Convicted! What Does the Tornado Cash Ruling Mean for DeFi Regulation?

Author: Rhythm

A Dutch judge at the court in Schiedam ruled that Alexey Pertsev, one of the founders and core developers of Tornado Cash, was guilty of money laundering. The court sentenced Pertsev to 64 months in prison. Over the past year, the regulatory issues surrounding DeFi sparked by Tornado Cash have drawn significant attention from the industry. This year, despite the team's repeated emphasis on compliance, the "big brother" of the DeFi space, Uniswap, was still sued by the SEC. What impact will the guilty verdict against the co-founder of Tornado Cash have on future DeFi startups? How will DeFi coexist with regulation in the future?

Separation of Team and Protocol, Still Hard to Escape DeFi Regulation?

The trial of the Tornado Cash case serves as a warning for other cryptocurrency service providers.

In April 2023, the U.S. Treasury released an assessment report on illegal financial activities in DeFi, revealing potential risks in DeFi services and analyzing how illicit actors exploit these services for criminal activities. Three months later, four U.S. senators proposed the "Crypto Asset National Security Enhancement and Enforcement Act," aimed at strengthening regulation in KYC, AML, and the DeFi space.

The "Crypto Asset National Security Enhancement and Enforcement Act" provides a new framework for regulating DeFi, requiring that DeFi be regulated similarly to other cryptocurrency entities, mandating that any "person" who can control the project must be held accountable. The bill suggests that if no specific person can control the DeFi service, any investor who invests more than $250,000 in the project should be held responsible.

In line with current regulatory hotspots, the focus of the Pertsev trial revolves around whether laws aimed at curbing money laundering can adapt to blockchain-based financial innovations and the values of anonymous transactions.

During a hearing in March, prosecutors argued that the protocol developers did not do enough to prevent criminals from exploiting Tornado Cash. Pertsev's defense countered that prosecutors should consider the open-source and automated nature of Tornado Cash's core smart contracts. "Holding Pertsev accountable for Tornado Cash users is wrong, as these users are designed to be anonymous and independent."

Pertsev's defense attorney, Keith Cheng, stated that project teams cannot prevent users from using open-source smart contract code in any way they prefer. The contributors to the protocol are a decentralized organization without a single responsible party like a traditional company.

However, prosecutors rejected this viewpoint, arguing that the benefits of technology outweigh the legal obligations to prevent the platform from helping criminals and sanctioned entities (such as the North Korean hacking group Lazarus Group) conceal the origins of stolen assets. Prosecutor Martine Boerlage stated, "Tornado Cash is not just a smart contract; it operates like a company."

Perhaps considering the controversial nature of the case, the trial process for Pertsev in the Netherlands has been quite opaque, with the prosecution only disclosing his indictment a week before his trial. The preliminary hearings and a series of hearings were also conducted in Dutch.

Pertsev has garnered various forms of support, including petitions, legal fundraising, and statements from hacked protocols declaring his innocence. The crypto community, especially the developer group, has strongly protested Pertsev's arrest, fearing that the charges against him could set a dangerous precedent for convicting software developers.

Previously, supporters of Alexey Pertsev distributed posters outside the Dutch court.

Previously, U.S. regulatory agencies, including the Department of Justice (DOJ), filed criminal charges against Tornado Cash founders Roman Storm and Roman Semenov, accusing them of conspiracy to commit money laundering, violating sanctions, and operating an unlicensed money transfer business. The two face at least 20 years in prison.

Storm was arrested last year and will stand trial in September, while Semenov has not yet been arrested. The outcome of Pertsev's verdict is likely to influence the future trial results for these two Tornado Cash founders.

After Tornado, Uniswap Case Becomes the Focus

In fact, after Tornado Cash, several other crypto protocol owners have also faced accusations due to criminal activities occurring on their platforms. For example, Uniswap was accused of allowing fraudulent tokens to be issued and traded on its protocol, but this lawsuit was ultimately dismissed by the court in 2023.

At the end of last year, a16z wrote a commentary letter for the Financial Stability Board (FSB) on the theme of "International Regulation of Crypto Asset Activities," which began by emphasizing the need to clarify the distinction between DeFi and CeFi, and how an appropriate regulatory framework for DeFi should regulate Web3 applications rather than Web3 protocols (regulating businesses rather than software). The debate over which aspects of DeFi protocols and applications are suitable for a regulatory environment has continued, but even so, most legal experts agree that any DeFi front end with any connection to the U.S. must comply with U.S. sanctions laws.

On April 11 of this year, the U.S. Securities and Exchange Commission (SEC) issued a warning to Uniswap Labs, planning to take enforcement action against the company. Reportedly, the warning was issued in the form of a "Wells Notice," which is sent by the SEC to a company before initiating a formal lawsuit, providing the company with a final opportunity to rebut any allegations. Currently, the specific nature of the SEC's allegations against Uniswap Labs remains unclear.

The market reacted sensitively to this news; according to market data, following the "SEC warning" news, the price of UNI dropped from $14 to its current $9.58, plummeting over 14% in 24 hours. During this period, the on-chain trading volume of the UNI token surged, even topping the Dexscreener Ethereum token hot list.

Uniswap responded promptly. Uniswap founder Hayden Adams confirmed on social media that Uniswap Labs had received the SEC warning and issued an open letter in response. In the letter, Hayden mentioned that the team believes the products they provide are legal and accused the SEC of failing to establish clear, informed rules while choosing to target high-quality participants in the crypto space like Uniswap and Coinbase, while allowing bad actors like FTX to "get away."

Additionally, Hayden emphasized in the letter that Uniswap, as an internet company based in the U.S., has consistently adhered to a compliance-oriented development path. He also noted that this struggle with the SEC would last for several years, and they are prepared to appeal to the Supreme Court.

After Sanctions, Still the Largest Crypto Mixer

Tornado Cash is a privacy-preserving protocol that can mix ten types of cryptocurrencies, with the most mixed asset being native ETH on the Ethereum mainnet. At its peak in July 2021, the Tornado Cash pool contract held over $700 million in ETH.

A week before Pertsev's trial, a court-shared indictment revealed that between July 9, 2019, and August 10, 2022, "in at least several countries including the Netherlands, Russia, the United States, or Dubai, Pertsev developed a habit of money laundering with one or more other individuals." The court found that Pertsev should have at least suspected the criminal origins of illegal transactions on the Tornado Cash platform.

The indictment listed nearly 40 transactions processed by Tornado Cash from different crypto platforms, totaling 535,809 ETH, including KuCoin and Liquid (the exchange acquired by FTX before its collapse in 2022). The largest single amount was 175,100 ETH (approximately $585 million) from the Ronin network of Axie Infinity, involving the largest theft in cryptocurrency history at the time. The attackers were the notorious North Korean hacking group Lazarus.

In August 2022, Tornado Cash and related Ethereum addresses were placed on the U.S. Treasury's Office of Foreign Assets Control (OFAC) Specially Designated Nationals (SDN) List, with the Treasury claiming that Tornado Cash was a key tool for the Lazarus hacking group, which had orchestrated the $625 million hack of Axie Infinity and other significant cryptocurrency thefts.

According to analysis, as of early May 2022, the Lazarus Group had transferred 37,000 Ethereum to Tornado Cash, amounting to about $100 million. Some experts stated that "the dirty money of a certain country's official hackers" accounted for 20% of the balance held by Tornado Cash's smart contracts.

Tornado Cash has stated that despite numerous efforts, it could not prevent the Lazarus Group from adding dirty money to the platform. After all, Tornado Cash is designed to help users obfuscate their on-chain transaction history.

The crypto community also believes that developers becoming political prisoners of the U.S. government simply for writing code is not just an attack on cryptocurrency. However, the sanctions did not have a shocking impact on the Tornado Cash project itself; in the following month, $77.35 million in assets were still transferred through Tornado Cash on the Ethereum mainnet.