How crypto betting connects to financial censorship

Cryptocurrency exchange Kraken has recently been valued in the crypto world due to its loss to the US Securities and Exchange Commission over the “staking” issue.

Why it’s important: Who can and cannot participate in staking — the process of checking transactions on various cryptocurrency networks — will have implications for another point of tension between blockchains and nation states: international sanctions.

Flashback: Last year, the Office of Foreign Asset Control (OFAC) sanctioned the collection of smart contracts known as Tornado Cash.

• Tornado Cash makes it difficult to connect the sender and recipient of a transaction. It masks them in a large pool of transactions that all go through one neutral smart contract.
• Because it was frequently used by criminals and hostile nation states, OFAC prohibits anyone in the United States and any U.S. citizen from transacting through Tornado Cash.

How it works: Blockchains use a “consensus mechanism” to ensure that all transactions on a blockchain are valid. The most popular mechanism is “proof of stake”, where validators post valuable crypto-assets as insurance against their own misuse of the network.

• Proof-of-stake created an opportunity for investors of all sizes to participate in consensus, by contributing their assets to the stake of validators they trust.
• That way, they could grow their holdings by sharing in rewards, compensation for a faithful validation of transactions.

Last fall, Ethereum became a proof-of-stake blockchain. When it did, many cryptocurrency exchanges (including Kraken) began creating opportunities for their users to participate in proof-of-stake on Ethereum, the world’s second-largest blockchain by value.

The big picture: According to MEVWatch, a site that tracks block censorship on Ethereum, Coinbase and Kraken both easily comply with OFAC sanctions, skipping blocks that touch Tornado Cash or eyebrow-raising Ethereum addresses.

• It would not be possible for large US companies based on connections with the banking system to operate without complying with OFAC.

Yes, but: Kraken agreed to shut down the program last week, because the SEC said the product was an unregistered security (this follows its own previous run-in with sanctions rules). Coinbase has vowed to fight if asked to shut down its own staking offering.

The intrigue: Other validators, with less surface area for US regulators to grasp, do not censor, or do so less.

• Other crypto exchanges, such as Binance, Bitmex and OKX, also frequently post censored blocks.

What they say: “We shouldn’t be too quick to celebrate, as a heavy-handed SEC crackdown could have much larger ramifications for the blockchain sector,” Lachlan Feeney, founder and CEO of Labrys, an Australian blockchain consultancy that created MEVWatch, said in a statement via a spokesperson.

• By Labrys’s reckoning, Kraken proposes about 4% of Ethereum’s daily blocks.

The other side: “The censorship concerns are a bit overblown at this point,” Dragonfly Capital’s Tom Schmidt tells Axios. “OFAC-related transactions can still be mined in less than a minute by other validators.”

What we’re looking at: The proportion of validators ignoring US sanctions guidelines as the SEC drives cryptocurrency exchanges and similar companies out of business.

With the numbers: The proportion of blocks that censor transactions has decreased, according to MEVWatch, but it is still around 50%.

Be smart: Validators are not ideological. If the most lucrative channel to pick up transactions censors them, they’re going to pick up that channel.

• As long as a few validators don’t censor, all transactions can still get through. So, OFAC-compliant validators don’t actually end up really censoring the transactions, but it does add friction.

Our thought bubble: Cryptocurrency was created to be limitless money for the internet. Boundless means global, but it also means politically neutral.

• Who isn’t crazy about politically neutral tools? Politicians.