Crypto executives love to complain about ill-defined rules — of "regulation by enforcement," of living through another version of "Operation Choke Point." They have a point. There’s widespread consensus the U.S. needs a more comprehensive approach to regulating a trillion-dollar asset class whose backers harbor an expansive vision of its role in the world. There's just not much agreement about what that approach should look like. Now the Foundation for Defense of Democracies is wading into the fray with a set of proposals meant, in part, to prevent "regulation by enforcement" from becoming the norm in policing crypto’s national security risks. The hawkish think tank, known for its hardline stance on Iran, wields significant influence in Washington foreign policy circles, and it sees crypto-enabled money laundering as a big national security threat. It wants to bring the industry in line with the extensive compliance regime that applies to traditional financial firms — along with some additional measures to address the unique technical characteristics of digital assets. It gave DFD an exclusive look at its new framework ahead of a public release later today. The goal is to spur policymakers to fill in gaps and eliminate ambiguities in crypto rules that could impact national security, including those governing areas such as privacy-focused coins like Monero and anonymizing currency mixers like Tornado Cash. The think tank plans to follow up with briefings of its contacts in the Biden administration and Congress. The idea, as the report puts it, is to head off “a national security version of the FTX implosion.” If that doesn't sound like a ringing endorsement of crypto — well, to put it mildly, FDD doesn't subscribe to crypto purists’ vision of anonymous, borderless, permissionless finance. “The industry may oppose some of these steps because they’re costly,” the framework’s co-author, FDD senior advisor Rich Goldberg tells DFD. “Or because they’re antithetical to their business models” National security concerns raised by crypto have grown in recent years as U.S. adversaries like Iran and North Korea have seized on the pseudonymity and decentralization of blockchain networks to evade sanctions and launder the spoils of state-backed hacking schemes. The FDD framework is meant to build on a plan for countering illicit crypto-finance released by the Treasury Department in September, in response to President Joe Biden’s executive order on digital assets. Goldberg said he hopes it will permit the Treasury Department to avoid replicating the ad hoc approach taken (most notably) by the SEC in its enforcement of consumer protection rules when it comes to policing illicit flows of money. Laying out explicit rules tailored for digital assets could prevent a repeat of the firestorm that occurred last summer when the Treasury Department sanctioned Tornado Cash, a decentralized protocol for anonymizing crypto transactions. Tornado Cash had been used extensively for money laundering, but the unprecedented nature of sanctions against a software tool — as opposed to a company or people running a conventional piece of software — created fears of overreach. Crypto supporters worried the sanctions could implicate all kinds of users who had nothing to do with money laundering, including passive recipients of crypto sent with the tool or impinge on free expression by prohibiting the publication of Tornado Cash’s source code. Following weeks of uproar, Treasury published additional guidance saying that it would not prioritize enforcement against people who received small amounts of unsolicited crypto with the tool, and that its rules did not forbid people from interacting with the source code if they are not involved in banned transactions. FDD’s report finds that some questions raised by the Tornado Cash sanctions remain unanswered. They include how far back in a crypto token’s transaction history a firm has to look when making sure it hasn’t passed through a sanctioned address. The U.S. also needs to step up pressure on other governments to enforce financial surveillance rules for crypto firms, the report argues. Specifically, FDD wants the U.S. to lean on fellow members of the Financial Action Task Force — an intergovernmental group charged with countering money laundering and terror finance — to comply with the task force’s crypto compliance recommendations. The framework calls, too, for investment in on-chain analysis capabilities by government agencies and says Congress should consider requiring crypto firms to incorporate such methods into their compliance systems. Other recommendations include minimum cybersecurity standards for crypto firms and a higher standard of scrutiny for crypto exchanges based in jurisdictions deemed high-risk for money laundering and terror finance. For harried crypto execs still reeling from this year’s crackdown, there’s one more recommendation in particular to take note of. Despite its preference for proactive rulemaking, the framework still calls for regulating through enforcement “when necessary.” “Sometimes you have to kill the chicken to scare the monkey,” Goldberg said, invoking a Chinese idiom about making an example of someone. “But that shouldn't be your primary position.”
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