Last month, the blockchain Ethereum celebrated the successful completion of the merge, a long-anticipated technical update. The merge made Ethereum far more environmentally sustainable and harder to hack, and it laid the groundwork for the network to scale toward mass adoption.
But the merge has also brought at least one unintended consequence that critics argue threaten the whole premise of the network: More than half of the network’s activity is now subject to new U.S. government sanctions. It’s a twist that runs counter to everything Ethereum stands for, as it has long prided itself on being autonomous from governments and resistant to censorship.
Some proponents of Ethereum argue that this is a short-term problem with no real consequences. Skeptics say that the current situation sets a dangerous precedent about how much power the government might be able to exert upon pressure points in the network.
“[Government] regulators will look at this and say, ‘Okay, that was easy.’ And if Ethereum becomes a centralized, censorship-controlled chain that also has bad scalability, then there’s no point in building on Ethereum any more,” says Lachlan Feeney, the founder and CEO of the blockchain consulting and development company Labrys. “So this issue attacks the core premise of Ethereum.”
Explaining the crypto sanctions
The U.S. crypto sanctions that are now affecting Ethereum were issued about a month before the merge. As crypto has exploded in value and usage over the past two years, hacks and criminal activity on the blockchain have skyrocketed, too. Regulators started to take notice, and in August, the Office of Foreign Assets Control, (OFAC), an agency within the U.S. Treasury Department, banned Americans from using Tornado Cash, a service that provides anonymity to users. OFAC argued that Tornado Cash was the primary tool used by North Korean hackers in a $600 million hack, and that the program posed “a significant threat to the national security” of the United States.
While crypto evangelists concede criminals use Tornado Cash, they also defend it on ideological grounds, as a huge strength of crypto lies in its autonomy from governmental rule. Several high-powered crypto organizations, including Coinbase, and community members have filed lawsuits against OFAC and accused them of overstepping legal bounds.
But given the slowness of legal processes, it’s unlikely the issue will be resolved in court any time soon. Before that happens, various players in the Ethereum ecosystem have been forced to make their own decision about whether to abide by OFAC’s rules—in the process, betraying the community’s ideals—or potentially risk lawsuits, fines, or even jail time. (In Amsterdam, a blockchain developer was arrested for his connection to Tornado Cash).
Why sanctions are affecting Ethereum after the merge
Before the merge, many Ethereum community members worried that established centralizing entities like Coinbase would be the ones to cave to governmental pressure. But since the merge, a new category of middlemen, called relays, have emerged, and many of them abide by OFAC rules. Relays are programs that help the Proof of Stake validators—watchdogs who safeguard the network—maximize their profit. (You can read more about the technical details of relays here.)
Relays have proven very profitable for validators after the merge, so their usage has steadily increased: roughly 60% of transactions are now routed through them, as opposed to just 10% on the day of the merge, according to Labrys. But these relays also possess the power to approve or not approve certain transactions, so they’re increasingly writing the de facto rules of the road. And the most-used relay by far, called Flashbots, is OFAC-compliant, meaning they won’t approve any Tornado Cash transactions. The result is that a month after the merge, 53% of Ethereum blocks are effectively being censored.
“The number is rising so quickly that it’s hard to keep up,” says Feeney. “As a result of users acting in their own economic self-interest, we’ve found ourselves in this situation where half the network is getting censored.”
Potential ripple effects
Crypto users aren’t necessarily feeling the effects of this. Tornado Cash is routing transactions through non-compliant relays—it takes just twice as long as they did before.
But the real battle is over ideals. Many in the community argue that it sets a dangerous precedent for the network’s autonomy from governmental oversight. “Regulators can look at this and say, ‘All we had to do was ban this smart contract and in three weeks, half the validators complied,’” Feeney says. “They might say, ‘Next, we’ll write a rule that you can’t build a chain with these transactions on them,’ which is hard censorship.”
John Lo, managing partner of digital assets at the investment firm Recharge Capital, is similarly worried. “The product that Ethereum is selling is decentralized blockspace, and there are more centralized alternatives out there that trade off security for speed and performance issues,” he says. “If Ethereum became less decentralized, I would argue it loses a lot of value. They’d be in danger of reverting back to a traditional database system that is no different from Citibank’s database.”
Flashbots has acknowledged the problem, and the Ethereum Foundation and other independent developers are also at work on solutions, but say they’re still far off. Alex Stokes, a researcher at the Ethereum Foundation, described the implementation of technical solutions as a “multi-month sort of project,” saying, “There’s still a good chunk of R&D [research and development] that we need to do to understand what makes sense and how to roll it out.”
“It definitely has everyone concerned,” Stokes says. “But blockchain technology is well-positioned to navigate these mismatches of incentives.”
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