Is crypto still fungible?
"Those little pens they use on Benjamins at the gas-station cash register."
I admit that I told my readers that, when Bitcoin was like $1, that theoretically it could go to the moon. But probably the government would shut it down eventually and it would go to $0. I admit that over time, my “probably” has become “possibly.” The theory, however, has not changed.
But still. Here is something that has just happened to crypto: with the OFAC attack on Tornado Cash, a large pool of crypto ($400M worth) has become formally tainted. This has never happened to crypto before. Here is what happens next—I fear. (But please bear in mind that my fears here don’t have the world’s best track record.)
Crypto disaster scenario
The compliance staff at the most reputable exchange writes a memo to the CEO that says: it is not enough to prohibit direct transactions with OFAC listed wallets. Rather, before converting from crypto to fiat, reputable exchanges need to check whether they are contaminated with Tornado coins.
This requires actual chain analysis on every account at the exchange, so that tainted coins cannot be converted into fiat. Rather, tainted exchange accounts may receive a message that they are frozen until they transfer all tainted coins to Treasury. If our masters are really clever, proper wallets will be able to absolve themselves this way.
Also, to be safe, this restriction may be applied to Tornado tainted coins from before the OFAC listing. And since Tornado is an Ethereum thing, and Ethereum uses accounts rather than true coins (UTXOs), any tainted inputs taint a whole account—creating maximum taint amplification.
And since WBTC is a thing, taint chains can stretch over to Bitcoin or to any other coin. As for privacy coins—writes the compliance staff—Tornado used the same tech, zero-knowledge proofs. It is safe to say that ZCash, etc, fall under the same regulatory precedent—meaning that anything that has touched a privacy coin is also tornadoed.
What ensues is an arms race in taint defense. Anyone who accepts any coin has to check a tornado API. An on-chain API can check against the OFAC list—it can’t do chain analysis. This shuts down any on-chain exchange of value—nobody wants to be caught exchanging clean coin for tornadoed coin. Moreover, holders of tainted coin will look for every avenue to remove the taint, even if that avenue may not necessarily work—if it may be traceable enough to taint the clean coin.
As this fear spreads downward from the most reputable exchange, it’s devil take the hindmost. The last people who still accept dirty coin are liable to end up with all of it.
What a mess! What comes out of this mess? Here are four scenarios:
Scenario 0: nothing happens
In scenario 0, nothing happens. The dog does not bark in the night. The OFAC action is toothless. Just moving your tainted crypto through another wallet cleans it right up. Everyone with a clue can even get their $400M out of Tornado. No one actually cares! Everything is fine! I would like to be wrong like this.
Scenario 1: default compliance
Default compliance is what happens if no one does anything.
What happens if no one does anything (I fear) is that Ethereum is no longer fungible enough for distributed finance. Which vanishes, fleeing from the taint pool. You will not lend ETH if you fear you will be repaid in stinky tainted ETH.
No real loss, as “DeFi” is before its time in this market anyway—all lenders, no true borrowers (except to relend). It is true that there should be finance in a currency, but not until there is true, profitable borrowing in it—real commercial activity that uses capital to return money over time.
Next, any commerce in Ethereum or Bitcoin (again, tainted Ethereum can cross into BTC via WBTC) will turn out to require a taint analyzer. Payment in tainted coin is not payment. Everyone who takes payments will need the equivalent of one of those little pens they use on Benjamins at the gas-station cash register. And again, the last places tainted coin can be spent will find themselves with—all the tainted coin.
The present time in which anyone will take any coin from anyone vanishes, like the world of gay San Francisco before AIDS. Now, a tainted payment is not a payment—it requires an offline check. Everyone prays that there is only one standard taint check. Monetary HIV has entered the formerly carefree financial-commercial world of crypto.
In a way this is not so bad, because “DeFi” is before its time. But the loss of crypto fungibility, or at least onchain fungibility (because, again, onchain taint analysis is not practical) also deals a crippling blow to any kind of smart contract. It returns crypto to its core function—which is not even commerce, but merely a medium of saving.