First Digital Asset Hearing: Self-Custodial Wallets Are Hamas

Yesterday, the Senate Banking Subcommittee on Digital Assets held its first hearing chaired by Senator Lummis of Wyoming to explore "bipartisan legislative frameworks for Digital Assets".

Invited as witnesses were former CFTC Chair and Research Fellow at the Kennedy School of Government at Harvard University Tim Massad, Global Head of Policy and Government Relations at Kraken Jonathan Jachym, Chief Legal Officer at Lightspark Jai Massari, and Lewis Cohen, Partner at Cahill Gordon & Reindel LLP.

As reported by Bitcoin Magazine, the hearing mainly focused on stablecoin regulation, with witnesses praising regulatory frameworks in Wyoming and the EU's MiCA framework.

"Stablecoins must be backed one-to-one with reserves of high quality liquid assets," said Lightspark's Massari; "Assets should be segregated and beneficially owned by stablecoin holders." Additionally, Massari said, "stablecoin issuers should compete based on innovative payment use cases, not on reserve design." Former CFTC Chair Massad agreed, stating that he supports the Genius Act's full reserve requirements.

Overall, the hearing's focus on stablecoin reserves may be bad news for Tether, which has recently been driven out of the EU due to MiCA's full reserve requirements, and has faced widespread critique for the intransparency surrounding its stablecoin's backing.

However, much more interesting than possible stablecoin regulation was the committee's focus on digital asset compliance. While stablecoins remained in focus, witnesses agreed that existing banking laws should extend to all digital assets.

"The Genius Act does not do enough to address the risks of financial crime and sanctions evasion," Massad stated. "It's good that it says that stablecoin issuers are subject to the Bank Secrecy Act, but the BSA only focusses on obligations on centralized intermediaries, while stablecoins can be transferred without a centralized intermediary, whether that's on a self-hosted wallet or on an automated decentralized exchange. "

While stablecoins have KYC requirements, "once that stablecoin has been issued it can be transfered many times; there's no requirement to follow that customer," said Senator Mark Warner of Virginia.

"I can transfer [a digital asset] from self-hosted wallet to self-hosted wallet," agreed Massad. "That can happen several times and that's why we've seen these things be used for sanctions evasion and for money laundering by Russian Smugglers, by Hamas, and by others."

Warner stated that he recognizes "what others have said from a classified side," that these assets are used for "a whole bunch of bad stuff" due to "the anonymity and the disintermediation role that blockchain plays," asking "how do we put [in place] some protection from the issuer all the way to conversion to fiat".

Massari agreed, stating that "the use of stablecoins as a true means of payment is dependent on our ability to get it right when it comes to combating illicit finance and enforcing sanctions."

"When a transaction happens between self-custody wallets, there isn't KYC obligations on those and so those can happen without KYC," Massari continued, however adding that "there is an immutable on-chain record of those transactions that can be monitored not only by the issuer but by third parties."

"But isn't there this process of mixers where you [...] still have that blockchain to follow the entity but you may not know who that entity is without KYC next to it?", Senator Warner asked.

"Absolutely right," Massari responded. "People can use a variety of different technologies to on purpose obfuscate their financial transactions, that's true on blockchain that's true in traditional finance. [...] I think it's a really important issue and I agree that as an industry we need to continue to develop new tools to address these issues."

"When a user transfers a stablecoin to a custodial wallet, so an exchange, that's another point of KYC right there, so the gap is widest when you're talking about unhosted wallet transfers," Massari agreed.

"Kraken's role in the market is as a centralized intermediary, and we know who's coming in, who's coming out," Kraken's Jachym responded. "We track not only KYC so we know everyone coming into our platform, anything that leaves our platform, if there's any risk of hitting a sanctioned address it's blocked, there's enhanced monitoring tools."

"We run these assets through rigorous due diligence tests, cyber security tests, legal tests" Jachym stated, "to make sure that everyone participating in our market is subject to KYC and sanctions."

"My colleague Mr. Massad is absolutely correct that there is an ecosystem out there outside of centralized intermediaries," Jachym added, "but the surveillance, the traceability that is available thanks to blockchain technology is unparalleled [...] to any technology we have seen in history."

"We briefly alluded to the ability with crypto assets to freeze and seize, which is different from tracking," added Cohen, "but it can mean that if a stable coin issuer identifies that a particular amount of stable coin is added [to an] address controlled by an illicit actor they can functionally turn that off at that time," noting that "stablecoins in many ways are a step change better than [...] other assets."

Going purely on vibes, it seems plausible that we may see Congress attempt to rewrite 18. US Code paragraph 1960 as well as the International Emergency Economic Powers Act (IEEPA) to apply KYC/AML/CFT requirements to self-custodial wallet providers and decentralized services as suggested by the Fifth Circuit's Tornado Cash sanctions reversal as well as Financial Action Task Force virtual asset guidance.

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