Bitcoin Lightning Network at regulatory risk after Tornado Cash saga

Policy Advisor Patrick Hansen posted his thoughts on the regulatory risk now facing the Bitcoin Lightning Network following sanctions against crypto mixer Tornado Cash.

U.S. authorities added Tornado Cash to the Office of Foreign Assets Control (OFAC) sanctions list on August 8. The Treasury Department claimed more than $7 billion of illicit funds have been laundered through the protocol since 2019.

Since then, Tornado Cash addresses have been blacklisted, the developers have been booted from Github, and the website has been taken down. The team announced the shuttering of operations on August 13.

The saga has brought to light questions about personal privacies and the remit of authorities overseeing the crypto space. More so, considering Tornado Cash is a neutral tool comprised of code and not a sanctionable “person.”

Bitcoin Lightning in danger of being flagged as high risk

Commenting on this, Hansen pointed out that custodial Bitcoin Lightning services will be forced to comply with the Financial Action Task Force (FATF) Travel Rule. This states service providers must share relevant originator and beneficiary information alongside crypto transactions to combat money laundering and terrorist financing.

“VASPs and other financial institutions to share relevant originator and beneficiary information alongside virtual asset transactions, therefore helping to prevent criminal and terrorist misuse.”

However, Hansen said the implementation of this would be difficult for Lightning nodes to carry out in practice. The issue is further compounded by nodes potentially being classified as regulated payment service providers, which may necessitate additional requirements such as customer authentication.

The issue is that flows through the Lightning Network may be seen as high risk under existing anti-money laundering frameworks. But policymakers have yet to address where they stand on the matter.

Is there hope for privacy after the Tornado Cash saga?

Regarding governmental overreach, the CEO of Aztec Network (an Ethereum-based privacy layer,) Zac Williamson, said he remains optimistic that Web3 technology can help protect personal privacies.

“Despite the dark circumstances of the present, there are grounds to be optimistic about the future for web3.“

Williamson said it is possible that Web3 networks can adhere to the goals of regulators and still protect user privacy “but will not conform to existing regulatory structures.”

He explained that the above scenario can exist if regulators target the application layer, such as ramps and wallets, instead of going after the network level. This was further clarified using the analogy of internet service providers not being held accountable for the “data in their cables.”

“There is a place for regulation in web3. It is not at the network level. It is at the application level; companies and entities that tap into web3 to provide services to users and businesses. e.g. cryptocurrency on/off ramps and hosted wallets.“

Despite the heavy-handed approach taken against Tornado Cash, Williamson expressed confidence that regulators will gradually accept and legislate for financial privacy. After all, a continuation down the current path will only lead to innovation going elsewhere.