Up Only Was Not Resumed

Over the past three weeks, we have seen ‘scam’ pumps and dumps, especially on the weekends. Generally, the market will skew towards one side after the close of the US markets on Friday, before stabilizing on Monday. Both the US stock market and crypto have been moving together hand-in-hand. We saw a bullish bias since 1st August but have now reverted to dump central. This pattern indicates very low liquidity during the weekends, which leads to solid price movements during buys/sells. Over the weekend, we saw a massive correction, slicing through support, including everyone’s favorite 200 WMA for BTC. 

Source: TradingView

Friday alone saw $560M worth of longs liquidated across crypto, the highest for the month. 

Source: CoinGlass

A likely catalyst for this was the expiration of $2.1T worth of monthly US options during the same day. Many anticipated increased volatility and sold ahead of time to mitigate risk. The debate is out on whether these call-option holders will roll them forward. Selling them and buying new ones with later expiry dates will require more capital and, therefore, more risk. Pundits believe that the market can go both ways, and it would heavily depend on the Fed’s direction. If the Fed continues to ramp up its hawkish behavior, everything will likely dump. However, if the Fed becomes more dovish in response to slowing inflation, bidders will be under pressure to revive the rally, given the size of sidelined capital. 

For the most part, we have discussed the price action from a largely macro-oriented point of view. However, there are other ways to interpret this. During bear markets, buyers/HODLers dry up as everyone expects the price to dump further. With no bidders left in the market, capitulation leads to drastic price drops. There are not many new prevalent market narratives/events, for now, to lead to reactionary price movements (other than the options expiry), which suggests that existential fears over the imminent/current recession remain unchanged. In other words, HODLers got bored/tired of waiting for that pump and exited the market.

The contrarian view is that market makers (i.e. whales) are manipulating the price for more accumulation. By removing their bids and dumping, they can scare people off and buy your coins for cheap. Some hopium for those interested in the TA side of this angle can be seen below: 

#Bitcoin / $BTC

Another day accumulating in the $21K range, and another day where the doom prophecies on your feed aren't being fulfilled.

Patiently waiting for a bit more accumulation before the bounce / reclaim of early August highs, and then $28K+. pic.twitter.com/8wkKGc0nyA

— K A L E O (@CryptoKaleo) August 21, 2022

Surprisingly, ETH fared much worse and dumped from $2000 to $1540, despite muh Merge. ETH/BTC peaked at 0.082 and is now 0.074.

One possible reason for this, beyond the macro side of things, could be the growing censorship concerns discussed further below.

Can Blockchains be Censored?

The recent US OFAC sanctions on Tornado Cash, as well as addresses of certain users of Tornado Cash, have triggered widespread discussion across the industry as to whether such sanctions should be honored and implemented on blockchains. 

Firstly, let’s get some basics out of the way. On Ethereum, at least, only addresses can be reasonably sanctioned, not ERC20 tokens coming out of specific addresses. While you may have heard talk of “virgin ETH” or “tainted ETH,” the reality is these are complex to keep track of as an address may have received and sent ETH / ERC20 tokens to and from multiple sources. They are entirely fungible - once they enter a pool of similar assets, there’s no way to differentiate “tainted ETH” from normal ETH.

However, even when we talk about sanctioned addresses, there are further nuances and levels of a dApp at which an address can be sanctioned or excluded. 

Front-End Layer Blocking

Almost immediately following the announcement of sanctions, various projects began to disallow these addresses to interact with their smart contracts via the “official” front-end, i.e. usually a website or widget. These included protocols such as Aave, Oasis, Uniswap, Ren, and Balancer. dYdX, which currently operates a hosted matching engine, has also implemented compliance controls that prevent sanctioned addresses from trading on dYdX. Most of these front-ends rely on an API from TRM Labs to identify sanctioned addresses before proceeding to blacklist / block their access. 

It’s important to note the distinction between blocking via the official front-end vs at the protocol level. Most of these projects have legal entities that host these front-ends, and these legal entities need to comply with US OFAC sanctions. These front-ends are off-chain - either hosted via IPFS or another website hosting service. However, the actual on-chain protocol and smart contracts are not censored, meaning that any address can (for now) still interact with the smart contracts directly if they know how to do so. Technically it's also possible for anyone to host their front-end for their favorite DeFi protocol, and the codebase for some DeFi front-ends are actually open-source to encourage this. 

Everyone flaming DeFi companies for using compliance tools should host the Uniswap frontend on their domain with no blocking

It’s easy to do

— Antonio | dYdX (@AntonioMJuliano) August 13, 2022

The Case of USDC and Centralized Stables

Centralized stablecoins such as USDT, USDC, and BUSD are significant parts of the industry. With USDC being the main centralized stablecoin on Ethereum and its issuer Circle regulated in the US, it was no surprise that they were also required to comply with the sanctions. Jeremy Allaire, the CEO of Circle, gave a lengthy explanation for restricting the movement of USDC from the sanctioned addresses. 

1/ Yesterday, US Treasury designated for sanctions ETH addresses associated with Tornado Cash. As a US regulated FI subject to Bank Secrecy Act (BSA) requirements, Circle, together with our partner @coinbase, restricted the movement of USDC funds in these sanctioned addresses.

— Jeremy Allaire (@jerallaire) August 9, 2022

Tl;dr they have no choice but to comply if they want to continue to operate in the US. Centralized stables are a unique case where the issuers have programmed the tokens such that they can “blacklist” certain addresses. Once an address is blacklisted, it is no longer able to receive USDC or transfer the USDC it holds on-chain to a different address. The blacklist was explicitly implemented to comply with court orders or sanctions. Other centralized stables, such as USDT, also have similar blacklist functions.

These latest developments have obviously ignited more discussions on the need for a truly decentralized stablecoin. We covered what this could mean for MakerDAO in light of Circle freezing the USDC in sanctioned addresses last week. However, we expect more sanctions to continue to spur more discussion and developments in the decentralized stablecoins space.

Censorship at the Protocol Layer

Most of the discussion surrounding blockchain censorship has centered around the protocol layer. To be clear during the block-building process, because of block size constraints, miners or validators can choose to arbitrarily include any transaction within the mempool into a given block, and it is up to the consensus mechanisms to resolve whether the said block is accepted onto the chain. This means miners or validators could permanently exclude any transactions coming from OFAC-sanctioned addresses. For example, Marathon Digital, one of the public listed US-based Bitcoin miners, used to run an OFAC-compliant mining pool before shutting it down due to community outcry. 

However, given that we are so close to Ethereum’s transition from Proof-of-Work to Proof-of-Stake, there are still nuanced differences between PoW and PoS. The BitMEX Research team did a good analysis here, but in effect, a PoS validator has a much more granular choice on how they choose to comply with OFAC sanctions

Source: BitMEX Research

Depending on what the majority of the validator network chooses to do, there could be significant ramifications for the chain itself. For example, a scenario where a certain segment of validators are actively censoring transactions could lead to: 

• Slower network finalization times

• No actual effective censorship of targeted users, just a slightly delayed experience

• Less staking from large financial institutions and lower overall levels of coins staking, resulting in higher yields

The Ethereum community, who are largely against censorship and advocating for a fully open and permissionless chain, have already asked validators to signal their stance towards protocol-level censorship. 

It's a hypothetical we hopefully won't actually face. But if we did we'd go with B i think. Got to focus on the bigger picture. There may be some better option (C) or a legal challenge as well that could help reach a better outcome.

— Brian Armstrong - barmstrong.eth (@brian_armstrong) August 17, 2022

Of the major validators, only Coinbase and Lido thus far have committed to non-censorship. In contrast, the rest of the major validators Kraken, Binance, Staked.us, Bitcoin Suisse and Stakefish have not indicated either way.

A poll was also conducted on how the community will react to validators who actively implement censorship. 

Question for the Ethereum community. If a majority of stake chooses A in this poll, will you:

X) Consider the censorship an attack on Ethereum and burn their stake via social consensus
Y) Tolerate the censorship https://t.co/Mf48co37jK

— Erica Wall X 🏴 (@ercwl) August 15, 2022

At the time of writing, 61.2% out of 9,584 respondents to the poll indicated that they were in favor of Option X, and that they would be willing to burn their stake via social consensus. Notably, Vitalik himself voted in favor of this option. There are multiple ways that such a burn could be done:

• Once ETH unstaking is available, the community can immediately unstake from these validators, thereby reducing their influence over the chain's consensus.

• More drastically (and perhaps the only option before unstaking is implemented), a User Activated Soft Fork (UASF) can be initiated to slash and burn the censoring validator’s stake. This would represent a nuclear option for the community as it breaks the principles of openness and permissionless for validators to combat what the community considers an attack against the network.

Current Thoughts

“Talk is cheap”, and while current pronunciations are all well and good, it remains to be seen how each party at every level will react when confronted with the authority of US sanctions. Efforts are underway by crypto lobbyists in the US to reinforce users’ right to privacy and to push back against overzealous censorship. In the doomsday scenario where the authorities call for protocol-layer censorship, and the chain is unable to resist or repel such efforts, it would crush one of the core tenets of the space as a whole, and that could be a body blow that it could never recover from. 

Looking at the bright side, this event has renewed the community’s focus on decentralization and how far more the space needs to go to achieve its tenets of genuine openness and permissionless access. Even at the front-end layer, people are talking about running multiple front-ends or creating decentralized front-ends that are more censorship tolerant. At the protocol layer, this event has resulted in Flashbots accelerating the open-sourcing of its MEV-boost relay code. These are challenging scenarios, and it’s good that the community gets to discuss and formulate possible solutions before the authorities become even more aggressive.

Ultimately, tech is only part of the solution, and the battle also needs to be waged not just in the arena of public policy but also in the realm of public opinion. If it comes down to having to slash censoring validators, individual stakers must be willing to take some losses from their stake to uphold the core principles of the space. It is not hard to imagine that drastic actions such as these are highly divisive and could result in a splintering of the community. From a public policy perspective, the challenge to educate policymakers continues while also advocating for the community’s shared values of openness, permissionless access, and right to privacy.

Other Things We're Watching

1. Overall, the regulatory climate is heating up. The CFTC and SEC continue to fight over the right to regulate crypto within their respective jurisdictions. Censorship is becoming a reality on Ethereum. And to top it off, Canada has capped the amount of ‘dangerous coins’ that a user can purchase on CEXs at $30k - the only exceptions are BTC, ETH, LTC, and BCH. Canadian regulators effectively choose which coins are ‘safer for consumers to buy’ without clear explanations. 

2. On the macro-economic front, it’s a quiet week for macro as the Fed conducts its annual off-site retreat to Jackson Hole. Chairman Jerome Powell is scheduled to speak during the conference on August 26, Friday morning, where he is expected to reaffirm the Fed’s resolve to combat inflation through rate hikes and QT.

This article was produced in collaboration with Zhong Yang Chan. You can follow him on Twitter here.