In reaction to the sanctions, organizations such as Coin Center have defended the mixer, stating that the smart contract code is not a sanctionable entity.

It is unclear whether privacy coins such as Monero would face similar restrictions in light of this new priority. A hard fork upgrade on August 13 made it harder to track Monero transactions.

Contrary to the idea that all bitcoin transactions are private in nature, data on a blockchain is public and transactions can be traced. Crypto mixers and privacy coins have been created to facilitate the anonymity of the open financial system. But each faces unique challenges.

What is a Crypto Mixer?

A crypto mixer, also a tumbler or blender, is a transaction mixing tool or service that anyone can use to conceal the source of funds for a crypto wallet. These technologies were originally designed for bitcoin in 2013, but once solutions like Tornado Cash made them available for a range of cryptocurrencies, they became a popular alternative to privacy coins.

Blender.io was the first custodial blender sanctioned by the US Treasury Department’s Office of Foreign Assets Control (OFAC). It did not attract the same attention as Tornado Cash since it belonged to the pattern of earlier punishments against individuals and organizations.

How Tornado Cash Works

Tornado Cash is an Ethereum-based crypto mixer that mixes ETH and ERC-20 tokens using non-custodial smart contracts. Using a zero-knowledge proof contract, users deposit funds to smart contract addresses that organize them by amount and efficiently mix deposits.

Tornado Treasury. Source: tornado.cash

For example, suppose you want to combine 11 ETH. Since deposits are ordered by amount, you send 10 ETH to the 10 ETH mixer and 1 ETH to the 1 ETH mixer. Once funds are given to each mixer, zero-knowledge proof verifies that you provided a deposit to each without revealing which one was originally yours. This provides the equivalent of a withdrawal authorization slip for each mixer.

Legal obstacles

On August 8, 2022, OFAC added a list of addresses related to Tornado Cash to the same list of sanctioned addresses, including Blender.io. OFAC used the same language for Blender.io as for Blender.io, but did not recognize their important custody distinction. Coin Center claims that Tornado Cash has two distinct components: the decentralized group of ruling members, Tornado Cash Entity, and the immutable smart coin mixers Tornado Cash Application.

The Tornado Cash Entity cannot modify or update the Tornado Cash Application due to the destruction of the original developers’ administrative keys. Smart contracts exist as long as the Ethereum blockchain is operational. Therefore, even if the Tornado Cash website is down, anyone can develop an alternative front end – or communicate directly with smart contracts – that gives users access to the same mixers.

The problem is that OFAC has included these immutable addresses for smart contracts in its sanctions list. Therefore, there are currently innocent Americans with funds in these mixtures. If they attempt to transfer the funds, they will be breaking the law and subjecting themselves to penalties. And because the app isn’t a legal business, it can’t ask OFAC to remove the penalties.

Coin Center claims that OFAC did not cite legal authority to add smart contract addresses to the sanctions list since the Tornado Cash app is not an organization, raising constitutional concerns. In response to OFAC’s notification, the companies agreed to screen people associated with these IP addresses. Aave, a decentralized finance app, banned any user who received Tornado Cash payments during a dust storm.

Privacy Coin Features

Privacy coins are digital currencies that use various techniques to conceal IP addresses, wallet balances, and transaction movement. Z-cash and Monero are the two most popular privacy-centric cryptocurrencies. Z-cash is a cryptocurrency that protects transaction data primarily through zero-knowledge proofs. They differ from crypto mixers by turning financial privacy into a commodity rather than a benefit.

Z-cash and Monero. Source: Investment

Since that first setback, Z-cash has never returned to the highs of the 2017 bull cycle and currently ranks second in total market capitalization behind Monero. While Monero prices were able to reach 2017 levels in 2021, they were unable to surpass their all-time high.

Monero is a privacy-centric cryptocurrency that provides financial anonymity via privacy-enhanced blockchain encryption. Each transaction uses unique stealth addresses to hide public address balances.

Privacy Barriers

Monero’s protocol was upgraded on August 13. The previous version of Monero offered a layer of anonymity, but its complete non-trackability was questionable. In 2018, detractors said the process of elimination could uncover the signature ring entries. And in 2021, CipherTracer reportedly patented transaction tracking technology used by the Department of Homeland Security (DHS).

Although CipherTracer has discovered real flaws, the extent of their impact remains unknown. They did not reveal their tactics or degree of success. Since it blocked CipherTracer from being accessible to anyone who didn’t want to pay, this earlier version still offered some financial anonymity.

In Canada, efforts have been made to trace the sources of funding for the truckers’ freedom convoy. Authorities sanctioned 34 cryptocurrency wallets associated with the move, and Monero addresses were included in that list.

By increasing the number of transactions in a ring signature, the Monero team expects this upgrade to address any possible security vulnerabilities. Even though the planned improvements to the Monero chain are essential, the principles for tracking the likely source of funds remain the same after the fork. If the update succeeds in eliminating these backdoors, there is a risk that OFAC will take similar action against Monero.

The developer’s prospective ability to benefit from these smart contracts empowers them. Dutch financial crimes agency FIOD has arrested a Tornado Cash developer on suspicion of using the app to launder money. It is unclear whether he was arrested for his money laundering attempts or for his association with others who did.

Barriers to Adoption

Although major privacy coins like Monero and Z-cash are actively trying to improve transaction privacy, they have not achieved the same level of acceptance as major layer-1 blockchains such as Ethereum. Many rivals, including Secret Network and Oasis Network, believe that privacy coins do not provide a layer of privacy that can be used to build Web3.

In 2020, Secret Network was the first privacy-based blockchain to offer smart contract programmability. It resides in the Cosmos ecosystem and works towards a Web3 privacy goal. Several applications have been launched, including the decentralized messaging service Altermail and the decentralized exchange SiennaSwap.

However, Secret Network and its rivals face the typical difficulty of a crowded marketplace. They have a long way to go before they overcome the market dominance of Monero and Z-Cash. The prospect of punishment has prompted many in the Z-Cash community to investigate the possibility of programming their smart contracts.

The future of digital financial privacy

Amid the battle for financial privacy, the state has so far used two separate instruments. They used the regulatory sanctions hammer with crypto mixers. If a financial privacy method is too popular with criminals or difficult to track, their strategy may be to eliminate it.

Advocacy groups such as Coin Center can challenge these measures in court, but it can take years. In the meantime, the sanctions are probably hurting innocent Americans.

They can continue their cat-and-mouse game with developer upgrades via surveys for other privacy solutions.

However, user adoption is a crucial aspect of this game. As more and more users use mixers or privacy coins, tracing transactions becomes increasingly difficult. It is comparable to the traditional police chase in a small alley. If the suspect approaches a busy procession, he may brush his teeth and blend into the crowd.

If a privacy coin, mixer, or base layer privacy solution gains widespread adoption, its censorship resistance could increase. State officials would struggle to garner political support for sweeping sanctions or the technologies needed to circumvent privacy protections. And the possible repercussions of Tornado Cash sanctions on Ethereum validators could draw millions more into this discussion.