Monday, June 10, 2024

"I didn't launder the cash, your honor. The robot did."

Crypto enthusiasts protest the trial of Alexey Pertsev

As the multiple Tornado Cash legal cases wend their way through courts in the Netherlands and the U.S., we continue to learn how society's money laundering laws will be applied to some of the more unique financial entities being created on the new technological medium of blockchains.

Last month Alexey Pertsev, a co-creator and co-administrator of privacy platform Tornado Cash, was found guilty of money laundering by a Dutch court. (The full decision translated into English is here). Meanwhile, Roman Storm and Roman Semenov, Pertsev's colleagues, are under indictment in the U.S. for engaging in money laundering, among other charges. Separately, Tornado Cash continues to be sanctioned by the U.S. Treasury.

In general, I think a guilty verdict is the right decision. It would have been dangerous to find Pertsev innocent, since to do so would have given all sorts of hardened money launderers  the mob, drug lords, and terrorist networks  the perfect techno-legal loophole for avoiding future money laundering charge. Shifts in the underlying technology used for disguising dirty money should not be enough to turn a crime into a non-crime.

Before I get into my reasoning, here's some context for people who are new to the issue of Tornado Cash.

Tornado Cash was introduced by Pertsev, Storm, and Semenov in 2019 as a means for crypto users to enjoy privacy, but it wasn't long before thieves and hackers began to regularly deposit large amounts of stolen crypto into the utility to be obfuscated. This was plain as day to anyone who was watching. Blockchains are radically transparent (that's why privacy tools like Tornado are needed) which meant that everyone could watch in real-time as criminal trails converged on Tornado Cash. 

Court cases in both the U.S. and the Netherlands reveal that Pertsev and his colleagues were well-aware that illicit activity passing through Tornado, yet they continued to work on the utility anyways. This is important because possessing a "knowing" state-of-mind is a key ingredient to being found guilty of money laundering. If he had had no idea that the money being disguised was dirty, Pertsev could not have been charged in the first place.

Criminals were not the only users of Tornado. Licit actors who wanted privacy also deposited funds into the entity, including Ethereum co-creator Vitalik Buterin. But the presence of good transactions amongst the bad ones doesn't dilute the seriousness of the alleged crime. All it takes to trigger a money laundering charge is a few dirty transactions. "C'mon! 82% of the money was licit!" is no alibi.

Tornado Cash is by no means the crypto economy's first privacy platform. The original generation of privacy tools, so called "mixers" or "tumblers," began to emerge in the early 2010s with the likes of ChipMixer, Helix, Bitcoin Fog, Sinbad, and Blender. Anyone who required anonymity could send their bitcoins to the platform owner, who would proceed to commingle, or "mix," all incoming bitcoins in a single address under their control, thus rendering them untraceable. After some time had passed, the platform owner manually re-sent the now obfuscated bitcoins to their original sender, less a fee.

Like Tornado Cash, the first generation of privacy utilities was used by both criminals and regular folks seeking privacy. None of these original mixers have had happy endings. The owners of Bitcoin Fog and Helix, Roman Sterlingov and Larry Harmon, were both found guilty of money laundering and are currently serving jail sentences. Minh Nguyen, the administrator of ChipMixer, has been indicted for money laundering and is on the FBI's most wanted cyber list. Blender and Sinbad have both been sanctioned by the U.S. government.

Source

By any legal standard, these bad endings were well-deserved. They may have been technological novelties, but ChipMixer, Helix, Bitcoin Fog, Sinbad, and Blender were very much text-book examples of money laundering. The owners of these entities knew that some of the transactions they were participating in involved proceeds derived from criminal sources, yet despite this knowledge they proceeded to disguise them anyways. The only thing new about Helix and the other first generation mixers was the medium they were disguising  bitcoin instead of cash or deposits.

And so professional mixers like Harmon and Nguyen join a long line of traditional money launderers  dirty bankers, drug cash couriers, crooked remittance shop owners, and hawala operators. The law shouldn't be fooled by technological novelty, and in the case of the first generation of mixers, it wasn't.

That these were textbook cases of money laundering isn't disputed by the crypto community. Crypto advocates are a vocal bunch, and while they have loudly voiced their complaints about the legal action taken against Tornado Cash, they have for the most part quietly accepted the punishments meted out to the first generation privacy platforms. A legal fundraiser to support the Tornado Cash accused, for instance, has raised hundreds of thousands of dollars; there have been no equivalent efforts to raise a legal defence for Harmon, Sterlingov, or Nguyen. Crypto lobbyists have gone to war for Tornado Cash by launching court appeals and filing amicus briefs in its support. But when it comes to defending the Bitcoin Fog or Helix operators, or challenging the government's sanctioning of Sinbad and Blender  crickets.

The Tornado Cash legal cases have been more controversial than those of the first generation mixers thanks to a technical innovation in Tornado's construction. Most of us would consider this to be a relatively obscure change, but crypto enthusiasts see it as a defining one.

Harmon and his counterparts controlled their platforms outright, taking possession of the dirty crypto before manually sending it back to criminals in disguised form. Not so Tornado Cash. When it was built, a layer of automation was inserted between Tornado Cash's users and Pertsev and his colleagues.

Instead of sending their crypto to wallets controlled by the trio, as users did with Helix, crypto was now deposited by users into a set of automated pools. These pools were not managed on an ongoing basis by Pertsev and his colleagues. Rather, they were built using fully automated code on the Ethereum blockchain. Originally co-created by Pertsev in 2019, this code was frozen in time by the designers in early 2020, at which point it could no longer be upgraded or changed by anyone, even Pertsev. To this day the pools continue to operate, even though the Tornado Cash creators are either jailed or under indictment.
 
Other parts of the Tornado Cash platform are not so set-in-stone and remained under the control of Pertsev and his colleagues throughout. This includes the main website by which users accessed the automated pools, which was regularly upgraded over time, as well as the relayer service. (A relayer is a way to guarantee the privacy of Tornado Cash users). Pertsev and his colleagues profited from their ongoing control over the website and relayers.

The lawyers for Pertsev, Storm, and Semenov have argued that this layer of automated code exonerates the trio of money laundering. After all, if they no longer control what the utility is doing, then how can they be said to be operating a money laundering enterprise? The lawyers also argue that as writers of code, Pertsev, Storm, and Semenov are protected by speech laws, much like an author who has written a book. It is the code-is-speech claim that has particularity riled up the crypto community.

I don't like the idea of someone being sent to jail, but I think it's a good thing that the Dutch court chose not to accept these arguments.

Using go-betweens is a time-tested criminal strategy for distancing oneself from the crime. In more conventional money laundering operations, this strategy might involve separating the leader of a cash laundering operation from the actual dirty cash with a layer of underlings. In the age of crypto, no need to use living human underlings; just insert a buffer of unliving code.  

But the law shouldn't be fooled by artificial distances between a launderer and dirty money, whether those intervening layers be living people or code.

Allowing a buffer of automated code to absolve folks like Pertsev of money laundering would make it much easier to be a professional money launderer. Bad actors like Harmon and Sterlingov who have already been deemed by the courts to be criminals would suddenly have the perfect techno-legal loophole at their disposal if they decide to reengage in crypto laundering once their jail terms are up. Instead of manually running their operations as before, Harmon an Sterlingov could insert a mute layer of automated code between them and their illicit clients, their criminal mixing no longer being a crime.

But this would be an absurd state of affairs. A simple technological change to the way a criminal mixer administers their back office shouldn't convert them into a non-criminal.

The danger of the "it was the code that did it" defence extends beyond the crypto economy. In the much-larger traditional economy, laundering physical cash is a relatively common criminal profession. Take the fictional example of Marty Byrde, the star of Ozark. If the Tornado Cash defence were to be accepted in a court of law, then Byrde need only program a set of self-operating cash-handling robots to do most of his tasks for him, and he can get away scot-free. "I don't exercise any control over the packages of cash, your honor. The robots did!"

Or take the example of drug cash couriers, who run the risk of being convicted for money laundering when they move cash across the U.S.-Mexico border. Taking a cue from Tornado Cash, if a courier were to deploy an autonomous fleet of AI-powered drones instead, then when charged with a money laundering offence he or she need only invoke the now-standard defence: "it was the drones who controlled the cash, not me."

Taken to an extreme, the Tornado Cash defence means that money laundering effectively ceases to exist as a crime. All the culpability shifts onto the undead intermediaries, which can't be punished. This eclipsing of money laundering laws would be unfortunate. Professional money laundering is a key sector within the broader criminal economy, greasing the wheels for the entire enterprise. Without any legal defences against launderers, we are all much more vulnerable to crime-in-general.

In what follows, I want to provide a historical example of how the law should act when confronted with the changing tactics and technologies of money launderers.

Money laundering is a relatively new crime, but it has a much older predecessor in the crime of fencing, also known as receiving. The laws against fencing and money laundering are similar, the idea being to punish not the original criminals but the third-parties who knowingly participate in the crime by accepting dirty proceeds.

Any thief runs a big risk of being caught with stolen goods. At some point in the middle ages, specialized intermediaries, or fences, emerged to absorb this risk by accepting stolen property from professional thieves and redistributing it. Thieves could now offload their goods much quicker, thereby achieving a degree of safe harbor. For their part the fences themselves were safe from prosecution. After all, they hadn't committed the original theft, and accepting stolen property was not a crime.

The addition of specialized wholesalers to the thievery production process helped drive a rise in the incidence of theft, according to historian Rictor Norton. To close this loophole, fencing was criminalized in England in 1692. For the first time, a third-party who knowingly accepted stolen goods could be punished as an accessory to the original theft. The business of reselling hot property, risk-free until then, suddenly became much more dangerous.

The illegal fencing market quickly evolved new tactics. Enter Jonathan Wild, an incredibly successful launderer of stolen goods who, by the mid 1710s, is said to have been the "undisputed leader in the fencing business of London," according to marketing professor Ronald Hill. Wild evaded the 1692 anti-fencing law by never himself handling stolen property. Instead, he acted as an early version of Craigslist, but for stolen objects. He arm-twisted all of London's thieves to secretly report any robbery immediately to him, asking them to retain possession until he contacted them. At the same time, the unfortunate victims of those thefts were encouraged to approach Wild with requests to help locate their missing property.

Once Wild knew who was at both ends of a theft, he would pay the thief and tell him to return the goods to the victim using an anonymous porter. The happy victim got their stolen goods back, paying Wild a large reward for his troubles.

With Wild running circles around the law, Parliament passed an additional anti-fencing law in 1718 that punished anyone who took a reward under the pretence of helping a victim of theft, without actually prosecuting the original felon. In 1725, Wild was apprehended, tried, and condemned to death on the basis of this statute. 

A gallows ticket to view the hanging of Jonathan Wild (Wikipedia)

Now, a death sentence is extreme. But this is a good example of the law staying hip to both the changing technology of theft and its evolving division of labour. As the profession began to be subdivided into specialist thieves and an emerging class of allied wholesalers of stolen goods, lawmakers recognized that wholesaling was really just an appendage of theft, and thus fencing was criminalized. Later on, when fences like Wild adapted with new methods, the law kept up by finding additional means to reach fencing operations.

With Tornado Cash, we are at a "Jonathan Wild" stage of the modern money laundering profession's development. Control of dirty proceeds is being shifted to autonomous intermediaries so that the perpetrators can avoid prosecution. Much like how the law adapted in the 1700s to encompass Wild's tactics of distancing himself from dirty property, it will have to do the same with money launderers who use crypto code, autonomous robots, or AI drones to dissociate themselves. While I don't enjoy the idea of anyone spending time in jail, finding Pertsev guilty is part of that process.

Unlike Jonathan Wild, who was a criminal mastermind, Alexey Pertsev and colleagues seem to have bungled into the crime partly out of an ideological commitment to crypto ethics, the wider community unhelpfully egging him on. That doesn't mean he's not guilty, but it does suggest a lighter sentence than the 64-month one he received might be appropriate.

I've been arguing throughout this article that money laundering law should extend to innovative financial entities created on blockchains, such as Tornado Cash. I want to close by pushing back on this a bit.

A guilty verdict for Pertsev and his colleagues should not be tantamount to a ban the creation of autonomous financial institutions, particularly those focused on privacy. If a coder wants to create an open privacy mechanism for crypto, promote it, and financially profit from it, I think that he or she should have the right to do so, subject to the following condition. The code needs to include a component that screens out dirty crypto  and this filter shouldn't be a sham attempt, it has to be a genuine effort.  

While I think the law got it right in this instance, shame on lawmakers and law enforcement if they don't accommodate future generations of code-based entities (and their creators) that actually do make good faith efforts to freeze out dirty money.

Tuesday, May 28, 2024

Monetagium

An English penny minted by William the Conqueror, who brought monetagium to England. Source: History in Coins

The way that a modern mafia protection racket works is the mafia starts doing very bad things to regular folks, say you and your business. To stop the damage, you pay them a regular fee. Both sides come out ahead. The mafia earns a tidy stream of income. Your suffering comes to an end.

In feudal Europe, a monetary practice called "monetagium" worked along the same principles as a mafia protection racket. It began with the feudal lord threatening to do very bad things to the coinage. To prevent these very bad things from happening, the public would pay a fee called monetagium to the lord. Both sides came out ahead. The lord earned revenue. His vassals avoided a worsening of the coinage.

To better understand the intricacies of monetagium, or monetary blackmail, we need to explore how the monetary system worked back in the 11th and 12th centuries.
 
A feudal lord had a number of ways to earn revenue. These included gabelle, a tax on salt; heriot, a death duty that was paid to the lord upon the death of a tenant; merchet, fee paid on marriage, and the Saladin tithe, a tax paid by all those who did not go on Crusades. Another common revenues source was the prince's monopoly over the coinage. Anyone could bring their personal silver to the royal mints and have it be converted into coins, for a fee. This revenue source was known as seigniorage. The lord of the realm, or seigneur, often outsourced the running of their mints to professional third-parties, or moneyers, who collected the fee and remitted it to the seigneur after subtracting what was needed to pay their own costs and earn a profit.

Seigniorage provided a steady stream of revenue to the lord. But if he really wanted to turbocharge his revenues, a debasement of the coinage could be introduced.

A debasement means a reduction in the silver content of new coins. Post-debasement, a canny merchant could bring a chest full of old silver coins to the mint and get those converted into even more new ones. So for example, if he had 1,000 old coins on hand, and a 20% debasement had been introduced, a merchant would be able to have his 1,000 coins reminted into 1,200 new coins. He might have to pay 50 of those to the lord, leaving 1,150 coins. The extra 150 coins now in his possession provided him with the opportunity to buy more goods & services than before (at least until prices adjusted) and settle more debts.

To take advantage of the opportunity provided by the debasement, a wave of customers would arrive at the mint to convert their silver into new coins, the result being a temporary boost to the seigneur's minting profits. If a single debasement provided a one-time boost to the lord's revenues, a series of such debasements could repetitively turbocharge those revenues. (Henry VIII notoriously used this technique to fund his expensive French wars.)

Debasements may have boosted feudal revenues, but they were generally unpopular with the public, a fact that many writers from that period have commented on. And you can understand why. Debasing the coinage caused inflation, or a rise in the price level, and in no age has inflation ever been popular. Furthermore, the penny was the unit of account, or the means by which people reckoned and computed their financial lives. As the penny was mutated, its ability to serve as a measuring tool was compromised.

By the 11th century, Normandy's dukes had been resorting to regular debasements as a revenue device for some time. But they soon had an epiphany. They realized that they needn't enact an actual debasement to earn a profit. Instead, they could just threaten to enact one, and then extort the public for a ransom to prevent it from going through.

This tax was known as monetagium. By the late 11th century, monetagium was being levied on Norman citizens every three years in return for the Duke's promise not to reduce the silver content of the coinage. The tax worked out to 12 pennies per household, or hearth, which according to historian Thomas Bisson amounted to the wages of "a day's field work per year." Knights and the clergy were exempt. In scope, monetagium was an "important but unspectacular financial resource," says Bisson, raising a fraction of the much larger land tax on farms.

In other parts of France, including Orléans and Paris, the monetagium was known as the "tallage on bread and wine," writes Bisson. Calculated based on the amount of provisions that subjects had on hand, including measures of winter wheat and spring oats, the bread and wine tax was justified to the population as the king's generous substitute for debasement.

From the perspective of the king or feudal lord, monetagium must have been a superior tax policy to debasing the coinage. Gone was the need to force the population to trudge each few years with their silver coins to the mint for recoinage every three years. And the coinage at least stayed constant, removing the difficulties and uncertainties imposed by inflation on the feudal economy. But while monetagium was less capricious, it was still abusive  in the same way that the mafia's protection payments are abusive. This was especially apparent to the inhabitants of England.

There is evidence that the Normans exported the practice of monetagium to England after William the Conqueror's successful invasion of the island in 1066. The English version of monetagium appears to have operated on slightly different principles than the Norman one, however.

Whereas Normandy had a long history of debasement, England's coinage up till 1066 had remained relatively consistent in weight and purity, a tradition that the Norman invaders were expected to (and did) uphold. Unable to use the threat of a debasement to extract monetagium, England's new Norman lords came up with another excuse.

For almost a century prior to the Norman invasion, the English coinage had been regularly renewed each three years. That is, a new version of the penny was regularly issued, the imagery being updated but the silver content staying the same. So this was not debasement. The older versions of the penny were generally allowed to stay in circulation, although from time-to-time the most dated coins would be declared void, says W.J. Andrew, a numismatist. Once they ceased to be legal tender, citizens were required to bring in these discontinued coins to be reminted into new ones, for a fee. The fees earned from demonetization were one of the ways the English kings earned income.

According to Andrew, the English tradition of recurring triennial renovatio monetae gave the Norman kings the missing hook they needed to extract monetagium from the English population. By declaring all coin types to be void each three years (instead of just some of the oldest ones), as was his right, England's new Norman kings could place a costly burden on the population. English-folk would have to regularly haul all their coins to the local mint for costly conversion. To avoid this burden they were proffered an alternative: pay the monetagium every three years instead, and in return the king would let old pennies remain as legal tender.
 
This was not a popular practice with the English. When Henry I came to power in 1100 he would officially end it, proclaiming the following: "The common monetagium... which was collected through the cities and through the counties, which did not exist in Kind Edward's time, this I utterly abolish from now on."

The phenomenon of monetagium also pops up in Denmark in the 13th century in the form of a "plough tax," as recounted by historian Sture Bolin. Like many parts of Europe, Denmark's coinage was subject to renovatio monetae whereby it was routinely recalled and cancelled. The conversion rate was costly; for every three demonetized coins submitted, a Dane might receive only two in return. The policy of renovatio monetae was brought to an end in 1234 by King Valdemar II. In its place, a new tax was levied such that for every plough owned, Danes had to pay one öre in coin. Valdemar justified the plough tax to his Danish subjects as the price they had to pay to enjoy permanent coinage.

Notably, the coins that Valdemar issued in 1234 have the distinction of being the first European coins in the Christian era to have a date stamped on them. In the image below, they are dated MCCXXXIIII, although I must confess that I can't quite make it out. (This source may help you pick out the numerals.)

A penny from Roskilde, Denmark dated 1234 holds the honor of being the earliest Anno Domini dated coin in the history of European coinage Source: Reddit


Bolin suggests that the novelty of coin dating was intended to commemorate both the permanent nature of Danish coinage and the simultaneous introduction of the plough tax.

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So what are we to make of all this today? Modern democracies are not feudal mafioso, yet they often face the similar dilemma of what mix of revenue sources to rely on, one of those sources being monetary debasement. A literal debasement of the coinage is no longer a policy that can be pursued  our currencies are no longer metallic. The modern equivalent would be for a democratic government to lean on the central bank to fund government spending, too much of this resulting in inflation.

In general, democracies have not resorted to modern version of debasement as a revenue source due to the unpopularity of rising prices. Instead, contemporary policymakers tend to rely on income taxes, consumption taxes, and property taxes. I suppose we can think of these obligations as our modern version of monetagium. They are the "better taxes," akin to the Danish plough tax or the Parisian grain and wine tax, that we subject ourselves to instead of the not-so-good taxes that get levied via the monetary system.

Wednesday, May 8, 2024

Renovatio monetae

This silver pfennig from the Archbishopric of Magdeburg (1152-1192) was subject to a policy of renovatio monetae. Twice a year whoever held it had to bring it in to be changed for new coins at a rate of four old coins to three new coins. That suggests an annualized tax rate on coinage of 44%. Image source: British Museum

This is another post in a series that explores how European monarchs harnessed the minting of coins to earn revenues for their coffers. 

A king or queen generally resorted to two different strategies for profiting from the mints. The first was to mint long-lived coinage. The second involved issuing short-lived coinage subject to a policy of renovatio monetae, which is the topic of this post. These aren't mutually exclusive buckets. It's possible for elements of both policies to be blended together.

Almost everything I've written about medieval coinage on this blog has been about the long-lived sort, because that was the dominant pattern in Europe. Under a long-lived coinage system, once a coin had been minted it remained in permanent legal circulation. For example, England's long-lived coinage policy meant that an English penny produced in 1600 would have been just as valid a hundred years later, in 1700, as a penny produced in 1699.

The monarch earned a one-time fee from the original minting of the coin. More specifically, a citizen who brought raw silver to the royal mint left with that same amount of silver now transformed into coin form, less a small part going to the crown. This profit was known as seigniorage. In England, the seigniorage rate on silver typically hovered around 5%, my source for this number being The Debasement Puzzle by economists Rolnick, Velde, and Weber. Once a particular coin was produced, however, the king or queen no longer earned revenue from it.

As society grew and more coins were needed, raw silver was constantly brought to the royal mints by the public in order to be coined, the monarch earning a steady stream of income. This was known as free coinage, since everyone had the right to access the royal mints.

Short-lived coinage subject to a policy of renovatio monetae was an entirely different manner. Under this model, coins didn't circulate permanently. When a king or queen announced what was known as a renovatio monetae, or a renewal of the coinage, all existing coins had to be brought back to the mint to be recoined into new coins. The monarch collected a fee upon each renovatio monetae. 

To help reinforce the monarch's ability to collect a profit, only the most recent coin was allowed to be used within the monarch's domain. Older local coins and coins from other realms were illegal. To distinguish the new version from the outgoing version, the new type was stamped with a different pattern. The penalties for not obeying the rules of renovatio could be harsh. According to Philip Grierson, a numismatist, anyone caught using expired coinage could face imprisonment, a fine, or have their face branded with the old pattern of coin.

Source: Svensson

The period of time between one renovatio monetae and the next varied widely. In England, the monarch initially adopted an interval of nine years, beginning in 973 AD with Edgar. Later on, this was shortened to just three years. In many parts of Germany and Poland, renovatio monetae occurred yearly, as recounted by economist Roger Svensson in his wide-ranging book on the topic. In the Archbishopric of Magdeburg it was carried out twice a year, coinciding with important market days in the spring and autumn. The Teutonic order in Prussia used a much slower ten-year cycle, according to Svensson. 

The date for the switch was often chosen to occur just prior to annual tax payment day or, as in the case of Magdeburg, ahead of a regularly occurring market or festival (see figure above). Requiring that all tax payments or market transactions be conducted with new coins reinforced the necessity of  bringing in old coinage to be melted down into new coinage, thus guaranteeing a boost to the monarch's revenues.

The coinage that prevailed in Poland and Germany from the 12th century almost seems to have been designed with a short lifespan in mind, since it is leaf-thin and fragile. Coins minted in this style are known as bracteates, one of which can be seen below. Svensson speculates that the bracteate format was better suited for the purposes of renovatio monetae than standard coins since the costs of periodically reforming silver into thin and pliable coin would have been lower than heavier coins. 

Leaf-thin bracteates from Frankenhausen. Source: Svensson
 

How much profit did the monarch collect from renovatio monetae? 

For many years the Teutonic order in Prussia used a conversion rate of seven old coins to six new ones, says Svensson. Combined with the fact that renovatio only occurred every ten years, the effective tax rate was relatively light. According to Christine Desan, a law professor, English royal profits amounted to 25% of the metal minted (she cites Spufford), but recall that this tax was levied only every three years so that works out to a yearly tax of around 8%. (Some people may notice the similarity of renovatio monetae to ideas promulgated by Silvio Gesell, who came up with the idea of stamped scrip—money that depreciates.)

In some cases, though, the conversion rate bordered on exploitative. Svensson says that a common exchange rate in Germany was four old bracteates for three new ones. Given two renovatio per year in places like Magdeburg, that works out to a yearly tax rate on coinage of 44%! If a citizen of Magdeburg started the year with 16 bracteates in their stash, and they complied with both renovatio, by year-end target would only have nine bracteates.

This may have created a very weird effect whereby coins became "cheaper and cheaper" over the course of the year in anticipation of the inevitable withdrawal day, according to historian Sture Bolin. Since everyone would have known ahead of time that there was to be a 4:3 conversion on a fixed date, and no one wanted to be stuck holding coins and bearing the conversion tax, sellers would only accept coins at a discount to compensate them for conversion. That discount varied with time. As the final day approached, it would have got progressively wider.

In modern times we don't have to deal with the hassles of renovatio monetae. The coins and banknotes we use are long-lasting: a nickel from 1956 is just as valid as one from 2022. Or consider that while the $1 note is no longer printed in Canada, anyone can still bring them to a bank to be deposited for free. If a policy of renovatio monetae were to be announced by the Bank of Canada in 2025, and Canadians were required to bring our coins and banknotes in each year to be exchanged for new ones, there would probably be a revolt against the inconvenience of it, especially if the fee was high.

This combination of exploitation and inconvenience may explain why the English abandoned renovatio monetae in the middle of the 12th century in favor of permanent coinage. "The renovatio monetae witnessed to the extent of royal control and suggests that coining was routinely coercive," writes Desan. "This new system reduced the burdens placed on people required so frequently to remint their money at a cost."   

However, if renovatio monetae was inconvenient (and frequently exploitative), it also had a key benefit. As silver coins passed from hand to hand, they suffered from natural wear and tear. On top of that, bad actors regularly clipped off their edges, keeping the silver shavings for themselves. By renewing the coinage every year or two, the monarch ensured that the coinage was kept in relatively good condition.

Alas, the same can't be said for long-lived coinage systems, which were particularly prone to the wear and tear problem. After a decade or two of circulating, a typical coin would have lost a significant amount of its original silver content, at which point it would no longer be equal in weight to new coins. This meant that the realm's coins were no longer fungible, or interchangeable, with each other. The familiar problem of Gresham's law would now begin to plague the monetary system, whereby the "bad" coins, which meant the old underweight coins, drove out the "good" coins, the new full-weighted ones. With only shabby coins being used in trade, the money supply was more prone to counterfeiting and clipping, leading to an even shabbier coin supply, and more counterfeiting and clipping. 

Mind you, there were ways to defend against the inevitable downward spiral of long-lived coinage. By adopting a policy of defensive debasements, which I've written about before, the fungibility of coins could be restored.

Nor were long-lived coinage systems spared from being exploitative in nature. The method of abuse was different than that used to exploit short-lived coinage, involving a policy of repetitive debasements in the silver content of coinage.

As an example of this, I wrote a post last year exploring how Henry VIII financed his wars in France using debasement of his long-lived coinage. Do read it, but in short the trick was to increase the number of people visiting the royal mints to convert raw silver into new coins. This would in turn boost the monarch's profits. After all, he or she earned a 5% cut from each new coin produced.  The rush to the mint was linked to the fact that, post-debasement, the public could now get more silver pennies from the mint than before for a given quantity of silver, which in turn allowed them to buy more goods and services than they would have otherwise been able to purchase.

After a series of such debasements, Henry VIII was much richer, but the coinage was debauched. Going into 1542, for instance, the English penny contained 92.5% silver. Nine years later its purity stood at just 25% silver, the majority being base metal such as copper. 

To sum up, short-lived coinage issued under a policy of renovatio monetae was one of several ways to administer the monetary system. It had some advantages over other methods, but was also easily abused. This abuse was linked to the fact that coinage was simultaneously a crucial tool for day-to-day commerce, both as a medium of exchange and a unit of account, and also a way for the monarch to fund itself. Maximizing its latter role by relying on frequent and onerous renovatio may have done severe damage to money's capacity to perform the former role. 

This tension was not necessarily resolved with the move towards long-lived coinage, as Henry VIII demonstrates. And while we may think we have left these these medieval issues behind in the 21st century, I don't think that we can ever fully escape the tensions embodied in money's dual roles as crucial tool of commerce and source of government funding.

Friday, April 19, 2024

Thoughts on the Tornado Cash defence and what happens when everyone adopts it


Payments companies are regularly punished for engaging in money laundering. MoneyGram, for instance, has has to pay multiple fines. Western Union was famously busted in 2017. Meanwhile, Cash App is being probed as we speak for inadequate anti-money laundering controls.

In the future, these companies may have in their grasp a very simple techno-legal trick that allows them to deal with dirty money and get away with it. All they need to do is transfer their entire IT apparatus from a regular set of databases onto "immutable" smart contracts hosted on blockchains.

This, at least, is what happens when you take the arguments put forward by the Tornado Cash defence team to their logical conclusion.

If you follow this blog, you'll know I've written a lot about Tornado Cash.

Cryptocurrency isn't private; it's radically transparent. The function that Tornado Cash serves is to accept traceable crypto from users, both licit and illicit, and return it to them in untraceable format. Beginning in late 2020, a steady stream of stolen crypto began to be moved by thieves onto Tornado Cash for the purposes of obfuscation. In effect, money laundering was now occurring on the platform. But who were Tornado Cash's money launderers? More specifically, someone was to blame for helping these thieves to disguise their tracks  who was this someone?

Last August the U.S. government indicted two people involved with Tornado Cash for conspiracy to commit money laundering.  I wrote about the government's indictment here. (They were also indicted for conspiracy to evade sanctions and the operation of an unregistered money transmitting business, but that's another story.)

Roman Storm and Roman Semenov, the accused, wrote the original smart contracts for Tornado Cash and exercised a degree of control over a key website for accessing those smart contracts. The government alleges that Storm and Semenov knew that the property being transferred to Tornado Cash was criminally derived, and that they also knew that the hackers wanted to disguise its source. Yet the duo conducted the financial transactions anyways. These three elements knowledge, the conducting of financial transactions, and the presence of unlawful money  are key ingredients to building a money laundering charge. (See specifically 18 U.S.C. § 1956(a)(1)B(i).)

Last week the defence lawyers for one of the accused parties, Roman Storm, filed a motion to dismiss the case, giving observers some initial insights into what arguments will be used to try and beat the government's money laundering charge. As I'll show, assuming these arguments are right, then a big chunk of the existing payments system has a fool proof plan for avoiding money laundering laws.

The distinction between the Tornado Cash front end and the actual Tornado Cash smart contracts looms large in the case, so let's touch on that briefly. The smart contracts are bits of code that reside directly on the Ethereum blockchain. This code allows users to deposit their trackable crypto to a pool along with many other users and then withdraw it, obfuscated. A front end, by contrast, is a regular website that allows users to interact with the smart contracts, and is hosted through a normal internet provider .

While users are free to interact directly with the Tornado Cash code, the most popular way to access Tornado was allegedly via the intermediation of the main website that was under the control of Storm and his colleagues.

The key argument made by Storm's lawyers is that the accused are not subject to the money laundering statutes because the money laundering statutes only apply to people who "conduct" what are defined as "financial transactions," and Storm did not conduct financial transactions.

The defence says that in order to show that someone was conducting a financial transaction it must be the case that control was exercised by that person over the actual criminally-derived funds. Storm may have had some control over the front end, but the defence claims this doesn't really matter because the front end itself did not exercise any control over the proceeds. "It did not access the funds directly," the lawyers argue. "It merely provided an interface to permit a user to interact with the smart contracts."  

As for the smart contracts, Storm clearly had no control over them. He had relinquished control back in May 2020, when a trusted setup ceremony ensured that no further changes could be made to the code. At that point, the smart contracts worked automatically. Bad actors only discovered Tornado Cash several months after the ceremony, at which time Storm had long gone. Furthermore, the smart contracts didn't actually control the funds, say Storm's lawyers, it was users of Tornado Cash who controlled the funds within the pool.

So, there you have it. The government's money laundering charge against Storm and Semenov requires locating a person or institution who is in control of the dirty funds and conducts financial transactions with them, says the defence. But it isn't the accused who exercised this control, it is the users who did so, via the intermediation of a set of financial automatons, the smart contracts.

For the philosophically crypto-pilled, the defence's arguments will make sense, since according to this view crypto is a revolutionary force for good, one destined to "break" what they see as a corrupt and old-fashioned financial system. For this breaking to happen, crypto shouldn't be forced to conform to the same old laws as stodgy payments companies like Western Union. New laws, or new ways of looking at old laws, should be shaped around crypto.

But to the non-crypto pilled, a successful defence of Storm and Semenov is quite concerning. As described by Bruce Schneier and Henry Farrel, it could potentially mean that anyone who wants to facilitate illegal activities would have a strong incentive to copy Tornado Cash, effectively turning their operation into a "golem"  a deathless artificial being run on smart contracts  and then throwing away the keys to avoid the law.

More specifically, by shifting their entire IT infrastructure over to smart contracts or some other equivalent automaton, payments institutions like MoneyGram that are currently subject to the money laundering statutes (and have already been punished under them several times) might be able to avoid future prosecution. If criminals start using the autonomous MoneyGram robot to make payments, MoneyGram can simply say: "The robot allowed them to do it, not us!" As for the official MoneyGram front end, even if the mob becomes a happy customer MoneyGram needn't worry since the front end is nothing but a filmy gauze between users and the autonomous robot, the company never actually controlling the funds (although according to the Tornado Cash lawyers the front end can continue to safely generate a profit for its owners!)*

The money laundering statutes  18 U.S.C. § 1956 and § 1957  are two of democratic society's key legal bulwarks against criminal behaviour. In a world in which the Tornado Cash defence prevails and payments companies adopt it as a techno-legal shield against money laundering charges, 1956 and 1957 become much less effective  and not because we decided to soften them via a democratic process, but because financial institutions found sneaky ways to get around the rules.

Mind you, the money laundering statutes wouldn't disappear entirely. The Tornado Cash defence's point is not that there is *no* money launderer. Rather, their argument is that it is the users of Tornado Cash, the public, who had "exclusive control," and not Storm and Semenov, so the latter duo aren't the guilty parties. Taking this control theory further, if the government wants to charge anyone with money laundering, it should probably be trying to target folks like Vitalik Buterin, a member of the public who regularly put his funds into Tornado Cash and thus potentially participated in the concealment of unlawful proceeds deposited by criminals.

What a dangerous financial tool to make available to the public!

Right now, I can safely transfer $1000 to Western Union without having to worry about commingling my $1000 with a criminal and thus facing a potential money laundering charge. The company takes on that liability for me. But if Western Union stops performing this legal responsibility by building financial automatons to which everyone has open access, both good and bad actors, then I am suddenly at risk of being a counterparty to criminals when I transfer $1000 to Western Union, and that could turn me into a money launderer. Money launderers can face up to 20 years in prison.

For users, a Western Union transfer suddenly becomes the financial equivalent of handling nuclear waste or operating a five-story crane. It's a task most people can't, and shouldn't, handle. Given the inherent legal risks, it's possible that the market will never widely adopt financial services delivered in the form of robots or golems or immutable smart contracts, preferring to stick with the traditional safe intermediaries who take on the burden of compliance. Or not?

Storm's lawyers may win this particular case. Their logic certainly seems sound, but I'm no lawyer. If so, there's a good argument to be made for lawmakers to consider modifying the definitions of words like "conducting" and "financial transactions" found under the money laundering statutes to prevent future efforts to use the Tornado Cash techno-legal trick. If  by merely swapping the technology used to deliver financial services a payments institution can suddenly avoid the law and offload legal responsibility onto users, that's probably a hole that needs closing.


* MoneyGram would still be able to financially profit from the combination of smart contracts and a front end, much like how Storm and Semenov did with Tornado Cash, by finding canny ways to use their control over the front end. According to the indictment, Storm and Semenov, along with others who had control over the front end, curated a list of "relayers"  third parties who provided users with bolstered privacy protection  and then extracted resources from relayers who wanted the privilege of getting on the list.

This profit motive can't help prove that Storm was engaged money laundering, says the defence, since there are many examples of criminals using "lawful tools for unlawful ends," and even though the tools' developers have "profited from that use" those developers were not punished.

Thursday, April 11, 2024

Why I'm in favor of financial illiteracy

 
I'm not a fan of mandatory investor education classes. The issue was brought up recently by former chair of FDIC, Sheila Bair, who sees early financial education as ways to stop future FTX-style disasters.

The model of finance I've been using for many years is the fairly dismal dark forest model. The financial industry is a shadowy forest full of sly foxes waiting to prey on retail investors. The list of sly foxes is long: all sorts of Samuel Bankman-Frieds, IRS scammers, internet ponzi schemers, stock con-artists, bankers hocking high-fee products, fly-by-night gold mine promoters, and shady crypto platforms. It's truly horrifying out there.

So why not implement mandatory high school financial literacy classes to upgrade the retail class's defences against this dark forest?

My first concern is that high school students can only absorb so much. Mandatory financial literacy classes will inevitably come at the expense of learning other very important things like math, writing, and science, which are at the base of so many vital disciplines.

Second, while I'm sure financial literacy classes might help a bit to protect us against the dark forest, I don't think they'll do much. The prototypical retail investor's single biggest weakness is that we are all incredibly busy people. As we rush through the dark forest we simply don't have enough time to familiarize ourselves with its many arcana. This incapacity to pay sufficient attention makes us easy pickings, no matter whether we've had a few financial literacy classes or not.  

The dark forest preys not only on our rushed lives, but also our need to keep up with the Joneses, our precarious and stressful financial situations, and our worries for loved ones. I'm just not convinced that a few years of high-school financial literacy classes will release us from these eternal and very-exploitable emotions.

Luckily, we have two other major defences against the dark forest: the competitive market and the government.

The government can make the dark forest safer by flushing out bad actors and pushing fraudsters to the nether regions, then nudging us retail investors towards the parts made safe. It does so by regulation, standard investor protections, licensing requirements, and through law enforcement and the court system.

As for the market, its competitive nature gives rise to a class of trained and experienced financial professionals who are generally equipped to lead retail investors through the dark forest.

If we get these two defences right, then we can afford ourselves a great luxury: a retail investor class that gets to remain relatively ignorant of finance while being safe in its ignorance. This ignorance is a thing of beauty. Instead of folks having to waste time and energy learning about the forest's fox population, its patois, and its dangerous pathways, they can focus on their own very busy lives, families, studies, hobbies, and careers. That's what we want them to do. We don't want a world where the average person needs to give up an hour or two each week slogging through financial literacy 101. We want them to blithely use financial products and take for granted they will be safe, and then get on with more important things.

Alas, if we get these two defences wrong, then we get disasters like Sam Bankman-Fried's FTX, which destroyed the financial lives of thousands of innocent retail investors. 

What happened with FTX? In the case of FTX's offshore exchange, there was a complete absence of government regulation. Not so FTX's US arm. Alas, FTX-US operated under a bare-bones regulatory framework courtesy of state licensing boards, which are simply not appropriate for overseeing a trading venue like FTX, and are more equipped for watching over remittance companies like Western Union. (See my article Let's stop regulating crypto exchanges like Western Union.) This was the dark forest at its darkest.

To see how see this first line of defence can be properly deployed, take a look at what happened in Japan when FTX collapsed. FTX's Japanese customers were made 100% whole a few months after the debacle. (American ones are still waiting). That's because Japan got things right and forced FTX Japan to adopt appropriate regulation, effectively preventing the sly fox Bankman-Fried from preying on Japanese citizens. (See my article Six reasons why FTX Japan survived while the rest of FTX burned.) 

The second defence against predators like Sam Bankman-Fried, a market-supplied legion of trained and experience financial professionals, was lacking, too, since stuff like dogecoin and dogwifhat is outside the ambit of the financial professional class, and deservedly so. Had seasoned institutional investors and other financial professionals been operating in the sector, they would have used their training to suss out the FTX fraud much earlier, guiding folks away to safer exchanges.

The two defences entirely lacking, the result was a wave of innocent retail investors left free to venture into into the dark forest. But mandatory financial literacy classes don't fix this. Government regulation and elite financial professionals do. 

Friday, March 29, 2024

The effects of Russian sanctions as portrayed in YouTube videos

Last month American provocateur Tucker Carlson visited a Russian grocery store. Because it was filled to the brim with food, Carlson claims that western sanctions placed on Russia aren't having an effect. "We've been told sanctions on Russia have had a devastating effect on its economy," writes Carlson. "We visited a grocery store in Moscow and found a very different situation."

Carlson's video is just one of many in a strange genre of "sanctions aren't working" videos produced by Westerners visiting or living in Russia. (Here is a good rebuttal to Carlson's video by Russian YouTuber NFKRZ.) In another video, Dutch-Canadian farmer Arend Feenstra, who has recently moved to Russia with his wife and nine children, walks through a hardware store full of tools. "Sanctions???" he quips.

Don't let the videos fool you. Sanctions have had a big effect on Russia. And by sanctions I'm referring not only to the official sanctions levied by coalition governments, but also self-sanctions imposed by Western companies. Self-sanctioning occurs when companies like Lego, Coke, or McDonald's choose to leave Russia, not because their government says they must, but because their customers and employees have pressured them to leave, or out of a general sense of solidarity with Ukraine. (Here is a list of companies that have left.)

While Carlson and Feenstra's videos of store shelves suggest prosperity, what they don't show is how many resources Russian businesses have been forced to sacrifice in order to re-order their affairs so as to provide Russians with full shelves. These businesses have had to go out and build new relationships with manufacturers in places like China or Turkey. The alternative products that have been introduced often aren't as good, or as familiar, or as useful to customers. 

Many of the "sanctions don't work" videos spotlight the contraband Western goods that are often found on Russian store shelves. This video, for instance, shows Coke being sold at Spar, a grocery store. Coke is banned in Russia, so the message here is presumably that the sanctions are a waste of time. But what they don't show is that the prices for these contraband goods will be higher than before. The Coke products in the video are no longer made in Russia but must be smuggled in via third-parties such as Poland, Afghanistan, and Kazakhstan, the extra shipping and handling costs being incorporated into their final price. Think of this as a sanctions-induced smuggling tax.

Put differently, coping with sanctions and self-sanctions is costly for Russia; in Carlson's videos we only see the final product, full shelves, but not all the hassle and resources that have gone into producing that state of affairs. Nor is the set of full shelves on display in his video necessarily as desirable as the set of full shelves that existed prior to sanctions.

A much more realistic illustration of the effect of sanction is provided in a recent video by Arend Feenstra, the Dutch-Canadian farmer, of a visit he makes to a Russian tractor dealership.


I watched it so you don't have to. What follows is a quick summary of the relevant bits. It starts out with an excited Feenstra driving out to is what he believes to be a Case/New Holland dealership. Since the Case and New Holland tractor brands are popular in Canada, Feenstra's previous home, he will get to see some brands that he is familiar with. Ah, nostalgia.

(A side note: As a Dutch-Canadian myself, I find it jarring that someone of my ilk has decided to emigrate to Vladimir Putin's Russia. But digging deeper, we learn that Feenstra is a bigot: he doesn't like the LGTBQ community. Given that Russia's regime considers the "international LGBT movement" to be a terrorist organization, I suppose there's a natural fit for folks like him in Russia.)

Unfortunately for Feenstra, when he arrives at the dealership he discovers that it no longer sells Case or New Holland tractors. Both brands of farm equipment are built by CNH, a UK-headquartered equipment manufacturer, and along with most other Western farm companies CNH pulled out of Russia in 2022, effectively ending all its Russian dealership relationships. 

The only new tractors that the dealership has available are Chinese-built YTOs, which the dealership was forced to turn to in 2022 to fill the sudden gap in its show room.We learn in the video that YTOs are a regression in terms of technology. Feenstra points out throughout that the Chinese tractors have less electronics than their western equivalents and more mechanical parts. Instead of electronic shifting, for instance, the YTOs use mechanical shifting. The fuel pumps are mechanical too. It's like stepping back in time.

A regression to mechanical components is a nuissance, but it's not awful. However, things get worse. Enter the triple mower problem.

A tractor with a triple mower

Prior to the sanctions, we learn that the dealership's most popular tractors were larger horsepower products like the New Holland 210. These larger tractors are particularly desired by farmers in the region for their ability to accept an attachment known as a triple mower, says the employee. A triple mower is designed to cut a wider swath of grass or crops compared to a single mower. This allows farmers to cover more ground in less time, improving overall efficiency during harvesting or haymaking operations.

Alas, the Chinese-made YTOs can't use a triple mower, the employee tells us. The dealer is in talks with the manufacturer to make changes to the frame to accommodate them, but there's no indication when this will occur. Feenstra is not impressed by any of this.

Feenstra checking out a YTO tractor

In the meantime, the dealer tells Feenstra that if he needs a new tractor with triple mower compatibility, he will have to import a Western one via the parallel market. This will involve buying a tractor in Europe and sending it through a third-party transit country, like Turkey, then moving it to Russia. But the whole process will be expensive, warns the employee, including paying VAT three times.

Russian farmers who bought New Holland or Case tractors prior to the sanctions are no better off, we learn, because they now face hurdles getting spare parts for their tractors. Prior to the self-sanctions they could rely on the Case/New Holland dealership for a steady supply of Case and New Holland parts, but with the dealer having lost its relationship with CNH, the only way to get parts is by smuggling them in. Alas, smuggling adds uncertainty and a higher price tag.

Another conversation between Feenstra and the employee centres around a piece of machinery known as a baler, which can be attached to the back of a tractor in order to convert a row of hay into a convenient bale. According to the employee there are a number of Russian companies that make balers, but they are "not very good". The video reveals that one Western-made baler brand is available for purchase, a German-made Kuhn. (Is Kuhn one of those rare European farm companies that has chosen not to self sanction?) But the Kuhn baler it is quite expensive, more than the cost of an entire tractor.

Stepping back, Feenstra's video is great illustration of the costs imposed on Russia by sanctions and self-sanctions. The dealership is struggling to fill the void left by departing Western brands. Its customers, Russian farmers, are stuck with the option of an inferior replacement for Western-made tractors, like the YTO, or a more expensive smuggled products. The dealership and its customers seem to be getting by, but they are clearly worse off than before.

Feenstra isn't the only western farmer in Russia to be producing "sanctions don't work" videos. An Australian family that has moved to Russia in order to start a farm also makes YouTube videos on the topic. "So, the sanctions really haven't been bad for Russia," says the family patriarch, John, standing in a Russian mall. "If they have done anything, they have been great for Russia."

But another video (see below) suggests the opposite. In it the Australians are paying a visit to a nearby John Deere tractor dealership. We learn from an employee that this particular dealership is part of a Russian dealership network that, prior to the sanctions, was the largest John Deere distributor in all of Europe. John Deere is a U.S. equipment manufacturer.


Near the start, John optimistically films a large sign boasting the dealership's many relationships with western manufacturers, including JCB, Pottinger, Väderstad and Haybuster. But as he learns later on, the sign is no longer meaningful. Along with most other farm product companies, John Deere and JCB exited Russia in 2022. The dealership has lost its dealer status and can no longer sell either John Deere or JCB products, nor most of the other brands that are advertised on its sign.

To fill the void, the dealership now offers Turkish-made Basak tractors and Chinese-made Noma tractors. An employee who shows the family around the dealership grouses to John about the quality of the Chinese tractors that he stocks, saying: "I don't know what we will do with it, because if I sit inside of the cabin and look down I can see the ground because there in a gap in the floor." The tractor is the technological equivalent of a first generation John Deere, he complains.

Interestingly, the owner of this particular network of Russian dealers, known as EkoNiva-Technika, is based in Germany and produces public financial statements. I dug through the numbers to get a better feel for how the dealership is doing. 

In 2021, prior to self-sanctions, the EkoNiva-Technika dealership network sold 403 tractors. Then Russia invaded Ukraine, and the dealership's sales fell to 263 tractors in 2022. In 2023 it sold just 131 tractors. That's a big fall.

The German parent blames the decline in tractor sales on a "significant drop in demand" for new agricultural machinery by Russian farmers, as well as the loss of its main suppliers, which were replaced by alternatives from China and Turkey whose "products fell far short of the previous sales figures." Meanwhile, the dealer's spare parts business saw a big jump in revenue thanks to an intensification in demand for Western parts and higher parts prices, no doubt due to having to resort to costly transshipment routes. Spare parts have gone from 24% of the dealership network's revenues prior to sanctions to 49% of revenues in 2023.

Back to John, the Australian farmer. When he does eventually buy a tractor, we find out that it's a used Japanese-made Yanmar tractor. All the controls are written in Japanese and he can't read the manual. Compounding matters, Yanmar has officially left Russia, so John will likely find that getting parts is a pain. Again, that's the nuissance of sanctions. Rather than getting the first-best, the only option is often second- or third-best.

John and his new Japanese tractor

Given all the anecdotes I've assembled, what is the bigger picture?

Prior to being sanctioned, Russia's farming sector had evolved towards a particular pattern of specialization and trade comprised of middlemen dealerships, their relationships with Western manufacturers, and the farmers they served. The sanctions (and self-sanctions) immediately upended that pattern, forcing dealers and farmers to undergo a massive and costly recalculation event.

The new pattern of specialization and trade that the Russian farm sector has arrived at doesn't appear to be as good as the initial pattern. 

To begin with, the alternative brands that have filled the void seem to be a downgrade. The Chinese YTOs that the first dealer is selling won't accept a triple mower while the tractors the second dealer stocks have holes in the floors. Spare parts that were once widely available thanks to dealerships' stable relationships with their western suppliers are harder to come by. Dealership resources are now being diverted to smuggling in contraband parts, which means higher prices for farmers. Finally, as suggested by the dealership's financials, farmers are refurbishing old tractors rather than investing in new tractors. This slowdown in capital investment will presumably hurt crop yields in the long term.

In sum, contrary to Tucker's video and many other "sanctions aren't working" videos on YouTube, the videos made by expatriate Canadian and Australian farmers suggest that the opposite: sanction are having an effect. And it isn't a good one.

Monday, March 18, 2024

How PayPal can use stablecoins to avoid AML requirements and make big profits


There's a new financial loophole in town: stablecoins. Stablecoins are dollar, yen, or pound-based payments platforms that are built using crypto database technology.

Financial institutions are always looking for loopholes to game the system. Typically this has meant avoiding capital requirements or liquidity ratios in one jurisdiction in favor of a looser standards elsewhere. The new stablecoin loophole allows for a different set of financial standards to be avoided, society's anti-money laundering regulations.

I'll explain this new loophole using PayPal as my example.

PayPal now offers its customers two sorts of regulated platforms for making U.S. dollar payments. The first type will be familiar to most of us. It is a traditional PayPal account with a U.S. dollar balance, and includes PayPal's flagship platform as well as PayPal-owned platforms Xoom and Venmo. These all have strict anti-money laundering controls.

The second type is PayPal's newer stablecoin platform, PayPal USD, which has loose anti-money laundering controls. PayPal USD is built on one of the world's most popular crypto databases, Ethereum. Dollars held on crypto databases are typically known as stablecoins, the most well-known of which are Tether and USDC.

What do I mean by fewer anti-money laundering controls?

If I want to transfer you $5,000 on PayPal's traditional platform, PayPal will first have to grant both of us permission to do so. It does so by obliging us go through an account-opening process. PayPal will carry out due diligence on both of us by collecting our IDs and verifying them, then running our information against various regulatory blacklists, like sanctions lists. Only after we have passed a gamut of checks will PayPal allow us to use its platform to make our $5,000 transfer.

Contrast this to how a payment is made via PayPal's new stablecoin platform.

First, we both have to set up an Ethereum wallet. No ID check is required for this. That now allows us to access PayPal's stablecoin platform. Next, I have to fund my wallet with $5,000. I can get these these funds from a third-party who already holds money on PayPal's stablecoin platform, say from a friend, or from someone who buys goods from me, or from a decentralized exchange. Again, no ID is required for this transaction to occur. Once I have the funds, PayPal will process my $5,000 transfer to you.

Can you spot the difference? In the transaction made via PayPal's legacy platform, PayPal has diligently got to know everyone involved. In the second transaction, PayPal makes no effort to gather information on us. And lacking our names, physical addresses, email addresses, or phone numbers, it can't do a full cross-check against various regulatory black lists.  

More concretely, PayPal's legacy platform does its best to stop someone like Vladimir Putin, who is sanctioned, from ever being able to sign up and make payments. But if Putin wanted to use PayPal's new stablecoin platform, PayPal makes almost no effort to stop him from jumping on.

One of the biggest expenses of running a legacy financial platform is anti-money laundering compliance. Programmers must be deployed to set up onboarding and screening processes. Compliance officers must be hired. If a transaction is suspicious, that may trigger a halt, and the transaction will have to be painstakingly investigated by one of these officers. The platform is hurt by lost customer goodwill  no one likes a delay.

That's where the stablecoin loophole begins.

PayPal can reduce its costs of getting to know its customer by nudging customers off its traditional platform and onto its PayPal USD stablecoin platform. Now it can onboard them without asking for ID. Since it no longer collects personal information about its user base, fewer transactions trigger flags for being suspicious, and only rarely do they register hits on sanctions blacklists. That means fewer halts, delays, and costly investigations. PayPal can now fire a large chunk of its compliance staff. The reduction in costs leads to a big rise in earnings. Its share price goes to the moon.

For now, PayPal's stablecoin platform remains quite small. Only $150 million worth of value is held on the platform, as the chart at the top of this post shows. The company's legacy platforms are much larger, with around $40 billion worth of balances held. Given the compliance cost difference, though, I suspect PayPal would love it if its stablecoin platform were to grow at the expense of its legacy platform.

I've used PayPal as my example, but the same calculus works for the financial industry in general. If every single bank in the financial system were to convert over to a stablecoin platform for the delivery of financial services, and no longer use their legacy platforms, the industry's total anti-money laundering compliance costs would plummet.

So far I've just explained this all from the perspective of financial institutions, but what about from the viewpoint of the rest of us? Society has set itself the noble goal of preventing bad actors from using the financial system. A large part of this effort is delegated to financial institutions by requiring them to incur the expense of performing due diligence on their platform users. This requires a big outlay of resources. Many of these costs are ultimately passed on to us, the users.

If institutions like PayPal switch onto infrastructure that doesn't vet users, then resources are no longer being deployed for the purposes we have intended, and the broader goals we have set out are being subverted. Is that what we want? I'd suggest not.



Some followup thoughts:

1. PayPal's stablecoin platform employs fewer anti-money laundering controls than its regular platform. On the other hand, its stablecoin platform has stricter standards in other areas, including the safety of its customer funds. I wrote about this here: "It's the PayPal dollars hosted on crypto databases that are the safer of the two, if not along every dimension, at least in terms of the degree to which customers are protected by: 1) the quality of underlying assets; 2) their seniority (or ranking relative to other creditors); and 3) transparency."

2. The pseudonymity of stablecoins is something I've been writing about for a while. In a 2019 post, I worried that at some point this loophole would lead to "hyper-stablecoinization," a process by which every bank account gets converted into a stablecoin. I'm surprised that almost five years later, this loophole still hasn't been closed.

3. The typical riposte to this post will be: "But JP, stablecoins are implemented on blockchains, and blockchains are transparent. This prevents bad actors from using them, and so stablecoins should be exempt from standard anti-money laundering rules." I don't buy this. Bad actors are using stablecoin platforms, despite their pseudo-traceability. "Its convenient, it's quick," say a pair of sanctions breakers about payments made via Tether, the largest stablecoin platform. Society has deputized financial institutions to perform the crucial task of vetting all their users. By not doing so, stablecoin platforms are shirkers. Trying to outsource the policing task to the public or to the government by using a semi-transparent database technology doesn't cut it.

Wednesday, March 13, 2024

Have the sanctions on Russia failed?

I very much enjoy economist Robin Brooks's tweets, especially his charts showing how sanctions imposed on Russia have affected regional trade patterns. While direct trade between Europe and Russia has collapsed thanks to Russia's invasion of Ukraine and subsequent sanctions, the chart below shows a suspicious-looking countervailing boom in European trade with Kyrgyzstan.

A big chunk of these European goods are presumably being on-shipped from Kyrgyzstan to Russia.

Now, you can look at this chart and arrive at two contradictory conclusions. The first is that the EU's sanctions are not working because they are being avoided via third-party nations like Kyrgyzstan. (This is Steve Hanke's take on Robin's charts.) Or you can see the charts as evidence that the sanctions are working, for the following reasons.

Sure, prohibited goods are filtering through to Russia  that was always going to be the case. But consider all the extra nuisances and frictions that now exist thanks to sanctions. For instance, instead of JCB tractors being shipped directly from factories in Europe to Russia, they have to be transferred to a third-party country, like Armenia, then perhaps re-routed to yet another country for the sake of obfuscation, say UAE, prior to those tractors finally entering Russia. (One of Robin's charts illustrates the rise of the EU-Armenia-UAE-Russia nexus).

These new roundabout trade routes introduce all sorts of additional costs including taxes, customs fees, shipping, insurance, and warehousing, not to mention extra palms to grease. There is also the extra risk of getting caught somewhere along this chain. A dealer involved in moving tractors to Russia via a third-party country, for instance, might be blacklisted by JCB (which has voluntarily chosen to exit Russia), losing their dealer status.

These combined costs get built into the final sticker price that Russian must pay for contraband American and European imports. Think of this extra wedge as a "sanctions tax." This sanctions tax leaves Russians with less in their pocket. And that means fewer resources for Putin to wage war than if the sanctions had never been levied.  

So when I see Robin's charts of various transshipment routes, they suggest to me that sanctions are effective courtesy of the sand-in-the-gears effect I just explained.

Now, this doesn't mean that I think the coalition's existing sanctions program is sufficient. We are in a sanctions war with Putin, and that necessitates constantly opening up new economic fronts in order to throw Putin off guard and make it harder for him fund his war. The transshipment points illustrated in Robin's charts are a sign to me that existing sanctions are working, but they also seem like a great target for future sanctions.

And in fact, the coalition has already taking two steps to pressure transshipment to Russia.

The U.S. Treasury recently imposed secondary sanctions on any foreign financial institution that facilitates transactions involving Russia's military/industrial complex. (I wrote about this here). What this means, for example, is that banks in transshipment points like Kyrgyzstan will have to be more careful when they deal with Russian entities. Any trade involving the military-industrial sector that passes through Kyrgyzstan will likely grind to a halt. Other non-military trade transiting through Kyrgyzstan, say JCB tractors, will probably continue to make it through, but thanks to heightened sanctions risk, banks will pass on this risk to Russians in the form of a higher sanctions tax.

The second step is the EU's new and very provocative "no-Russia clause." It requires EU exporters to contractually prohibit their trading partners from re-exporting certain restricted goods to Russia. If caught, fines must be paid or the contract voided. That adds more sand in the gears.

One hopes that the coalition of nations arrayed against Russia continues to increase its pressure on transshipment points. For instance, the EU could widen the range of goods subject to the no-Russia clause, the current list being somewhat limited. For now, though, my guess is that Robin's charts will show that the coalition's sanctions program is doing a better job in 2024 than it did in 2023, with the EU's no-Russia clause and the U.S.'s secondary sanctions being the proximate cause of that improvement.