.png)
NY Fed Report Shows Mixed Effects of Sanctions on Tornado Cash
What happened?
The Federal Reserve Bank of New York published a research report earlier this month evaluating the impact of the Office of Foreign Assets Control’s (OFAC) Tornado Cash smart contract sanctions with which US persons are obligated to comply. Using on-chain transaction and pricing data from January 2020 to December 2023, the report found that:
1) the total value, transaction volume, and user diversity of Tornado Cash pools declined after the designations on August 8, 2022;
2) while the net flow into the largest pools (100 ETH) decreased after the sanctions, all small pools (0.1, 1, and 10 ETH) have shown increases in their net deposits and reached or exceeded pre-designation levels;
3) since the introduction of the Proposer-Builder Separation (PBS) design, by the end of August 2023, block builders responsible for 89% of blocks validated had stopped including Tornado Cash transactions. However, the two largest block proposers, accounting for 40% of all validated blocks, consistently continued to propose blocks that include Tornado Cash transactions, highlighting a significant divergence in behavior between builders and proposers.
What does this mean?
The NY Fed’s report shows that the Treasury’s sanctions on Tornado Cash do have a significant impact on lowering the protocol’s overall usage. Despite the drops in total volumes in Tornado Cash transactions, especially in the largest pools, increases in net flows in smaller pools suggest that Tornado Cash’s core functionality of providing greater privacy continues to attract users.
The mixed level of sanctions cooperation among different Ethereum actors evidences the jurisdictional diversity of the network, as only US persons are obligated to comply with US sanctions. As the Fed economists conclude, crypto values may also play a role in continued use of the protocol.
IRS Broker Rulemaking
What happened?
Last week, the Internal Revenue Service (IRS) published a revised draft of the third-party tax reporting form 1099-DA, Digital Asset Proceeds from Broker Transactions. The publication of this revised tax form reflects the finalized “Broker” rulemaking, which the IRS published in June. Most importantly, the revised draft form excludes DeFi and non-custodial wallet providers from its reporting requirements, and removes the “unhosted wallet provider” box, which is a victory for DeFi and the peer-to-peer crypto ecosystem.
In November 2023, DeFi Education Fund (DEF), submitted a comment letter to the U.S. Treasury Department and the IRS in response to their highly concerning proposed “broker” rulemaking. The proposed regulations for “digital asset middlemen” were overly broad and vague, classifying nearly all blockchain participants as brokers, which far exceeded the century-long historical and reasonable understanding of the term. DEF argued that, if finalized in their original form, the proposed regulations would have stretched the definition of “broker” so far it would impinge on user’s constitutional rights, required information collection and reporting by individuals and entities incapable of collecting that information, unnecessarily endangered the personal data of millions of Americans, confused taxpayers, stressed government resources, stifled innovation, and crippled American businesses and competitiveness.
On June 21, DEF submitted an additional comment letter arguing that the IRS's proposed broker rule violated the Paperwork Reduction Act. DEF argued that the proposed regulations’ definitions for “broker” and “digital asset middlemen” were not clear, coherent, and unambiguous, preventing the public from gauging whether or not they are required to comply with the proposed collection requirements. DEF argued that the proposed information collection imposed an undue burden on DeFi participants by failing to minimize compliance challenges and consider differing resources, while also inefficiently increasing taxpayer compliance, leading to unnecessary burdens for both taxpayers and the government.
The Treasury and IRS finalized the proposed “Broker” rulemaking in late June and thankfully removed DeFi from the final rule. The Treasury and IRS finalized rules only for custodial participants, noting that DeFi actors would not be included in a broker rule until “additional consideration of issues involving non-custodial industry participants is completed because custodial brokers and brokers acting as principals carry out a substantial majority of digital asset transactions."
What does this mean?
The revision of the 1099-DA tax form to exclude DeFi and non-custodial wallets from reporting obligations is a significant victory for DeFi developers and users. The choice by Treasury and IRS to consider DeFi in a separate rulemaking down the road evidences a good faith effort to grapple with the complexities in DeFi, and we are thankful for the IRS’s and Treasury’s careful consideration. It is promising that the IRS and Treasury Department have chosen to evaluate non-custodial actors through a distinct lens.
Coin Center wins Appeal in 6050I Lawsuit
What happened?
Last week, Coin Center won an appeal in its constitutional challenge to a crypto-related amendment to Section 6050i of the Tax Code, which was passed as part of the Infrastructure Investment and Jobs Act (IIJA) in 2021. The amendment would require people engaged in a trade or business who receive $10,000 or more in digital assets to report transaction information to the government, including the name of who sent the funds, their date of birth, and their Social Security number.
The amendment subjects digital assets to the same reporting requirements as physical currency and requires large scale reporting of personal identification information for crypto users in peer-to-peer transactions. The 6050I amendment went into effect on January 1, 2024, but enforcement of its terms was delayed two weeks later by the IRS.
In June of 2022, Coin Center, along with its co-plaintiffs bitcoin users Dan Carman, Raymond Walsh, and Bitcoin mining company Quiet Industries, filed a challenge in federal district court against the Treasury Department alleging that the 6050i amendment was unconstitutional. The suit alleged two primary claims: (1) forcing ordinary people to collect highly intrusive information about other people and report it to the government without a warrant is unconstitutional under the Fourth Amendment; and (2) demanding that politically active organizations create and report lists of their donors’ names and identifying information to the government is unconstitutional under the First Amendment.
The district court dismissed the case on standing and ripeness grounds. “Standing” is a prominent judicial doctrine that requires any person seeking to challenge a law to demonstrate injury, establish causal connection between that injury and the law, and show that the court can redress that injury. “Ripeness” is another prominent judicial doctrine which ensures that cases are “ripe” for judicial review, meaning courts do not get involved in abstract or hypothetical legal disputes. Essentially, the district court ruled that Coin Center failed to demonstrate injury and standing to challenge 6050I, and that the law was not ripe for adjudication by the court. Coin Center appealed the district court decision.
Last week, the Court of Appeals ruled in favor of Coin Center, holding that “the very disclosure of the information required by § 6050I is injurious, and because plaintiffs have pleaded they will have to make the disclosures, they have suffered an injury in fact as the direct objects of the action at issue.” The Court of Appeals determined that Coin Center has demonstrated standing and constitutional ripeness regarding its enumerated powers, Fourth Amendment, and First Amendment claims, and remanded the case to district court. Following this remand, the lower court must rule on the merits of Coin Center’s allegations.
What does this mean?
This is an important procedural victory for user privacy in peer-to-peer crypto transactions. As we noted in our comment letter to the Senate Committee On Finance, Section 6050I makes it exceedingly difficult for Americans to participate in the burgeoning on-chain economy, increases the risk of “information honeypots” ripe for exploitation by hackers, and raises serious constitutional questions. The case will now return to the district court to hear the merits of Coin Center’s claims: that 6050I reporting, as extended to crypto transactions over $10,000, violates the First and Fourth Amendment rights of those obligated to report, and that the statute exceeds the enumerated powers of Congress. We applaud Coin Center for their continued efforts to protect user privacy in peer-to-peer transactions.
SCOTUS Goes After the Admin State: What it Means for Crypto
This week, DEF legal intern Jonathan Obeda published a blog post providing a deep dive into this summer’s series of SCOTUS decisions affecting administrative and regulatory law. Readers interested in understanding the changing regulatory procedure landscape and the likely effects of these cases on the digital asset industry are encouraged to check it out. Read here.
Please note that there will be no DEF Weekly the next two weeks. We will be back after Labor Day and hope everyone enjoys the end of summer!
Comments