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Regulating Decentralized Systems: Evidence from Sanctions on Tornado Cash

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Abstract

Blockchain-based systems are run by a decentralized network of participants and are designed to be censorship-resistant. We use sanctions imposed by the U.S. Department of Treasury on Tornado Cash (TC), a smart contract protocol, to study the impact and effectiveness of regulation in decentralized systems. We document an immediate and lasting impact on TC following the sanction announcement, measured by market reaction, transaction volume, and diversity of users. Still, net flows into TC contracts recover to and surpass pre-announcement levels for most pools, supporting viability of TC. Evidence on cooperation at the settlement layer is mixed: the aggregate share of non-cooperative blocks increases over time, but a shrinking number of actors process Tornado Cash transactions, indicating a fragility to the sustainability of censorship-resistance. Non-cooperation is not explained by tokenomics, and changes in perception around legal authority and clarity of regulation appears to be a key factor for whether to cooperate.

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  • Anders Brownworth & Jon Durfee & Michael Junho Lee & Antoine Martin, 2024. "Regulating Decentralized Systems: Evidence from Sanctions on Tornado Cash," Staff Reports 1112, Federal Reserve Bank of New York.
    • Handle: RePEc:fip:fednsr:98635
    DOI: 10.59576/sr.1112
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    References listed on IDEAS

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    1. Raphael Auer & Stijn Claessens, 2018. "Regulating cryptocurrencies: assessing market reactions," BIS Quarterly Review, Bank for International Settlements, September.
    2. Sean Foley & Jonathan R Karlsen & Tālis J Putniņš, 2019. "Sex, Drugs, and Bitcoin: How Much Illegal Activity Is Financed through Cryptocurrencies?," The Review of Financial Studies, Society for Financial Studies, vol. 32(5), pages 1798-1853.
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    More about this item

    Keywords

    decentralized systems; digital assets; privacy; regulation; sanctions;
    All these keywords.

    JEL classification:

    • G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
    • G29 - Financial Economics - - Financial Institutions and Services - - - Other
    • D40 - Microeconomics - - Market Structure, Pricing, and Design - - - General
    • F51 - International Economics - - International Relations, National Security, and International Political Economy - - - International Conflicts; Negotiations; Sanctions
    • O30 - Economic Development, Innovation, Technological Change, and Growth - - Innovation; Research and Development; Technological Change; Intellectual Property Rights - - - General

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