The U.S. Government Goes on a Cryptocurrency Whale Hunt

Sanctions evasion just got harder, and crypto just got much less attractive.

Photo by Todd Cravens on Unsplash

Cards on the table: the hard-working staff here at Drezner’s World has been consistently skeptical about the utility of cryptocurrencies. The best argument I have seen for them is Nicholas Anthony’s Cato essay. He defends crypto as a potentially useful innovation facilitating cross-border remittances without the costly fees incurred through conventional payments systems. Even Anthony, however, acknowledges that crypto’s utility on that point remains more theoretical than real:

Additional fees can be incurred when exchanging, for example, dollars for bitcoins and then bitcoins for pesos. In a somewhat ironic fashion, by removing traditional intermediaries (e.g., banks or payment transmitters), using cryptocurrencies for remittances introduces another step to the process as users seek access to on and off ramps. With that said, this challenge does come with a silver lining: it only matters to the extent that someone does not want to use cryptocurrency as a medium of exchange. With everything from corner stores to mortgage lenders embracing cryptocurrency, it is likely that many people may be perfectly happy to receive and keep cryptocurrency as adoption increases.

Yeah… so that’s probably not gonna happen. Cryptocurrencies remain a pretty terrible medium of exchange and a completely useless unit of account. This is one reason why cryptocurrency exchanges like FTX and Binance became so popular — they facilitate trade in different coins.¹

You know what is likely to stunt the growth of cryptocurrencies even further? The recent Binance settlement with the Justice Department, Treasury Department and Commodity Futures Trading Commission over accusations of money laundering and sanctions-busting, that’s what! That settlement included a fine in excess of $4 billion for the firm. A statement from Binance acknowledged, “our company’s responsibility for historical, criminal compliance violations,” allowing that, “Binance made misguided decisions along the way.”²

Between this and the conviction of FTX’s Sam Bankman-Fried last month, it’s been a rough few weeks for believers in crypto. As the New York Times write-up of the Binance plea deal noted:

For the relatively young and fast-growing crypto world, the guilty pleas from Binance and Mr. Zhao were a monumental development. At times, Binance has processed two-thirds of all digital currency trades, making it a vital power broker and intermediary in the crypto world. Long believed to be the richest man in crypto, Mr. Zhao is the industry’s most prominent and closely watched champion, with more than 8.5 million followers on X.

The guilty pleas completed something of a one-two punch by the Justice Department. This month, the disgraced crypto mogul Sam Bankman-Fried was convicted of fraud at a criminal trial arising from the collapse of his FTX crypto exchange….

Since the implosion of FTX a year ago, federal authorities have criminally charged a procession of crypto executives, and the Securities and Exchange Commission has filed lawsuits against some of the largest companies in the industry, including Coinbase, the publicly traded American exchange. On Monday, the S.E.C. sued Kraken, another crypto exchange, accusing it of operating without proper registration and commingling customer deposits with its own corporate assets.

So it’s been tough for crypto. In many ways, however, it’s about to get much worse.

To understand why, you need to appreciate one genuine advantage of cryptocurrencies: they are a great way to evade U.S. financial sanctions. It’s been well known for years that U.S. adversaries are super-keen to use crypto to evade sanctions.

It seems, however, that U.S. authorities have adopted a “whale-hunting” strategy in forcing cryptocurrencies to adopt more rigorous compliance controls. As Bryan Early and Keith Preble argued in a series of recent papers, the U.S. Office of Foreign Assets Control (OFAC) shifted its sanctions enforcement strategy against financial actors around about 2009. Instead of “going fishing” and trying to punish as many firms as possible, OFAC began more targeted enforcement of egregious sanctions-busters, seeking whopping fines in the billions of dollars. As Early and Preble explained in their 2020 Washington Quarterly paper: “The fear and uncertainty created by OFAC’s dramatic sanctions enforcement actions against a relatively small number of companies—mainly foreign banks—changed global perceptions about the risks of violating US sanctions.”

The whale hunting described by Early and Preble applies to the conventional banking sector. The Binance fine of $4.3 billion? That is the first big whale targeted at cryptocurrencies, and it’s a doozy.

The problems get worse for crypto, however, Writing in the Wall Street Journal, Underground Empire authors Henry Farrell and Abraham Newman explain that the dynamics of crypto are playing out just like other arenas of weaponized interdependence :

Crypto’s creators aspired to create a decentralized money system, with no entry points for state oversight and surveillance. But the crypto economy has become increasingly centralized around exchanges like Binance and Coinbase. While these exchanges allow customers to store and convert money from one cryptocurrency into another, they also give the government a massive opening. Crypto is being tamed, as its central actors agree to implement U.S. rules, extending the government’s reach into the heart of the crypto economy….

The government’s growing reach has been enabled by the avidity of crypto founders for market power and profits. The blockchain may be decentralized in theory, but that isn’t true for the business models built on top of it. Everywhere you look in crypto, you see centralization, as companies try to make themselves essential, to control their market and to make money.

Equally important, Farrell and Newman explain that Binance’s plea deal converts the firm from a scofflaw to a tool of enforcement.

The monitoring agreement is less eye-catching, but it is arguably even more important. It is the first such arrangement in crypto. Binance is required to create a truly effective anti-money-laundering system, under the close observation of an independent outside party, which can report any foot-dragging and evasion to federal regulators. Binance’s new system will then process the myriad transactions that flow through its platform, blocking those that seem to break the rules and reporting them to U.S. authorities.

This will mean painful changes to Binance’s freewheeling culture. Even traditional banks such as HSBC have reportedly had a tough time complying with similar arrangements. But it will also transform the platform from a scofflaw into a watcher and enforcer on behalf of the U.S. government.

This leads to the last problem. As Anthony points out in his Cato essay, one of crypto’s advantage over traditional financial institutions is that it has faced fewer compliance costs. The Binance deal highlights that those days are coming to an end. If economic actors have to choose between a well-established medium of exchange and a crypto medium of exchange that faces similar costs and compliance mechanisms, most will pick commercial banks.

Maybe there are legitimate advantages to blockchain, distributed ledgers, and cryptocurrencies. As I said at the outset, these stories feed into my pre-existing skepticism. But it will be interesting to see how the crypto industry adapts to being treated like every other financial sector.

1. There is also the inescapable problem that the high-profile folks who proselytize the utility of cryptocurrencies are the same people who have been spectacularly wrong about crypto as a useful inflation hedge. The Daily Show’s Desi Lydic was not that far off the mark when she observed, “Everyone in crypto is shady. Have you ever talked to someone who’s into crypto and thought to yourself, ‘Wow, what an upstanding human citizen!’” For the record, every crypto-enthusiast I have encountered in real life seems super-shady.

2. “Misguided”?! Points for understatement, Binance PR folks! According to the New York Times, “one Binance compliance employee said in a written communication that the company had an open door to people laundering drug money, according to the government. ‘Is washing drug money too hard these days,’ the employee wrote. ‘Come to Binance we got cake for you.’” Sounds super-shady!