The Breakdown - Ethereum’s Censorship Trial by Fire

Episode Date: August 28, 2022

This episode is sponsored by Nexo.io, Chainalysis and FTX US. On this edition of “Long Reads Sunday,” NLW reads Nic Carter’s “If Ethereum Starts Slashing, It Burns.” - Nexo is a security-first platform where you can buy, exchange and borrow against your crypto. The company safeguards your crypto by relying on five key fundamentals including real-time auditing and insurance on custodial assets. Learn more at nexo.io. - Chainalysis is the blockchain data platform. We provide data, software, services and research to government agencies, exchanges, financial institutions and insurance and cybersecurity companies. Our data powers investigation, compliance and market intelligence software that has been used to solve some of the world’s most high-profile criminal cases. For more information, visit www.chainalysis.com. - FTX US is the safe, regulated way to buy Bitcoin, ETH, SOL and other digital assets. Trade crypto with up to 85% lower fees than top competitors and trade ETH and SOL NFTs with no gas fees and subsidized gas on withdrawals. Sign up at FTX.US today. - I.D.E.A.S. 2022 by CoinDesk facilitates capital flow and market growth by connecting the digital economy with traditional finance through the presenter’s mainstage, capital allocation meeting rooms and sponsor expo floor. Use code BREAKDOWN20 for 20% off the General Pass. Learn more and register at coindesk.com/ideas. - “The Breakdown” is written, produced by and features Nathaniel Whittemore, aka NLW, with today’s editing by Eleanor Pahl and research by Scott Hill. Jared Schwartz is our executive producer and our theme music is “Countdown” by Neon Beach. Music behind our sponsors today is “The Now” by Aaron Sprinkle and “The Life We Had” by Moments. Image credit: Yifei Fang/Getty Images, modified by CoinDesk. Join the discussion at discord.gg/VrKRrfKCz8.

Welcome back to The Breakdown with me, NLW. It's a daily podcast on macro, Bitcoin, and the big picture power shifts remaking our world. The breakdown is sponsored by nexus.com, and FtX, and produced and distributed by CoinDess. What's going on, guys? It is Sunday, August 28th, and that means it's time for Long Read Sunday. Before we get into that, however, if you are enjoying the breakdown, please go subscribe to it, give it a rating, give it a review, or if you want to dive, deeper into the conversation. Come join us on the Breakers Discord. You can find a link in the show notes or go to bit.ly slash breakdown pod. Also a disclosure as always. In addition to them being a sponsor of the show,

I also work with FTX. This week for Longread Sunday, we're continuing the theme of censorship discussions in the wake of OFAC sanctions of tornado cash. We're going to be reading a new piece by Nick Carter called If Ethereum Start Slashing, It Burns. Before we get into that, though, let me do an admittedly radically simplified overview to help set the frame. Ethereum, as you well know, is moving from proof of work to proof of stake. In the upcoming proof of stake model, validators put Ethereum tokens at stake as a way to participate in proof of stake consensus. There is then a random assignment of the right to propose the next block among validators and a random committee of validators are assigned to sign the block is valid

or not. Validators are in control of which transactions they place in the block or exclude from the block to a certain extent, a control that's also present in proof of work. The mechanism to control bad behavior in Ethereum proof of state consensus is called slashing. If a validator refuses to sign valid blocks or proposes blocks that do not conform to the protocol rules, then their state can be slashed. In other words, some amount of their token stake is burned. Right now, it's not super clear if consistently proposing blocks without otherwise valid transactions that are censored by some regulator will be a slashable offense. Does seem that refusing to sign blocks that contain valid but censored transactions, which have been proposed by other validators, would be an action

which leads to a validator getting their stake slashed. But it's far from clear how that would work in practice. The concern is that validators will be pressured by regulators to refuse to sign blocks that contain sanctioned transactions. This is both a present concern with tornado cash transactions being sanctioned in the U.S. currently, and no clarification from Treasury thus far on how this should be handled by U.S.-based Ethereum miners, or validators after the merge, but it also opens up a gigantic it can of future worms. Many believe that if regulating the contents of a block is technically possible, then it's almost a certainty that regulators will be tempted to enforce censorship of transactions using this method. With the EU currently looking at regulating defy, whatever that means to them,

and the sophistication of the demands of regulators towards crypto networks increasing, it seems like a possibility that this sort of regulated censorship increases if it's demonstrated to be effective. With the sanctioning of tornado cash, we've seen a very clear demonstration that regulators are increasingly willing to shoot first and ask questions later, even if the second order effects are not well considered. And with that, let's read Nick's piece. The Ethereum community has of late been thrown into a state of mild disarray by the prospect of transaction filtering both at the protocol and the application layer,

brought on by the U.S. Treasury Department's sanctions against tornado cash. At the application layer, major decentralized finance platforms are imposing address screening at their interfaces. The blockchain itself isn't affected. Users can run nodes and use alternative interfaces to the extent that they exist to access these applications. But running nodes is hard, and switching from front end to front end is risky and difficult. These Web3 censorship tactics are not unlike the deep-de-platforming that happens on the internet to designated opponents of the regime. De-platformed with suspicious synchrony from

Facebook, AWS, Cloudfare, Salesforce, and PayPal? Just build your own social media, hosting, distributed denial of service protection, customer relationship management, and bank. The government didn't call it operation choke point for nothing. In practice, you just have to make it very inconvenient for users to access the service in question, and you have kicked them off. If they have to run their own beefy Ethereum node and use the command line to interact with an uncensored Ave or Oasis, the vast majority of users will be de facto walled out of the service. And the Treasury Department isn't content with de facto filtering at the interface level. It recently took the unprecedented step of sanctioning tornado cash, a cluster of autonomous contracts uncontrolled by any human. Not with

understanding the awkward questions Treasury must now answer regarding the constitutional feasibility of sanctioning blockchain addresses and contracts rather than individuals and entities, this was an aggressive shot across the bow. The effects were immediate. Tornado became inaccessible to anyone except the highly motivated and foolhardy. Notably, Ethereum's largest mining pool, Ether mine, has already incorporated filtering into its block construction. Now, a curious discourse has emerged whereby Ethereums are threatening to sanction slash validators like Coinbase if it complies with the law and filters sanction transaction. actions, as the firm surely will. Brian Armstrong can posture all he likes, but the board won't

allow him to shut down Coinbase's massively lucrative staking business because some Dot Eaths were mean to him online. They would sooner fire him. Eric Wall has described the credible threat of slashing, quote, a prerequisite for security and censorship resistance in a blockchain. Notable among Ethereum elites supporting the slashing of evil coinbase is Vitalik Boutyrin himself. No surprise that Bouturin is signed on to the crusade, as it is he who is largely responsible for promoting the concept in his early defense of proof of stake. We Will Slash the Bad People is so elegant in theory. The drone pilots only intend to drop the precision munitions on the insurgents and never the wedding guests. The first problem is, of course, that there's no actual slashing rule on Ethereum.

Any imposition of one, taking away stake tokens from validators, would be contrived in arbitrary, effectively unconstitutional. Now, you might say, as a young protocol, Ethereum's governance should be malleable, but the stakes are far too high for that now. Ethereum is a protocol that manages hundreds of billions of dollars worth of value daily. The very defensible Dow rollback, in 2016, following a $50 million hack, caused a mighty hangover that persuaded many that Ethereum was a hopelessly subjective mess, de facto controlled by a small group making things up on the fly. A newly imposed slashing rule, spirited from thin air, imposed against the crypto world's largest financial institution, no less, would be far more damaging.

Skeptics could justifiably point out that Ethereum will have completely surrendered the moral high ground, with leadership acting expediently. So Ethereum's reaction to nation-state sanctions would be to impose sanctions of its own. It's an identical desire to the one that drives the U.S. government to sanction so aggressively, to use purportedly surgical financial weapons to fight enemies foreign and domestic, without firing a shot. But Ethereum's leadership must rise above this urge, which would make the network no better than the system it seeks to replace. One of the distinct advantages public blockchains have over their legacy counterparts is their genuine neutrality. To impose a slashing rule in such an arbitrary and slapdash manner with no prior

codification would undo that advantage completely. An expropriation of Coinbase's funds as directed by, say, Vitalik Buterin, or others in the small community of Ethereum leaders would completely discredit any commitment to neutrality Ethereum is built up so far. Who is to say that Ethermine or any censoring POS validator is, quote, breaking Ethereum's rules by selecting transactions of their own volition? What rule? What line in the White Paper specifies this rule? If the rubric is instead social consensus, how is it measured? Who measures consensus? Does Coinbase get an appeal? In which court. These questions are unanswerable, given the vast array of Ethereum's many stakeholders in their many different views. There is no socially scalable way to slash only the bad people.

In the real world, there are no such things as villains. There are only competing interests. Coinbase's interest is to comply with the laws where it operates while running a profitable business. And as far as constitutionality is concerned, Eric Wall admits that there is no formal rule committing Ethereum to slashing censoring validators, or even language in the white paper to this effect. All we really have are Vitalik's writings on the theoretical merits of slashing. The Casper Upgrade White Paper discussed the mechanics of slashing at length, but does not describe how the intent of an attacker might be assessed, and how the committee would organize a slashing in response to an ambiguous attack. Ethereum's scattered constitutional

documents contain only letter and no spirit. In times like these, security of your assets should be your number one priority. If you want to offset risk as much as possible and still stay in crypto, you need a trusted partner by your side. Nexo is a security-first company that manages risk by relying on mechanisms such as over-collateralization, real-time auditing, and insurance on custodial assets. Learn more about Nexo's reliable business model and start your crypto journey at nexo.io. That's nexo.io. Eager to make more informed decisions around crypto, chain analysis is here to help. Chainalysis demystifies cryptocurrency by providing industry-leading compliance, market intelligence,

and investigations support for all crypto assets. For organizations like Gemini, Crypto.com, and BlockFi. Gain unparalleled visibility and maximize your potential with the leading blockchain data platform by visiting us now at Chainalysis.com slash CoinDesk. The breakdown is sponsored by FTXUS. FDXUS is the safe, regulated way to buy and sell Bitcoin and other digital assets with up to 85% lower fees than competitors. There are no fixed minimum fees, no ACH transaction fees, and no withdrawal fees.

One of the largest exchanges in the U.S. FDXUS is also the only leading exchange that supports both Ethereum and Solana NFTs. When you trade NFTs on FTCS, you pay no gas fees. Download the FTCX app today and use referral code Breakdown to support the show. The desire to simply confiscate the funds of designated wrongdoers is seductive, but completely short-sighted. It's the same impulse that drives all campaigns of nationalization, expropriation, and collectivization. This isn't working. Why don't we, the technocrats, suspend the rules, and simply commandeer these resources for ourselves. Countries that take a socialist turn

and expropriate foreign firms for crimes real or imagined always suffer in the long term. Their nationalized industries end up becoming inefficient. No one wants to lend to them as they have proven themselves unreliable, and no one is willing to invest there either. Securing meaningful credit and investment requires, above all else, stable governments and a commitment to property rights. If Ethereum Protocol elites arbitrarily sanction validators like Coinbase, they could suffer the same fate as an expropriating national government. The very best, most technically resourced and protocol-aligned firms would cease to work on behalf of the protocol. The risk of theft would dissuade others from investing in the infrastructure which keeps the system running. Now, this is not to say that if major validators impose sanctions related filtering at the protocol layer, Ethereum is doomed.

I am not advocating that Ethereum fight with one hand tied behind its back by moving to POS while spurning the slashing component. Simply remaining on proof of work, this on be taken as any endorsement of any fork, would likely abate the problem. Stake exposes consensus to government will through regulated financial institutions, which are slated to dominate validation, whereas proof of work is far more distributed and covert. Switching mining pools is instant and trivial, with POS it's cumbersome. The validator set churns constantly in proof of work, and there is no hardware bottleneck as Ethereum still uses mostly GPUs. In light of this state-level attack, I do question the prudence of the rush move to proof of stake, empirically dominated by large regulated custodial institutions.

But this doesn't mean Ethereum could never recover from a portion of its validators engaging in filtering. Ultimately, the question of unfiltered consensus comes down to decentralized block templating as well as production. Both are necessary, but neither is sufficient on its own. Ethereum's odds are likely better in my estimate if it remains on proof of work, but it is not necessarily doomed even post-merge. For instance, I don't buy the argument that the Treasury Department will forbid stakers from building on top of prior bad blocks, effectively creating a treasury-activated soft fork. For this reason, I am optimistic. Even if large validators do engage in transaction filtering, others will pick up the slack and include the neglected transactions.

All of that said, winning key victories against the creeping surveillance date does require that protocols like Ethereum successfully resist this overreach while we win the necessary political battles. It's not enough to complain that you are being badly abused by your government and hope replacements will arrive soon. You have to hold them off first so the political case is all the stronger. A law that is blatantly incompatible with technology and popular will is a brittle one, and one that is liable to be replaced. The greater the tension created by the incompatibility between the state's interpretation of the world and base reality itself, the better your odds are. Ultimately, obtaining the financial privacy that we all seek isn't really a matter of passing

or retiring specific regulation. It's not really about the 1970 Bank Secrecy Act, or the third-party doctrine, or the U.S. Constitution's Fourth Amendment, or the precise nature of a central bank digital currency. There's no magical incantation that will restore our lost transactional privacy in a world of digitized payments. No clever constitutional or legal argument, and certainly no line of code. Rather, it's very simply a question of how much we want to reclaim our lost freedoms. Holding off the sensor and maintaining the orderly function of these open monetary protocols is a necessary prerequisite. To achieve genuine change, we must understand that in a common law republic, laws are malleable,

and can and do adapt to new realities on the ground. We do have a new reality. Just take tornado cash, now twisting the government into indefensible contortions as it attempts to impose an ancient sanctions doctrine on a new terrain. I'm optimistic that, whether legislatively or in the courts, we will eventually win. But to even pose these hard questions, blockchains have to endure first, preemptively compromising blockchain neutrality and worse, showing that a small cabal of leaders can change core constitutional rules at a moment's notice, would do the government's job for them. If I were Treasury Secretary Janet Yellen or Senator Elizabeth Warren, I'd be thrilled that Ethereum leadership was considering debauching the protocol's neutrality with a panicked reaction

of this nature. I'd be much more fearful if Ethereum leadership recommitted to a truly neutral system that makes the highly politicized dollar infrastructure look like an embarrassment. So this is a really interesting and nuanced take from Nick. And to be clear, the Ethereum community has basically done nothing but debate these exact issues for the last two and a half weeks or whatever it's been since the tornado cash sanctions came. Part of what Nick is reacting to is in fact how vociferously many people in the Ethereum community want to preserve censorship resistance at the protocol level. What that group is grappling with is the reality that in the new proof-of-stake model, regulated financial institutions that represent significant parts of the

stake might be pressured to censor transactions. Nick is going a layer further, though, and actually arguing, I believe, that it would be even worse if Ethereum decided to punish those actors for complying with the law, rather than remaining neutral, even if neutrality means allowing certain large regulated actors to censor transactions. Coinbase, who's become a model for this discussion, currently represents something like 14.7% of Ethereum staked on the beacon chain. To Nick's point, Coinbase is positioning themselves as a defender of censorship resistance. Luke Youngblood, who used to work at Coinbase, said, As someone who helped build Ethereum staking for Coinbase,

Coinbase would fight this and wind down their product before they'd censor transactions. Censorship resistance is one of the first principles of crypto. One thing you might not know is that all of Coinbase retail Ethereum validators operate outside the U.S. for tax purposes. So not only will they fight censorship to their last dying breath, it's a stretch for U.S. regulators to censor transactions. Again, I'm just interpreting here, but I think that Nick's point is not that Luke's sense of Coinbase's values are wrong.

I think what he's arguing is that pressure from shareholders might ultimately win out regardless of those values. This is a big moment for the Ethereum community, and one I think that could lead them to being in a much stronger position. Ryan Sean Adams writes, Guys, the U.S. government isn't trying to censor ETH validators right now. Let's not get ahead of ourselves. But if they ever do, I'll be on the fork of Ethereum

that doesn't censor transactions. Simple as that. Layer zero is our security layer. Anthony Sassel said something similar. I want to be very clear on this, he writes. If the Ethereum base layer ends up engaging in permanent censorship, then I will consider the Ethereum experiment a failure and I will move on. Thankfully, I believe the Ethereum community is strong enough to fight off base layer censorship. This is something that we're going to be talking about a lot more.

I think that Ryan is right to note that these things haven't happened yet, and this discourse needs to happen dispassionately and more calmly than it has been because we've been living in the fog of war surprise of these tornado cash sanctions. At the same time, the issues are urgent, and one's worth all of us paying attention to. For now, I want to say thanks again to my sponsors, nexus.com. And thanks to you guys for listening. Until tomorrow, be safe and take care of each other. Peace.

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