The Breakdown - The Balkanization of Bitcoin: The Next Attack on BTC Is About Mining Provenance

Starting point is 00:00:00 What feels clear to me is that this is a new attack vector on Bitcoin. And importantly, it will come not always from people who seek to destroy Bitcoin, but from a good, well-intentioned, well-meaning place. 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.io, neared.org, and genesis trading, and produced and distributed by CoinDes. What's going on, guys? It is Friday, May 7th, and today we are talking about what seems to be

Starting point is 00:00:36 emerging as the next attack vector on Bitcoin, mining provenance. First up, however, let's do the brief. First on the brief today, Squares Bitcoin numbers. Earning seasons continues and damn did Square post some insane numbers. Bitcoin revenue for quarter one was $3.51 billion. That's an 11x increase year over year and a doubling from quarter four of last year. This included $75 million of gross profit. A full 70% of Square's revenue came from Bitcoin. Obviously, these things matter more than just to Square. They matter as a signal to other companies about just how much demand for Bitcoin products there is and just how profitable it can be to get involved. Next on the brief today, our first comments from Gary Gensler. New SEC Chair Gary Gensler,

Starting point is 00:01:27 gave his first hearing this week. The topics were wide-ranging, but there was certainly some about crypto. In response to a question from Congressman Patrick McHenry about crypto regulation, Gensler suggested that the SEC is limited to focusing on specific assets that may be securities, but that Congress might want to explore regulation around exchanges. Quote, right now these exchanges do not have a regulatory framework at the SEC or at our sister agency the Commodities Futures Trading Commission. Right now, there's not a market regulator around these crypto exchanges, and thus there's really no protection around fraud manipulation. This is, in point of fact, exactly what Patrick McHenry's Eliminate Barriers to

Starting point is 00:02:02 Innovation Act is designed to do, bringing the SEC and CFTC together to figure out the right way to regulate crypto that allows for its continued flourishing in the U.S. Now, people hear regulation and they freak out, but that's not necessarily the case. Avi Feldman from Block Tower writes, The market needs to internalize that regulation of crypto exchanges is not only inevitable, it's good for the industry. The more volumes that come from regulated exchanges, and the more comfortable the traditional world is with Bitcoin, the better off we all are. It does not hurt the value proposition of Bitcoin the more institutionalized it gets. The chain still functions as the chain does.

Starting point is 00:02:37 Selling headlines like this is akin to freaking out because someone just told you dihydrogen monoxide is dangerous and large quantity. By the way, guys, that's another way to say H2O. So we're going to talk a little bit more about the chain functioning as the chain does in just a minute. However, I would point out only that Gensler being clear about the limits of the SEC is a really positive sign. Speaking of institutions, our final note on the brief is quick hits on just a couple of institutional Bitcoin developments. I'm going to discuss these a bit more tomorrow on the weekly recap, but briefly, first, Nidig has recruited away Ray Talio's CFO from Bridgewater Associates, the biggest hedge fund in the world. That is a hell of a signal, someone voting with their

Starting point is 00:03:18 career that Bitcoin is where the puck is headed. Next up, Goldman Sachs was reported to be starting to offer derivatives that allow people to bet on the price of Bitcoin. But then this morning, they also announced officially a new crypto trading team. This is a far cry from last year when they were screaming about how this wasn't an asset class. Finally, cities head of Forex said that bottoms up demand is pushing them into this space, but they're not fomowing in because they believe that crypto is here to stay. In other words, this was quietly a massive. week for Bitcoin. Looking for the best way to unlock your crypto's liquidity,

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Starting point is 00:05:17 Visit genesistrading.com today to learn more. With that, let's move to our main topic. And I got to say, this development feels. at once, frustrating, and inevitable. Throughout Bitcoin's history, there have been various ways that the powers that be have tried to control it. They've used narrative warfare, for example, Jamie Diamond calling it worse than tulips than threatening to fire any JP Morgan traders trading it. They've used choking off access points. There are still extreme restrictions on exchanges in China, for example, that lead to most of the Bitcoin activity in that country happening over the counter. We are now, however, in a different phase of Bitcoin's life. There is, as we were just discussing,

Starting point is 00:05:59 scale institutional adoption and increasing mainstream acceptance. It's not just random libertarian nerds trying to torch the planet for fun and profit anymore. Now we have hedge fundies, we have corporate treasuries, we have insurance company general accounts, we have normies. This is one of the reasons that people have been so skeptical of the Dalio at all claims that this is just going to get banned out of existence. I mean, earlier this week, we talked about the NIDIG partnership with FIS that could make Bitcoin available directly to some 300 million bank accounts. While it's certainly not impossible to ban that? It gets harder and harder to walk back all the time. This suggests to me that the attempts at control are going to have to be more subtle. They're going to have to seem more

Starting point is 00:06:38 reasonable, and they're likely to come along different vectors than we've previously imagined. One that seems to be emerging is mining provenance. So here's the idea, at least from one perspective. If you can watch on chain which Bitcoin is awarded to different miners, you could apply qualifications to those miners. You could start to accept or deny Bitcoin based on the miners to whom it was originally rewarded. From there, you could theoretically start to segment, or perhaps a better way to say it might be balkanize, Bitcoin based on its origins. There is increasing evidence that this might be one of the next attempts to control Bitcoin. Let's start in Iran. You may remember a week or so ago, Iran announced that importers and other financial institutions could begin using

Starting point is 00:07:20 crypto as a payment mechanism for imports. However, they could only use crypto that was domestically mined from approved Iranian miners. That policy has now been reified in an expanded way. On May 5th, Iran International reported, quote, and this is just Google Translate, so it could be a little bit off, but the central bank announced that according to the decision of the cabinet, trading of digital currencies extracted abroad is prohibited, and only currencies extracted inside the country can be traded. So let's talk interpretation. A lot of bitcoiners are saying things like good luck enforcing that. But then others counter that and say, sure, that may be true for individuals, but at the the institutional level, this type of enforcement isn't that hard. At Falemay wrote,

Starting point is 00:08:00 crypto is already regulated in Iran. Mining is a legal industry while trading is banned to my understanding. This just means that Iran wants to export Iranian-produce coins more aggressively, encouraging mining and counter-capital flight in the face of a depreciating real. There's also the issue of getting around the SWIFT system. Iran is largely cut off from the rest of the financial world via the politicization of the U.S.-led global settlement system. This may be an attempt to go after that. Nick Carter reacted with questions, saying, are there any Iranian mining pools? Does the central bank give an exemption to coins mine in Iran but via a Chinese mining pool?

Starting point is 00:08:33 So you can see there's a lot of bitcoins who are trying to just figure out what this actually means. However, I think the conclusion is pretty clear, which has to do with Iran's desire to control Bitcoin and use it to its advantage. Coin desks Michael Casey wrote about this last week, and I'm actually going to read a rather long excerpt of it because I think it is really important. to understand. Quote, even though Iran is a major oil producer, years of crippling U.S. sanctions aimed at containing its nuclear weapons program have deprived its economy of dollars. That makes it very difficult for Iran to buy what it needs from the world and ensures that the local currency, the Rial is under perpetual downward pressure, which in turn stokes inflation. Now, by creating a legal framework in which Bitcoin can be mined locally, taxed under a strict licensing regime,

Starting point is 00:09:16 and used by regulated institutions to pay for imports, the government has a workaround. Iran will still struggle to sell its energy resources for dollars, but it can do the next best thing. It can convert that same local resource into Bitcoin, a harder currency than dollars. At the same time, the regime is showing its authoritarian instincts. In January, it said that Iran had 24 officially registered mining farms consuming 310 megawatts of power, and that the Ministry of Energy had shut down 1620 illegal Bitcoin mining operations, with a capacity of 250 megawatts over the prior 18 months. It offered rewards of up to 100 million reaels, about $2,300 U.S., for information leading to the arrest of illegal miners. In a subsequent story by Kondesk's Ana Bidekova, one household miner,

Starting point is 00:09:57 Basir, not his real name, said he spent a week in jail before he could scrounge up the large bail amount by selling his house, his car, and his mining equipment. The premise for the crackdown is that a legal mining is disrupting Iran's overstretched electricity grid. But Bitcoin advocates say that is unfair, as the country's blackouts have continued even after the authorities have done their sweep. Regardless, by making itself the gatekeeper for domestically mined Bitcoin and discriminating over which entities can access it, the government is laying the groundwork for societal divisions, especially if Bitcoin grows in importance, as many expect it will. The TLDR for me is that this is another tool of control. It's a government trying to exert control and this mechanism of mining

Starting point is 00:10:37 provenance being a lever that they're trying to pull to do that. Interestingly, though, I spent a lot of time looking for trends, not just point stories, and this wasn't the only place, where Bitcoiners were forced to talk about mining origins this week. Marathon Digital Holdings, a publicly traded Bitcoin mining operation, this week mined their first, quote-unquote, clean block, their first, quote-unquote, OFAC-compliant block. OFAC is the Office of Foreign Assets Control and is the group that sanctions people and blacklist them from international financial networks like Swift. In March, Marathon announced that it was going to be mining regulatory-compliant Bitcoin, saying, quote,

Starting point is 00:11:12 While institutional interest in Bitcoin is accelerating, many large funds and corporations have expressed concerns over purchasing Bitcoin that may have been tainted by nefarious actors. What does this even mean? The pool refrains from processing Bitcoin transactions from people listed on OFAC's specially designated nationals and blocked persons lists. And importantly, this is one of those things that to some will sound reasonable. Just blacklist known criminals, right? Well, that's not really the issue.

Starting point is 00:11:39 There are more fundamental implications for this. Here's how Bitcoin magazine puts it. Quote, censoring Bitcoin transactions at the mining level has been fairly uncharted territory up to now, and it is unclear what the ramifications could be. It is arguably dangerous to some vital Bitcoin properties as a medium of exchange, such as its fungibility and censorship resistance. If some coins get treated differently than others based on government regulations, that could pose a challenge to the free exchanging of Bitcoin worldwide.

Starting point is 00:12:05 To be clear, Bitcoin is designed to be fungible, Just like one US dollar can be perfectly substituted for any other US dollar, one Bitcoin should be able to be perfectly substituted for any other Bitcoin. This is a fundamental threat to that fungibility. However, a question comes up, is this even possible? Marty Bent argues no. He wrote, Marathon's attempt to create a clean regulatory compliant pool is nothing more than just that. An attempt.

Starting point is 00:12:31 It is literally impossible to create a regulatory compliant pool unless you have enough hash rate to continually reorganize the chain to remove blocks that do include transactions that regulators don't want to happen. Marathon's very sad and small pool certainly isn't going to be able to accomplish this. The only thing produced from Marathon's pool's mined block today was a pure virtue signal. They did nothing to comply with OFAC regulations. In fact, one can easily make the argument that they are helping to facilitate transactions that are, quote, not approved by regulators, because the addition of the block they mined this morning adds an extra block of security to unapproved transactions in previous blocks.

Starting point is 00:13:04 He then points to a thread by J.B. Decht who writes, The concept of a compliant block is a fundamental misunderstanding of the protocol. If you mine on top of a block, you secure all previous transactions a little bit more, regardless if you include a non-compliant transaction in your block. Since a compliant miner is using an address blacklist, a non-compliant transaction involves an address that previously transacted before the block a compliant minor is mining. Thus, even in attempting to avoid securing the non-compliant transaction's latest transaction in their block,

Starting point is 00:13:34 they are securing the previous non-compliant transaction by simply participating in the same blockchain. Said another way, even before considering if such a miner would mine on top of a non-compliant block after they mine their first block, this miner is securing the non-compliant transactor's transaction by simply coming to the table. This fundamental misunderstanding of the protocol means that the censorship efforts are little more than window dressing and do not ultimately have the intended effect of ostracizing the non-compliant transactor. Bitcoin game theory is rad like that. That does not mean that these efforts should be ignored. Complacency is how protocols die. Censorship resistance is a key tenant of Bitcoin, a major part of its value.

Starting point is 00:14:12 Number go up, while fun, is not the underlying value of Bitcoin. So as you can see, in this context, Marty and others are calling it just a virtue signal. Another group of Bitcoiners tried to send them dust from transactions from non-compliant actors to make the whole thing null and void. Others pointed out that there was major fee degradation for this block and that it might be economically unviable to do this sort of thing. Either way, for me, taken with the Iran news, it's starting to become not just one individual discussion but the beginning of a trend, and let's add one more to the pile. Kevin O'Leary, Shark Tank's Mr. Wonderful. He's become a

Starting point is 00:14:46 Bitcoin convert over the last year. He's down in a big way with the inflation hedge argument. He says that 3% of his portfolio was BTC, but he's been screaming about the idea that he doesn't want to own any Bitcoin mined in China. On Wednesday, he was on Yahoo Finance discussing this. He said, currently 60% of coins mined in Bitcoin come from China, where they don't care about sustainability and they certainly have issues around human rights. The actual provenance of a coin over time, one that's mined sustainably, could be worth more than just a generic coin that can't prove its prominence. O'Leary has claimed a ton of institutional investors have pinged him about this, but so far that's entirely anecdotal. He went on to say, quote, I know the provenance of where my wallet coins were mine now,

Starting point is 00:15:25 and that means I've had to take equity positions in miners. I've had to start investing in them with the covenants in place that I would like to be paid back in a royalty of a clean coin. Now, what many big-coiners would agree with O'Leary about is an interest in less of the total Bitcoin network hash power coming from China. In April, Barry Silbert tweeted, incredibly proud to announce that the founder USA Bitcoin mining pool from Foundry Services just became a top five pool in the world. Bitcoin hash rate is quickly shifting from China to North America. This week, China co-founder at F2 Pool, wrote here at F2 Pool in April 2021, the first month in our eight years of operation, we have seen more Bitcoin hash rate coming from outside of China

Starting point is 00:16:02 than from the inside. The shifting is real. So clearly there is genuine interest in shifting hash power, however not at the cost of the fundamental fungibility and censorship resistance at the core of the network itself. There's a lot more to dig into here, including the way that the UTXO system in Bitcoin may make this just completely null and void and represents a misunderstanding of how Bitcoin moves as a whole. That's a whole technical episode that at some point if we want to do, we can. But what feels clear to me is that this is a new attack factor on Bitcoin. And importantly, it will come not always from people who seek to destroy Bitcoin, but from a good, well-intentioned, well-meaning place. People who are excited about and buy into the idea of Bitcoin

Starting point is 00:16:45 as a force for capturing energy that would otherwise be lost, could easily walk down the path of, Well, sure, but then why not just cut out all that other bad Bitcoin mind in bad ways? The problem is that this isn't just censoring an end user or some blacklist that we've seen before. It represents a fundamental shift in how the underlying protocol is meant to work. Now, the optimistic thing is the game theory points to Bitcoin ultimately shrugging off most of these efforts. But there is a seductive simplicity to these arguments that feel to me likely to attract more people. Now, before this becomes a trend, is the right. right time to start engaging in this discussion and helping people understand why it is such a threat

Starting point is 00:17:25 to what makes Bitcoin great. For now, guys, I appreciate you listening. I hope you're headed off to an awesome weekend. Until tomorrow, be safe and take care of each other. Peace. We're witnessing the greatest paradigm shift in finance in modern history. Join thousands of newsmakers and influencers talking the future of money at Consensus by CoinDesk. A live virtual experience of leaders, change makers, virtual reality meetups, keynotes from Ray Dalio. Gary Vaynerchuk, and much more. Get an up-close look at the boom in crypto, the surge in institutional investment in Bitcoin,

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The Breakdown - The Balkanization of Bitcoin: The Next Attack on BTC Is About Mining Provenance

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