Chaos in Web3: Meltdowns, Bankruptcies, Sanctions, and Regulatory Scrutiny

Recent happenings in Web3 have shaken the confidence of many in the space, but is the long term viability of Web3 really under question?

Introduction

DeFi was meant to provide alternatives to traditional finance, centralized banking, and fiat currencies. In fact, DeFi empowers ordinary users and reduces banking friction amongst its users, allowing for new market entrants to introduce novel or cheaper alternatives to legacy options. Nevertheless, there have been quite a few speed bumps along the way, with several high-profile Web3 projects suffering from exploits or other financial crises. 

The following article will summarize a few of the most recent disasters to occur in the Web3 space as the sector attempts to find its wings. The Terra-Luna crash, Celsius’ suspension of withdrawals and subsequent bankruptcy proceedings, and the Tornado Cash sanctions will all be explored before getting into some of the solutions needed to build a better Web3 for the future.

Terra-Luna UST Stablecoin Meltdown

The utter meltdown of the Terra stablecoin (UST) and its associated LUNA token will be remembered as a watershed moment in Web3 history. It effectively took broader crypto markets and investor confidence into the proverbial gutter which they have yet to climb out. Consequently, wiping out $60 billion in crypto assets is certain to invite extraordinary regulatory scrutiny towards stablecoins in particular. 

Some worry that the targeting of stablecoins as an asset class by regulators could unfairly hamper legitimate development in the space since UST uses an algorithm to peg its value to $1 USD rather than by holding matching fiat reserves in a traditional bank as collateral for their stablecoins. As examples, Circle’s USDC and Tether’s USDT directly collateralize the dollar-pegged tokens they issue with fiat reserves, though there have been suspicions floating around for years regarding the quality of Tether’s reserves. With the algorithmic TerraUSD, the stablecoin maintained its peg to a US dollar by connecting its circulating supply with its governance token LUNA. 

Basically, users could burn either token in order to mint new tokens of an equivalent quantity to the other. Ideally, users watching market prices could use opportunities for trade arbitrages via their ability to burn or mint either UST or LUNA, though things turned nasty when the Internet began reporting that Terra’s stablecoin was quickly losing its peg to the dollar, sparking panic amongst token holders.

What transpired was that a large withdrawal led UST and LUNA into a sharp, spiraling doom-cycle of sell-offs that caused its peg to crash quickly below its peg. Imagine holding what you thought were stable $1 coins only to find that you could only sell them for $0.76 or hope that the crash reversed itself.

Watching a “stablecoin” suffer a massive bout of volatility to the downside took many users by surprise, while others long believed algorithmic stablecoins to be ticking time-bombs ready to be blown up.

As the days passed, the spot prices for both UST and LUNA continued their descent towards zero, despite the Luna Foundation’s attempts to defend UST’s peg by burning over $3 billion in Bitcoin and other crypto reserves. Despite the Luna Foundation’s efforts and massive amounts of crypto spent, the algorithmic stablecoin and its corresponding governance token has never recovered from its death-spiral. 

After the dust settled, the Luna Foundation and CEO Do Kwon’s assets are now being contested by a number of stakeholders looking to find justice for the losses they suffered. So many users who had invested in either UST or LUNA were left with severe losses, prompting authorities in South Korea to subpoena Do Kown to appear in front of parliament to potentially face repercussions.

Do Kwon recently participated in an interview in which he assumed responsibility for Terra’s failures. He said that his overconfidence was irrational, and that he could not have predicted his megaproject would end up in flames. He also admitted that he named his daughter Luna, but vowed to continue making it a name she could be proud of, indicating that Do Kwon will not go quietly into the night despite his recent misfortunes with Terra.

Celsius Halts Withdrawals and Files Bankruptcy

Prior to recent events, Celsius had always heralded itself as a better alternative to using traditional banks, offering depositors interest rates far above what banks have offered for at least several decades. Direct fiat-to-crypto on-ramps were provided for customers to use their credit cards or bank accounts to purchase digital assets from Celsius with the true selling point being that the purchased crypto would begin compounding due to the high interest rates offered to Celsius depositors. 

In fact, Celsius promised rates of 20% or even higher on some deposits like, including rates in the 7-8% range for commonly-used stablecoins like USDT or USDC.  They also offered incentives for utilizing their native CEL token. For the duration of the latest bull market, Celsius’ business model worked well as prices continued rising and users largely deposited their crypto as opposed to withdrawing it en masse. For the most part, users trusted Celsius, and their CEO Alex Mashinsky had built up a popular movement of loyal followers HODLing their crypto indefinitely. Thus, there always seemed to be enough liquidity, and relatively little money was withdrawn from the platform until market sentiment shifted.

Accordingly, extreme volatility and plunges in asset prices across the sector caused enough stress in lending markets for Celsius to halt all withdrawals by users from their platform to protect the long-term viability of their business model. Many speculated that this meant Celsius couldn’t cover their financial obligations and were scrambling to come up with enough capital to survive the crunch in which they had found themselves. Since then, angry users have filed letters with bankruptcy courts to demand Celsius return their funds, with an Unsecured Creditors Committee formed to investigate CEO Alex Mashinsky for misconduct and protect the interests of Celsius depositors following the incident.

Interestingly, just days before the company filed for bankruptcy, a former Celsius money managing partner KeyFi filed a lawsuit alleging that Celsius had used customer funds to manipulate the price of its native CEL token, and practiced poor risk-management strategies across the board during his time there. 

In response, Celsius countersued their former partner, claiming KeyFi CEO Jason Stone deceived Celsius about his investing capabilities before losing or stealing tens of millions of dollars in digital assets. Additionally, Celsius sued custodian provider Prime Trust, claiming it owed Celsius over $17 million worth of digital assets. The outcome of Celsius’ ordeal is still to be determined, and looks to be even messier than originally thought.

Tornado Cash Sanctions and Censorship Implications for Web3

Crypto mixers are typically centralized projects which receive users’ crypto deposits, tumbles the deposits together with other users’ deposits, then enables users to withdraw that same deposit, effectively producing “fresh” crypto which is now unrelated to the originally deposited assets. The point of all this is to offer users privacy regarding those assets moving forward since they would be untraceable after moving through this protocol and co-mingling deposits. 

Tornado Cash is somewhat unique as a crypto mixer since it is a decentralized app on Ethereum’s blockchain. Thus, there are no individuals heading up Tornado Cash who could be held accountable for running afoul of any laws or regulations since its operations are automated.

Crypto mixers are primarily used to preserve the privacy of users, particularly high-profile individuals or “whales” which are often tracked carefully on block explorers.

Tornado Cash is often cited as benefiting those donating to politically-charged causes, preventing financial censorship or repression, or avoiding surveillance by hackers targeting crypto whales. However, authorities allege it’s become a method of laundering stolen crypto among nefarious hackers who’ve been tied to a number of token bridge hacks, like Axie Infinity’s Ronin Network, and the Nomad mass-loot incident, for instance. 

Consequently, the US Treasury issued sanctions against Tornado Cash, prompting payments processor and USDC stablecoin issuer Circle to blacklist 45 Ethereum addresses named by the US Treasury’s OFAC. In addition, major Ethereum infrastructure and dev tool provider Infura dropped Tornado Cash as a client after discovering their tools had been utilized by Tornado Cash. The move is not entirely unprecedented either, since nearly every major centralized stablecoin issuer or exchange has blacklisted users in the past in some form or another.

The OFAC’s list consisted of addresses directly tied to Tornado Cash. It also included a Tornado Cash address utilized by a legitimate crypto grants program called Gitcoin to field donations. Unfortunately, one of the largest donations at Gitcoin’s Tornado Cash address came from the hacker responsible for an exploit of over $3 million on Iron Bank’s leveraged lending protocol, leading Gitcoin to be tied up in these sanctions from simply having received a donation. This has prompted some to speculate that attackers could use a similar strategy in the future to maliciously ‘dust attack’ strategic targets to taint their wallets with illicit assets. 

The sanctioning of Tornado Cash has undoubtedly caused headaches for law-abiding citizens who made use of the mixer to safeguard legitimate privacy interests. Nevertheless, it’s difficult to argue that such tools can’t be misused by criminals and attempts to veil illicit behaviors. Regardless of whether Tornado Cash is decentralized or not, financial regulators still hold sway over the fiat-to-crypto on or off-ramps, meaning that individual wallets can still be sanctioned so long as other users agree to participate in such measures.

Final Thoughts

The explosive rise to prominence followed by the epic disasters which have recently taken place are likely to invite scrutiny and regulation. Of course, low-hanging fruit, like centralized exchanges and others within the jurisdiction of the US’s SEC, will be hit hardest and earliest as warning shots. 

What this could mean for individual projects, investors, or users is hard to determine, but there is still hope out there on the horizon. Without throwing caution to the wind for the sake of growth, there’s still plenty of reason to be optimistic about Web3. Rarely has a new technology come along that doesn’t require a number of trial-and-error phases along the road to greatness. 

As interoperability becomes even more important, engineers and investors are sure to prioritize their commitments to security, transparency and accountability. Infura and Circle’s swift adherence to OFAC’s sanctioning certainly raised some eyebrows and exposed centralization vulnerabilities across DeFi, many of which have gone unnoticed until recent events. While this might be troubling to many in the Web3 space, it is nevertheless obvious that there are many legitimate players in the sector looking to eradicate illicit activities taking place on-chain.

References

1. Canellis, D. (2022, 9 Aug.). Tornado Cash sanctions expose potential DeFi Achilles’ heel. Blockworks.
2. Hill, J. (2022, 23 Aug.). Crypto lender Celsius accuses former money manager of theft. Bloomberg. 
3. Kharif, O. (2022, 23 Aug.). Celsius network’s bankruptcy mess gets even messier. Bloomberg. 
4. Kuhn, D. (2022, 18 Aug.). ‘Down infinite’: A ham-fisted attempt to rehabilitate Do Kwon’s image. CoinDesk. 
5. Nagarajan, S. (2022, 19 Aug.). FTX flags more privacy tools after Tornado Cash sanctions
6. Nagarajan, S. (2022, 24 Aug.). Celsius countersues KeyFi, claims millions stolen from wallets. Blockworks. 
7. Namcios. (2022, 19 Aug.). Now that authorities have sanctioned Tornado Cash, is Bitcoin next? Bitcoin Magazine. 
8. Press Release. (2022, 8 Aug.). US Treasury sanctions notorious virtual currency mixer Tornado Cash. U.S. Department of the Treasury.

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