organizations, and the American press have had no trouble seeing the downside of government-issued digital tokens, with their inherent ability to surveil and record all transactions in real time. But what about America?

If a FedCoin became our official payment system, what you are allowed to pay for legally could be controlled and shifted on a day-by-day basis depending on what services or products the government wants to discourage or quash. This would have a reach far beyond just truckers protesting vaccine mandates.

Authorities could bake in faddish, top-down social goals that you—the sucker who merely wants to spend your money to meet your needs and desires—want nothing to do with. These could concern the environment (do you really need to buy that much carbon-generating stuff in a month?), safety (guns and gun accessories not FedCoin-compatible at this time) or "equity" (let's make sure the right percentage of your spending goes to counterparties with the approved racial or gender mix).

Those who find such scenarios implausibly dystopian need only consider the credit card industry's overnight decision in September 2022 to adopt a special new code for all gun purchases. Or the government pressure, without a legal demand challengeable in court, that certain mavericks be booted from major social networks, such as vaccine skeptic Alex Berenson. The current administration is clearly not afraid to use its powers to restrict our ability to use markets and services—and when it comes to money, the government palpably wants unconstrained law enforcement and monetary policy powers.

We have tools both legal (the Constitution) and technological (paper cash and peer-to-peer crypto) to help us curb or evade government overreach. But both could be overcome by a sufficiently motivated government.

"Protecting consumer privacy is critical," the Fed's January paper assured us. But it also said this: "Any CBDC would need to strike an appropriate balance…between safeguarding the privacy rights of consumers and affording the transparency necessary to deter criminal activity." Guess who will be deciding on the appropriate balance?

The notion of shifting to a CBDC may seem unthinkably radical, but standard money usage can change surprisingly quickly. It took only around 10 years for the world to switch from the British pound to the U.S. dollar as its primary reserve currency. The U.S. government has proven itself willing to legally demonetize (and force you to exchange at rates it chose) things citizens had been saving and relying on for decades—see gold in the 1930s.

In a 2021 University of Chicago Law Review article, Gary B. Gorton of the Yale School of Management and Jeffery Zhang of the University of Michigan Law School laid out the issues at stake. "The question," they wrote, is "whether policymakers would want to have central bank digital currencies coexist with stablecoins or to have central bank digital currencies be the only form of money in circulation….Congress has the legal authority to create a fiat currency and to tax competitors of that uniform national currency out of existence."

The CBDC idea is very much on the Biden administration's mind; as the White House Office of Science and Technology Policy wrote in its September contribution to the crypto policy initiative, Biden's order "placed the highest urgency on research and development efforts into the potential design and deployment options of a U.S. CBDC." The office announced "an interagency effort to develop a National Digital Assets Research and Development (R&D) Agenda" to "place a high priority on advancing research on topics like cryptography that could be helpful to CBDC experimentation and development at the Federal Reserve."

Alarmingly, the Treasury Department's "Action Plan" states that "the U.S. government has also been engaging through multilateral fora to establish principles for CBDCs and ensure that they…mitigat[e] illicit finance risks" and "comply with the global AML/CFT standards currently in place…any CBDC needs to integrate a commitment to mitigate its use in facilitating crime." And once an obsession with making sure no one can use a currency to commit crime is a leading concern, there is almost no place the government has proven itself unwilling to go in hoovering up private information and preventing us from using our money in ways it disapproves of.

Powell told CNBC in April 2021 regarding a CBDC that "I think it's more important to do this right than to do it fast." Given that a government-run digital currency is a ready-made machine for the authorities to surveil, skim, manipulate, and control every single exchange of value we make, the only safe way to do it for American liberty is not to do it at all.