US Treasury Department Releases Illicit DeFi Report

If 2022 is remembered for the bear market, hacks, and almost unfathomable collapses, then 2023 will be remembered for the regulatory war.

So far this year, we’ve already seen:

• A scathing report by the White House.

• Signature Bank questionably closed as part of the broader banking war on crypto, known as Operation Choke Point 2.0. 

• Coinbase’s Wells Notice.

• Binance sued by the CTFC.

• Paxos ordered to stop issuing the Binance Stablecoin.

• Kraken end staking after an attack by the SEC.

• Elizabeth Warren campaign on “building an anti-crypto army”.

That’s a lot of regulatory hits in less than four months, but it’s about to get even worse.

This week, The US Treasury Department released a “DeFi Illicit Finance Risk Assessment”, to assess how decentralized finance, or DeFi, is being abused by illicit actors.

And already, pro-crypto lobbying outlets such as CoinCenter are pointing out that the report is unhelpful, inaccurate, and potentially dangerous.

So who’s right?

The report is worth a read in its entirety, but in this article, we’ll briefly summarize its good, bad, and ugly parts.

The Good

Against our expectations, the report isn’t all bad, as the Treasury actually makes some encouraging points.

First, the report repeatedly makes clear that it’s just a report, not binding law. This means that the 2019 FinCEN guidance, which CoinCenter believes is good law, is still the law of the land pertaining to DeFi.

The report also makes clear that DeFi is a relatively small fish, and that traditional finance is a much more significant money laundering threat. We couldn’t agree more.

Finally, the report states that it’s not concerned with transfers between two “self-hosted” wallets. In other words, the Treasury doesn’t care about you sending money directly to a friend. This is obviously positive, because if they were concerned about this, we would be entering the doldrums of a dystopian surveillance state where every transaction is monitored by the government. Oh yea, that's what CBDCs are for…

Anyway, on to the bad.

The Bad

Although the report claims the Treasury is cool with peer-to-peer transactions, it qualifies this by saying “as long as it doesn’t involve smart contracts” (paraphrasing). As smart contracts are the lifeblood of DeFi, this is basically the Treasury saying, “we have our eyes on DeFi.”

Beyond the implications for DeFi, this also shows a fundamental misunderstanding by the Treasury of how wallets work. Crypto wallets are on the blockchain, not in people’s pockets. To access them, you need to use smart contracts. Thus, every peer-to-peer transaction involves smart contracts in some form, making the Treasuries statement completely incoherent.

Moving on, the report spends page after page debating regulations for centralized vs. decentralized tools and protocols.

In the grand scheme of things, it shouldn’t matter whether a protocol is centralized or decentralized. What should matter is what the protocol is doing. If you’re managing other people’s money, you should be regulated. If you’re helping people secure their own money, you shouldn’t be regulated.

Whether you’re centralized or not is irrelevant.

The Ugly

Ultimately, the Treasury’s obsession with centralization and decentralization seems to be a step to regulate crypto protocols regardless of what the protocol is actually doing.

This is best seen in the report’s sections on the division of the Bank Secrecy Act (BSA, also known as the Anti Money Laundering law).

The way BSA authority is (supposed to be) triggered is based on what the party in question is doing. As these activities have very different definitions, this gets very complex very quickly. Thus, it’d be helpful for the report to dive into what DeFi activities trigger what BSA attention.

As you can probably guess, the report does none of that. Instead, it claims that “DeFi services at present often do not implement AML/CFT controls or other processes to identify customers”. In other words, all of DeFi is breaking the rules, irrespective of the protocol’s activities.

So, according to the Treasury Department, it doesn’t matter if you’re just publishing software to help people secure their money, you are (potentially criminally) breaking the law.

Not good.

Conclusion

As we stated in the good section, this is just a report, not binding law. But, that doesn’t change the fact that reports like these and the White House report are concerning for the future of crypto in the US.

It is clear that the powers-to-be are not fans of crypto and are working to destroy it, whether explicitly through CBDCs or implicitly through cutting off banking access.

This, as we have said many times, is extremely short-sighted. We should be encouraging innovation, not driving it away.

Unfortunately, it looks like the US Government sees crypto not as a tool for prosperity, but as a threat to be destroyed.