Three reasons why The Merge proceeds at its own peril

“I personally like hard forks. Particularly, I like the fact that they give users a measure of control, requiring them to opt in to protocol changes. Sure, they can be a little more chaotic if they’re controversial, but that’s the price of freedom.”
— Vitalik Buterin

“Within the ranks of the people, democracy is correlative with centralism and freedom with discipline. They are the two opposites of a single entity, contradictory as well as united, and we should not one-sidedly emphasize one to the denial of the other.

Within the ranks of the people, we cannot do without freedom, nor can we do without discipline; we cannot do without democracy, nor can we do without centralism. This unity of democracy and centralism, of freedom and discipline, constitutes our democratic centralism. Under this system, the people enjoy extensive democracy and freedom, but at the same time they have to keep within the bounds of socialist discipline.”
— Mao Zedong, 1957

In 1958, Communist China’s Mao Zedong undertook a comprehensive program to reorganize his country’s agricultural engine into a Communist Utopia by collectivizing the farms. What happened instead was an unmitigated catastrophe that resulted in unprecedented poverty and widespread famine. Estimates range between 15 to 55 million Chinese people died, starving to death in their socialist paradise.

In early 2020 the Ethereum core devs decided that security for the base-layer of the Ethereum protocol would have to move away from Proof-of-Work (mining) to Proof-of-Stake (PoS). This decision is rationalized as an energy efficient, “climate-friendly” way to secure the blockchain.

Ethereum’ s “Great Merge” is borne from similar high-minded aspirations. Proof-of-Stake is ultimately collectivist in nature. Not only that but it is centralized in the sense that staked assets can be appropriated by some authority and “slashed” (seized and burned) if a validator approves a block that is later deemed to be afoul of “the rules”.

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?
— Nic Carter, If Eth Starts Slashing, It Burns.

Those rules… are largely undefined. After the merge happens, nobody with ETH staked will know for sure what the validator nodes they delegated to are ultimately going to do. Anybody who has who staked their ETH by now is already locked in. Even after the merge is complete, there is no timeline for unstaking in place. It could be six to months to a year, according to some reports.

Reason #1: Can Proof-of-Stake be shoe-horned into OFAC compliance?

The Tornado Cash situation is showing us how the new terrain of decentralized  blockchains are a level of abstraction beyond the industrial age regulations like those of the Office of Foreign Assets Control (OFAC). Originally designed to sanction  Specially Designated Nationals and financial institutions, Tornado Cash is now listed as an “entity” under the CYBER2 program.

It isn’t a “Blocked Person” or institution staffed by people, it’s a smart contract. An open source one, at that.

Once Tornado cash (and earlier Blender.io) were sanctioned, huge swaths of the Ethereum ecosystem piled on and started hastily enacting protocol level transaction censorship. It didn’t take long for merry pranksters to demonstrate the futility of this approach by “dusting” wallets of luminaries ranging from Coinbase CEO Brian Armstrong to Shaquille O’Neal with tainted ETH. Have they all violated sanctions now?

Simply remaining on proof-of-work (PoW) … would likely abate the problem. Stake exposes consensus to government will through regulated financial institutions, which are slated to dominate validation, whereas PoW is far more distributed and covert. Switching mining pools is instant and trivial; with PoS, it’s cumbersome. The validator set churns constantly in PoW and there is no hardware bottleneck as Ethereum still uses mostly GPUs.
— Nic Carter, If Eth Starts Slashing, It Burns.

It is worth noting that Bitcoin’s PoW chain has already had a flirtation with these issues. In May 2021, Marathon Digital (NASDAQ: MARA) announced it was the first Bitcoin miner in the world that would be mining only “OFAC compliant” blocks.  There was a loud response to this from within the community outlining the reasons why this was untenable.

MARA proceeded anyway. Less than a week later they scrapped the program and started signalling for Bitcoin’s Taproot upgrade instead.

On its own the uncertainty introduced by OFAC sanctions should at the very least postpone the merge. So far there is no talk of that happening.

Reason #2: Ethereum Hard Fork Risks

Let’s start by saying the preferable way for Ethereum to move from PoW to PoS would have been to do a hard fork. That would have been driven by consensus, free markets and voluntary choice. If Beacon chain is truly a superior, better way to do it, then we would expect the critical mass of users and applications to move there.

Say what you will about Bitcoin Cash, the hard fork that resulted from the Blocksize Wars was exactly the right way to do it. Everybody made up their own mind, nobody was forced onto either chain – participants had the same starting position on each chain, and market forces took it from there.

That’s not what’s happening here. This was decided from on high, and damn the torpedos, it looks like it’s going through. No choice, other than to bounce onto another Layer 1 entirely.

That is unless, there is some manner of rebellion or coup d’état among Ethereum’s miners to run a hard fork of their own. There have been a few rumblings of this.

Where people may hastily conclude that the risk of this happening, and succeeding are small, simply spinning out another Ethereum Classic (ETC) of marginal importance, things could play out differently this time.

I direct to you to two Twitter threads, the first by Miles Suter

1st issue:

ETH miners are contentiously preserving the PoW chain.

Bc DeFi & stables are integral to ETH’s value prop, issuers like USDC essentially select which chain wins & which collapses.

Scary that future forks live or die based on a US company. https://t.co/qUJp7XAG2l

— Miles Suter ? (@milessuter) August 18, 2022

..and the second by Lyn Alden

I’ve seen a lot of people critique proof-of-stake but I’ve not seen many people point out that stablecoin custodians can basically decide the outcome of a hard fork for any blockchain that relies heavily on its DeFi ecosystem for its value proposition. pic.twitter.com/5alHREJsbt

— Lyn Alden (@LynAldenContact) November 29, 2021

…which table the real possibility that in the event of a hard fork that remains on PoW, the decision on which chain actually wins out may be made by some outside entity entirely, like Circle.

Reason #3: What if it doesn’t work?

At a technical level, Ethereum is about to do the equivalent of switching out all the engines on a passenger jet while it’s in mid-flight. Even if they get it right, a large player within the Ethereum ecosystem may get it wrong. If that player is big enough,  it could derail the merge.

In an interview on Bankless, the merge team lead Tim Beiko framed it as a possibility wherein if some large player like Geth (the most widely used Ethereum command line client) messes up, it could impact the system to the point where the Ethereum core devs may have to decide on a hard fork to save the system.

To be clear, he stated he was not worried about Geth in the least, he just used them as an example. It could be any large ecosystem player. I’m not worried about them either, but think: Metamask, Infura, some large Defi or Dex or something hardly any of us have ever heard of but everything uses (the ongoing situation involving the busted eth.link domain is a fitting microcosm here).

The merge itself could go flawlessly and then be derailed by a large ecosystem player having issues.

What To Do About It

Beiko was doing the Ethereum equivalent of Fed jawboning to allay any concerns around the merge. It had the opposite effect for me.

This is not investment advice, but I’m excerpting what I sent to The Crypto Capitalist (our premium letter) on how I’m personally positioning (bracing) for the merge:

• I reduced my own Ethereum exposure, knowing I could miss out on gains if I’m wrong or that ETH can move faster than Bitcoin during an up cycle. I reduced exposure by 70% and added to my stack of Bitcoin (the anchor asset in this space, nothing else compares).
• Real Bitcoin: unwrap any wrapped assets like wBTC (Wrapped Bitcoin) and get it back into its native form before the merge.
• Consider removing any staked, lent, or collateralized assets from any liquidity pools, DeFi applications, yield farms, go back into a non-algorithmic stablecoin, like USDC.
• If you staked any ETH into liquid staking (like Lido or Rocketpool) I’d sell those back into ETH and then do whatever. Reduce into Bitcoin like I did or just leave it in ETH if you think that overall, Ethereum will be fine.

If Ethereum does run ahead of the merge, it has all the makings of a textbook “buy the rumour, sell the news” setup. Even without the aforementioned showstoppers.

From where I’m sitting, the merge to Beacon Chain is almost entirely downside risk, with very marginal upside. To paraphrase Thomas Sowell, “Much of the impetus toward the Ethereum’s move to PoS involves replacing what worked with what sounds good”

I’ve been generally supportive of the Ethereum project from nearly the beginning and my main business has been active in the Ethereum Name Service (ENS) ecosystem since 2017. Gripes aside about gas fees (which won’t be solved by the merge, btw) Ethereum is an ambitious project that provided the rails for DeFi and tokenization which I thought had the potentional to end-run an obsolete banking system.

But this move to Proof-of-Stake seems misguided, taking the wrong path to get to a dubious goal. While Ethereum’s Great Leap Forward won’t result in millions of peasants starving to death, in a worst case scenario it could put about a quarter trillion dollars of wealth at risk or in limbo.

Basketball Entrepreneur, Shaquille “Big Sexy” O’Neal just crossed the line. Here’s the Etherscan page for Shaq’s NFT project showing the sanctioned, illegal transaction. The US Treasury announced sanctions applied to Tornado Cash transactions beginning last Monday. I’m not suggesting that Shaq’s done anything wrong, but this is an example of why the Treasury’s attack on Crypto mixing services via sanctions is unworkable.

Who Gets Invited To The Crypto Mixers?

Mixers are tools within the Cryptocurrency ecosystem that allow users to deposit tokens, combine them with other people’s tokens, and then withdraw to an unrelated wallet. They can be used simply for privacy reasons, or it can be used to hide the tracks of illicit funds.

The US Treasury was obviously focused on the latter when it sanctioned Tornado Cash, with an estimated $455M washed through Tornado over the last few years by North Korean hacker group Lazarus. 

I’m not defending the ability to hack and launder money, but you can walk the line if one can actually be laid down. Lazarus has been a scourge on the Crypto industry since at least 2017 and I would love nothing better than to see them dealt with effectively and severely. But that’s the problem…

The solution to Crypto hacks needs to be effective or there’s no point.

According to Chainalysis’ research on the topic, for every criminal use of crypto mixers, there appears to be a legitimate use. So a large part of the pushback on this round of sanctions is to do with preserving privacy tools in an increasingly aggressive surveillance state that jeopardizes citizens’ legitimate need for privacy in everyday life. 

Privacy is normal and needs to be defended.

Among notable legitimate and extremely necessary uses of privacy tools that have come out since the sanctions announcement are Ethereum founder Vitalik Buterin using Tornado Cash to donate money to Ukrainians. This reduced their risk. Blockchain developers can also use untraceable funds to seed new projects without exposing their entire net worth.

However, this article isn’t about privacy. There’s plenty written about that elsewhere. I’m talking about why sanctions aren’t the right tool for this problem. 

Sanctions Didn’t Stop Party Crasher Lazarus

This isn’t the first mixer the US has sanctioned. In May, the Treasury sanctioned Blender.io, another mixing service that had also been used extensively by Lazarus group. In that case, the sanctions worked well to shut down the service.

They had no meaningful effect on the Lazarus group who simply kept hacking and moved to the next mixer.

Blender.io was a custodial mixer. Users deposited funds into a centralized custodian who would then mix your funds and return them. The people running the service were targeted by sanctions and shut down. 

Tornado Cash is structured differently. Rather than having a centralized custodian making decisions it’s simply a smart contract hosted on the Ethereum blockchain which holds funds prior to mixing and withdrawal. It’s just a piece of code that will continue running indefinitely and doing what it was designed to do. No one that can take it down. It is an immutable smart contract. 

Tornado Cash is Bitcoinesque. It cannot be changed. It cannot be removed. 

The Treasury seems to not really be aware of this distinction. The actual text of the sanctions has identified a range of wallet addresses associated with the smart contract as being prohibited to transact with. Treasury hasn’t identified any specific people or organizations, other than a website that hosts a front end for accessing the service. That makes this the first time the Treasury has sanctioned code, rather than people or corporations.

Enforcement: “Buzzkill” US Treasury Just Doesn’t Get It

How will this be enforced? No one really knows, but so far Circle has frozen USDC currently held in the smart contract awaiting withdrawal. Circle’s CEO doesn’t seem very happy about being forced to do this. There are also significant amounts of Ethereum and Wrapped Bitcoin also held in the smart contract.

BitGo, the issuer of Wrapped Bitcoin can’t freeze their tokens and Ethereum also can’t be frozen at the protocol layer. The only logical way that US based companies like Coinbase can comply with sanctions is to prevent tokens that have been through Tornado Cash from being deposited onto their platforms.

Which raises a huge issue. Because tokens can’t be frozen on the protocol layer, these tokens are free to move around in the Ethereum DeFi ecosystem prior to deposit on Coinbase. Regular users will have a very hard time knowing whether or not tokens that they receive are going to be accepted with major US based companies.

We don’t have any guidance from the Treasury on how this is supposed to be dealt with, but I imagine there are currently extremely frustrated calls between Crypto exchanges and the Treasury department trying to sort out this issue without breaking Ethereum.

The Treasury department might have just accidentally broken Ethereum fungibility.

Do I think that is the likely outcome here? No, not at all. But it does speak to how recklessly uniformed and uncaring the US Treasury is becoming regarding the collateral damage of using sanctions to solve every problem. There doesn’t appear to have been any consultation with major Washington based Crypto education groups like Coin Center and the DeFi Education Fund.

Will the US Treasury be educated enough to make restrictions and reform possible. We don’t yet know how strict the Treasury will instruct US corporations to be about blocking deposits from Tornado Cash. Using blockchain records, it’s perfectly possible to trace Tornado Cash use through several transactions. It’s less possible to do the same through a DeFi system which inherently mixes up funds so that their origin can’t be ascertained.  

The maximum enforcement would be to block all deposits from DeFi because some deposits would have touched Tornado Cash at some point in time.

This highlights how useless sanctioning a medium of exchange really is. Usually transactions with a particular party are the sanctioned activity. This is what it means to have effective measures against cybercrime. These sanctions won’t shut down Tornado Cash and they won’t stop Lazarus Group. They have the potential to cripple Ethereum, if they’re applied strictly. It’s fundamentally a losing game. The USTreasury is playing whack-a-mole with privacy tools. 

So what happens when a government enacts an absurd law that can’t be enforced and doesn’t really make any sense?

People immediately break the law.

Guilty By Association: Shaq, Fallon And Others Get Dusted

Numerous celebrities and notable Crypto figures including Shaq, Jimmy Fallon, Brian Armstrong the CEO of Coinbase, Crypto Exchange cold wallets and numerous others got dusted by Tornado Cash transactions.

Dust attacks aren’t new, they’ve been around as long as I’ve been in Crypto. They describe when a wallet gets sent useless or harmful tokens without their consent. There is no need to accept Crypto transactions, they just show up when someone sends them to your wallet. 

Someone with a balance held in Tornado Cash started sending small Ethereum transactions to a range of known celebrity wallet addresses without their approval or knowledge. On the first day of sanctions over Tornado Cash. 

Did Shaq violated sanctions? Arguably yes.

Sanctions violations are strict liability offenses. There doesn’t need to be any intention to perform a transaction with the sanctioned party. There doesn’t have to be any benefit gained by transaction. All that needs to be shown is that a transaction occurred.

There is a defense that best efforts were taken to comply with sanctions. The prosecuting body will look at what steps were taken to avoid breaching sanctions, that will affect their likelihood to prosecute and the severity of the punishment. But what could Shaq have done to avoid breaching sanctions?

There is nothing that anyone could have done to avoid breaching sanctions by receiving unsolicited Tornado Cash transactions.

Obviously Shaq and Jimmy Fallon are not going to get prosecuted for sanctions violation because someone else sent them some Ethereum, but the fact that these celebrities will need to be excused for something that is arguably a breach of US sanctions according to the letter of the law is a big problem. 

If The Rules Are A Bluff, What Happens Next?

The sanctions are at best ineffective. Tornado Cash is the second mixer that has been sanctioned because it was used by Lazarus. The first set of sanctions just meant that Lazarus moved to using Tornado Cash instead of Blender.io. I imagine that due to the lack of enforceability of this round of sanctions, they won’t even stop Lazarus from using Tornado Cash as their mixer of choice. 

Will it change how Crypto exchanges treat mixed funds? Unlikely. Major US exchanges already had a responsibility to refuse shady deposits under existing anti-money laundering provisions. There were already reports earlier this year of Coinbase refusing to credit deposits directly from mixers or funds that had recently been through a mixer. 

What is the point of sanctioning Tornado cash if it doesn’t shut down the service or slow down Lazarus group?

Well it will likely prevent law abiding US citizens from accessing a financial privacy tool for non-criminal purposes. Fight for the Future compared the sanctions to banning email because it can be used for phishing scams. The Cato Institute noted that “Punishing every American by going after technology is not the solution for dealing with criminals”.

Banning mixers to stop cyber crime is like digging up roads to prevent carjackings.

I’m much more concerned about the big picture problems with this style of enforcement. The demonstrated lack of basic understanding of how this technology works and what they are doing at the Treasury department is frankly terrifying. 

It’s one thing to deliberately destroy Crypto ecosystems with regulation. It’s an entirely different thing to do it by accident. 

The Ethereum blockchain is open and readable. There are numerous firms and hobbyists who monitor transactions. All eyes will be on Tornado Cash to see if it continues to operate or if the sanctions shut it down. In the day after the sanctions came into effect almost $3M moved through Tornado Cash.

Sanctions are a powerful tool, but they are completely unsuited to dealing with decentralized or ungoverned entities like Tornado Cash. There is no one for the government to threaten here. There’s just users accessing open source code to assert their privacy. 

If the US Government is going to bluff, I’d prefer it if the entire world couldn’t see that bluff fail in real-time.