Why a Stablecoin Freeze Can Be Front Run: DEX in the City

Transcript

So V, tell us more about ordering power and sanctioning power. How that's sanctioning power. >> Yeah, these are like two things that I had never really thought about together, but um there were two stories that came out uh like this week or recently and and I wanted to sort of make a connection here because I think it's super interesting. Um, the first is a news report from TRM Labs looking at how Iranian actors continue to use stable coins and other onchain infrastructure despite sanctions. And then the second is a really fascinating academic paper called ordering power is sanctioning power. Um, and like I said, at first they seem totally unrelated, but I

actually think they're talking about the same thing in in some ways. So my first reaction when I saw the TR TRM report was okay fine. I mean I think we all knew that right that these bad actors are are using um blockchain and and crypto to to conduct illicit activity. Um but you know we also know that stable coin issuers can freeze wallets, right? So like what what's like the big deal here? Um but that's what where this paper comes in, right? So the authors are a group of researchers from various universities in China and they point out something that is obvious but sort of profound actually and that's that a stable coin freeze is not actually a

freeze until the freeze transaction gets included in a block. Um so if you compare that to tradi right if a if a bank wanted to freeze an account um I mean it basically happens immediately. It's the end of the story from the customer's perspective. The bank controls the ledger. So, it can just stop the movement of funds. But on a blockchain, the freeze itself is a transaction just like any other transaction. It has to be submitted. It has to compete for blockspace. Um, it has to be ordered by builders and validators and sequencers or whoever controls ordering in whatever system.

And in that window, the sanctioned actor may be able to see the freeze coming and try to move the funds first. Right? So the papers bigger point isn't just that sanctions can be evaded in this way. Like we I mean we already knew that sanctions could be evaded in other ways. The more interesting point is that sanctions enforcement then sort of becomes a market structure problem. Right? So I've written a lot about written and talked a lot about me and transaction ordering in the context of trading right so things like front running and sandwich attacks and priority fees and execution quality but this paper is saying that transaction ordering can also affect law

enforcement. Um if the freeze transaction loses the race to a transfer transaction then the legal authority to freeze just doesn't work right. So, another way to put this um in very simple terms is that a stable coin freeze can itself be frontr run. And so, I mean, just think about that, right? It's like the most crypto thing ever. Um, this just like it blew my mind in maybe the wrong ways, you know, and sometimes we all get stuck in our assumptions and preconceptions and I am definitely one of those, you know. I obviously have fought elicit finance in blockchain for many many years now and it's something

that's near and dear to my heart and a good narrative and one that I believed in and I still think is true is that the freezing the automatic riskmanagement component particularly of stable coins is an important one that we can put forward to regulators and people who are writing clarity and genius etc. for why this technology is better or at least as good. But I think the argument could be better in some ways than existing, you know, financial rails. But the problem is that that is potentially based on a somewhat flawed assumption according to this paper. And that scares

me because sometimes you just look at these academic papers and you read the abstract and you're like, interesting. And maybe you read parts of it or maybe you forget about it. the facts in here that I haven't personally verified, but like some of the stats are pretty scary to me. You know, in our like agreement here about stable coins, we've largely privatized sanction enforcement, which is not like unusual. We do that with banks as well, but you know, Tether and Circle are doing a lot of our freezing when it comes to stable coins, right?

And some of the paper is saying that >> a lot of the freeze transactions ran out of gas. >> Yeah. >> So they just didn't work. That a lot of them don't have anything to do with SDN and are privately put out there, which is not unusual, but it was something like 94% of onchain stable sanctions are issued driven compliance actions, which that's a high number, right? And that this one was crazy to me that in eight years there's just nine freeze circumstances that actually were able to stop the money midway or a significant portion of the money. I mean there's just like endless one of these like 7%

of the sanctioned addresses had a zero balance by the time the freeze hit. Now, the freeze has stopped a lot of money, millions in bad actor funds, and that has hopefully stopped bad activity. But the fact that there's so much that has not been achieved with these freezing powers that we were so excited about is um something I'm still coping with. >> And is it because the issuers just aren't acting fast enough because they have like a process they have to go through? Right. This has been like really controversial with respect to some of the hacks that have happened and circle either, you know, declining to act at all or if they do they have to

like maybe sometimes wait for a court order or whatever their policy is and that can take a while. Like what is the reason they're not freezing these things in time? >> No, it's it's that execution order is controlled by kind of a separate market driven layer. So that's the gap. It's not necessarily their own processes. It's how blockchains fundamentally work. >> And you know, I'm hearing this >> and I think it's really interesting to call this out in a way, but I also think it's important to say like this paper. I don't want this conflated with me separately. And as I think everyone's familiar or actually we shouldn't assume our listeners are familiar, but MEV stands for maximal extractable value.

It's a known concept in blockchains referring to often profit that miners or validators can extract by choosing how to order transactions, but not always profit. There's a multitude of reasons and ways um that that go to transaction ordering. And I always think our good friend Rebecca Reig has written a lot of really interesting scholarship on MEB and really compellingly defended it as uh a concept. Um, and it's Rebecca's birthday today, so I felt like I needed to shout her out.

>> Um, but I don't want to conflate ME as a concept with this kind of I believe the paper refers to it as sanctions MEV. This inherently is a problem but a benefit with everything on chain. Like speed hurts transactions on chain, but it helps transactions on chain. Like the fact that bad actors can move funds so quickly like that has created a lot of issues with theft and with the facilitation of the movement of dirty money but it also you know in in that is inherently one of the major points of appeal of transactions on chain.

>> Yeah. It's I mean like so many things in crypto it's a trade-off right? >> Yes. So >> like we have a constitution and due process for a reason right? So there is, you know, this rush to be like, well, we should be freezing faster. We got to stop elicit funds, right? And, you know, I'm in that camp. But also, we have a constitution and we have due process. So, how do we balance the speed of increasing tech with our constitution written a long time ago obviously and crypto was not the first uh technology that has dealt with this but it's one that's having to deal with it at a different speed and that is like a real struggle here and so

>> the paper itself I I don't think it's been peer- reviewviewed it's one paper but it's worth taking a look at because for someone like me that has talked a lot about stable coin freezes, it it should make you think about all the options out there, >> a thousand a thousand%. And it also so as you guys know, I'm an ex centralized exchange CLLO and centralized exchanges, you know, they're not stable coin issuers, but and Trady, they grapple with this kind of conceptual issue a lot. Meaning I remember we had multiple scenarios um or you know every centralized exchange has multiple scenarios where maybe you suspect wrongdoing. Your legal obligation is

fulfilled by filing a suspicious activity report as a money service business. So you filed a SAR you let you know that's kind of you're fulfilling your obligation like I think something sketchy is going on. It is not appropriate for any type of entity to be an investigator. Like that could very easily like you could say, "Oh, this is sketchy. I'm gonna freeze your account." And it could turn out later that actually nothing wrong was going on. And what right do you have to freeze someone's funds? You're not law enforcement. Uh so the this is there's a mechanism to respond to these things that is easily executable in the money service business context but it doesn't always ultimately result in catching the

bad guy you know as quick and as fast as we would all like it to be. Yeah, I I think like the so another issue that I've talked about and written about in the past is um the third party doctrine, which is I mean it's a little more nuanced than this, but the basic idea is that in certain situations, private actors have an obligation to assist law enforcement basically, right? And so I wonder if this is sort of a preview of law enforcement putting pressure on different actors within crypto to assist them to stop illicit activity. Right.

Obviously, right now it's it's really just stable coin issuers, but the reality is that there are a lot of different, you know, actors in the stack that should be credibly neutral. And I hope we do, you know, try to preserve that as much as we can. There are a lot of different actors in crypto market structure that could potentially be quote unquote deputized. But I but I think we have to be very careful there, right? The third party doctrine like you can't expand it too much because I think that would raise all sorts of constitutional issues. And if anything, the Supreme Court is probably headed in the direction of narrowing it, right?

Because like as Jesse said, the more technology advances, the more possible it's going to be um to force private actors to do things that could help law enforcement. And we always, I think, have to push back on that. We have to resist that temptation. >> And you see it happening, the expansion of the third party doctrine with AI. I mean, like we talked about it on this show before, but your logs that and prompts that you put into trap GPT, are you putting them in understanding that they were going to be handed over without a warrant to the police and we are increasingly seeing that fight propagate through case law.

>> Yep. Yep. >> And the third party doctrine, it's important to note that this actually comes from the fourth amendment. And as a reminder, that's the unreasonable search and seizure amendment. Okay. It requires law enforcement to get a warrant. A little civics lesson leading up to America's 250th birthday party, right? So, the third party doctrine, it it's it makes sense conceptually, but it also has been read in a multitude of context. It says that when you voluntarily share information with a third party, you lose any reasonable expectation of privacy in that info, even if you only shared it for a limited purpose. Because the Fourth Amendment was written for search and seizure. So

if you're handing things over, then it's not a search and seizure. But what does it mean to hand things over? And as we know, like email is like maybe we don't all know, but you need a warrant to get the contents of people's emails even though it's in Gmail or whatever that you've shared it. So where's the line there? This question has been perpetually an issue for tech and we're just seeing it continue in the crypto AI and other tech spaces. >> Yeah, >> I could talk about third party doctor. >> I love this one.

>> We're like, oh my god, the Supreme Court and the Fourth Amendment. Like, you know, like welcome to nerd hour. Come on. >> It's very relevant to crypto though. >> It's incredibly talk about it that much. >> And look, I think sometimes when there's really complicated concepts, I find this way. I I find this definitely with derivatives. If you explain the history behind the concept and why it was created in the first place, it makes sense to people from a more like fundamental human perspective. So I, you know, we had to throw in the Fourth Amendment throwback. But on this >> show title be Welcome to Nerd Hour. That was >> Should we rename the show? Like I maybe Okay, you know that's okay. The nerds win in the end. Okay. Like we've all

seen that as grown-ups. Hello. Uh, on that note, >> I don't know about you guys, but I was super cool in high school. So, >> Oh my god. >> Okay. >> I actually was I got in trouble so much. I was really bad. >> Okay. Okay. Well, my high school boyfriend was the homecoming king, so I wasn't cool, but somehow I don't know how that happened. >> I had Blake was in 11th grade, everybody. So, go there. >> Pictures or it didn't happen. Jesse, next episode. >> Exactly. Well, this conversation of the Fourth Amendment and search and seizure, it couldn't lead us more perfectly into our next topic. That was a clip from Decks in the City, where the wallets are

cold and the takes are hot. And we've got a lot more in the full episode. Links in the show notes. I'm host KK. Subscribe and join us on the live stream every Tuesday at noon Eastern. If you hold crypto on your phone, your biggest vulnerability isn't your wallet, it's your carrier. AT&T, Verizon, and T-Mobile have been breached again and again, and SIM swaps are still one of the easiest ways for attackers to drain accounts. That's where Cape comes in. America's privacy first mobile carrier.

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