Should stablecoin issuers be able to freeze accounts?
Plus: the forgotten conflict, Hezbollah, and more
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What Allium’s stablecoin data reveals: use case breakdown (B2B, C2C, cross-border), blockchain distribution, and why volume estimates vary so widely across reports
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Where the market goes over the next 12–24 months
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IN THIS NEWSLETTER
Should stablecoin issuers be able to freeze accounts?
Term of the day: Hezbollah
Markets: what conflict?
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WHAT I’M WATCHING:
Should stablecoin issuers be able to freeze accounts?
I don’t usually get into the weeds of legal debate, but this one is interesting as it impacts both how stablecoins will operate at a global level, and their potential demand.
On April 1st, the Drift Protocol – the largest decentralized perpetual futures exchange on Solana – lost roughly 50% of the total value in its smart contracts, in an exploit attributed to North Korea. The operation was sophisticated, involving hackers posing as collaborators in a long con that began months earlier and ended with more than $280 million worth of tokens being drained from vaults. These were then converted into USDC on Ethereum via Circle’s Cross-Chain Transfer Protocol (CCTP), and shuffled off to various mixers to cover their tracks.
Almost immediately, Circle started fielding accusations that it could have frozen the involved stablecoins, enabling Drift to recover the funds. CEO Jeremy Allaire has defended the company’s decision to not do so by insisting that it can’t go around freezing accounts without being officially directed to do so by law enforcement or the courts.
Technically, it seems he’s correct – I’m not a lawyer, but the GENIUS Act requires stablecoin issuers to comply with official requests to freeze or even seize tokens. It doesn’t say anything about doing so based on suspicion or community pressure. In fact, from what I gather, freezing funds because they “look stolen” could leave Circle vulnerable to claims of wrongful interference.
But… but…
In the case of the Drift Protocol exploit, it was obvious what was happening. Given the transparency of blockchains, the token drains were noticed almost immediately, Drift confirmed the exploit, and onchain forensic analysts got to work right away. Money was being “laundered” on a Circle platform, using a Circle token, and Circle had the power to stop it but didn’t do so for fear of legal liability.
Circle kept within the letter of the law, but broke with the spirit of crime prevention.
This is especially jarring, coming just days after it was criticized for freezing 16 seemingly unrelated hot wallets as part of an ongoing US civil case that has been “sealed”, which means no details or explanation have been or will be given. A couple of days later, some of these were unfrozen, confirming the impression that the firm had acted with a broad and possibly unjustified brush.
And rival Tether has often taken a more proactive approach – onchain investigator ZachXBT recently compiled a long list of exploits and theft where Tether froze funds almost immediately but Circle did nothing.
Yesterday, a hack was reported on Rhea Finance; Tether managed to freeze roughly half of the proceeds (while seizing the opportunity for a dig at its competitor).
The key here is “safe harbor” – can a money transmitter be penalized for freezing suspicious funds? The Bank Secrecy Act (BSA) has a “safe harbor” provision for Suspicious Activity Reports, as in no penalty for over-reporting, but it’s not clear whether this extends to actions on funds. But would a court rule against an entity proactively trying to prevent money laundering, especially since guilty parties are unlikely to come forward with a complaint? Parties that do protest and are deemed innocent can have token access restored in minutes.
In contrast, getting court orders can take days or weeks, impractical given the speed with which onchain funds move. Money launderers can hack protocols and whisk the funds away before the relevant law enforcement officials have answered the phone. It’s hard to see regulators supporting that system.
After all, a bank can freeze an account based on suspicion, without needing a court order or legal equivalent. Consumers have recourse if the bank can be shown to have acted unreasonably, or if the freeze is unnecessarily prolonged. But, it seems that banks currently have more leeway to prevent crime than stablecoin issuers. That makes no sense.
Yesterday, this case got even more interesting. Circle has now been served with a class action lawsuit for its inaction in the Drift exploit. Here’s an excerpt from the statement by the presenting lawyers:
“After the exploit, attackers allegedly bridged more than $230 million in stolen USDC from Solana to Ethereum using Circle’s own infrastructure — across 100+ transactions over eight hours. Circle allegedly took no action to freeze the funds, despite having the technical and contractual authority to do so.
As our lawsuit details, Circle has previously amassed over $420 million in alleged compliance failures, after repeatedly allowing unfettered use of its stablecoin and bridge services during large breaches involving millions of dollars in misappropriated funds.”
So, what now? Circle may settle out of court, but this is a hefty sum. Or, they may let this go to trial, in the hopes of establishing a legal precedent to guide and protect future action.
This is an especially delicate topic for the emerging world of DeFi, which will need to find better protection against this sort of theft if it wants to call itself “institutional grade”.
But for DeFi, precautionary freezes are a double-edged sword. Imagine the Drift Protocol exploiters deposited some of their USDC into an Aave lending pool – should Circle then freeze the whole pool? Or imagine proceeds from another crime were deposited into Drift’s vaults which were then frozen (either by Drift or the relevant token issuers), disabling any reaction to market moves and potentially adversely impacting innocent participants. Who should be given “freeze just in case” authorization, and how far should “safe harbor” extend?
At stake is regulatory support for decentralized protocols and expanded stablecoin use. Also at stake is just how “decentralized” protocols can be while enjoying some sort of legal and financial protection. And, even if regulators decide the risk of fast crime is not their problem, or are convinced by decentralization purists that a light touch is the way forward, institutions could well choose to stay away, depriving the ecosystem of some of its liquidity.
Meanwhile, business decisions have consequences in an increasingly competitive field. Yesterday, Drift announced a collaboration with Tether and “other partners” involving a contribution of $150 million to cover part of the loss – this includes a $100 million revenue-linked credit facility, an ecosystem grant, and loans to market makers to fund a user recovery pool. It also involves a move to relaunch with USDT (not USDC) “at the centre”.
