What’s the Role of Validators in Handling Illicit Crypto Transactions? (Part 1- Block censoring)
In November 2023 I penned a piece for Twinstake around the potential tactics an illicit actor may use within the staking space to steal funds from other stakers, cause them disruption or to launder their illicit funds through permissionless staking providers: https://www.twinstake.io/reports/illicit-threats-in-crypto-asset-staking-choosing-an-institutional-provider-to-mitigate-the-risks
In these examples I was considering a malicious actor as the staker, however it’s also possible that a perfectly legitimate staker or validator may be impacted by illicit actors’ activities on the blockchain and the question is therefore — what level of responsibility does or should a validator have for processing illicit-linked transactions?
There are a few scenarios in which this may be the case, and in this piece I will explore the illicit transactions and the current approach and situation with block censoring.
Transactions which include illicit actors
The Office of Foreign Assets Control (OFAC) has added more than 350 crypto addresses to its Specially Designated Nationals and Blocked Persons List (SDN List). This is a list of entities, individuals and now also software, which US persons cannot interact with or they have breached international sanctions violations and risk a hefty fine or even imprisonment.
Crypto businesses who operate in the US or who want to have dealings with US businesses or people must also abide by the OFAC sanctions list and so block any transactions involving anyone on this list.
Traditionally, the names of entities and people would be checked against this list (and other countries sanctions list) as part of customer onboarding through what’s known as a ‘PEPs and sanctions check’ — cross checking official lists to ensure they are not a politically exposed person or on a sanctions list. When OFAC added the first crypto address to the SDN list on November 28th 2018 it meant that anyone who interacted with the Bitcoin addresses 149w62rY42aZBox8fGcmqNsXUzSStKeq8C and 1AjZPMsnmpdK2Rv9KQNfMurTXinscVro9V would be committing a sanctions violation. In response, crypto businesses had to ensure they were checking their new customers were not connected to these addresses, and that no existing customer activity was to or from these addresses. These checks were most often facilitated by crypto compliance firms, like Elliptic, TRM Labs and Chainalysis who can trace through the blockchain and understand what addresses had sent or received funds from what other addresses. This became especially important as more addresses were added to the SDN list (there’s now over 350) and with the use of bridges, cross chain swaps and more complex defi dapps which allowed users to swap assets and hop across chains — often in an attempt to conceal their illicit activity and connections.
However whilst it may be clear that individuals and businesses who send or receive cryptocurrency cannot interact with OFAC designated crypto addresses, the situation is a little less clear for miners and validators.
In 2021 OFAC provided industry specific guidance for the “virtual currency industry” but this included scant mention of miners and no specific mention of validators.
Instead there are references to firms that “…process transactions…” and “… provide … technological support…”:
“As a general matter, U.S. persons and persons otherwise subject to OFAC jurisdiction, including firms that facilitate or engage in online commerce or process transactions using digital currency, are responsible for ensuring that they do not engage in unauthorized transactions prohibited by OFAC sanctions, such as dealings with blocked persons or property, or engaging in prohibited trade or investment-related transaction”
“Additionally, persons that provide financial, material, or technological support for or to a designated person may be designated by OFAC under the relevant sanctions authority.”
https://ofac.treasury.gov/faqs/topic/1626
The reference to ‘miners’ is within their 2021 nicely designed powerpoint presentation in which they state: “All companies in the virtual currency industry, including technology companies, exchangers, administrators, miners, and wallet providers, as well as more traditional financial institutions that may have exposure to virtual currencies or their service providers, are encouraged to develop, implement, and routinely update, a tailored, risk-based sanctions compliance program. Such compliance programs generally should include sanctions list and geographic screening and other appropriate measures as determined by the company’s unique risk profile.“ https://ofac.treasury.gov/media/913571/download?inline An interpretation of this guidance seems to be that anyone who processes transactions; miners and validators, could be held responsible if it is found that they have facilitated transactions for entities or companies or specific crypto addresses on the SDN list.
In response to concerns about this potential responsibility, some Bitcoin miners announced they would be censoring their blocks to not include transactions which involved addresses on the OFAC SDN list.
However just two years later Marathon announced that it was shutting down this service. It’s CEO said “Marathon is committed to the core tenets of the Bitcoin community, including decentralization, inclusion, and no censorship,”
In the Ethereum world, the question of OFAC censorship came to the fore when in August 2022 the popular ETH mixing service Tornado Cash was added onto the SDN list. This marked the first time that software, rather than a person or entity, was added to the list and left many crypto firms scrambling to understand and try to mitigate their sanctions risk since most users were connected to Tornado Cash, if not directly but only a few ‘hops’ away.
https://twitter.com/ElBarto_Crypto/status/1558428428763815942
I’ve previously written about the legitimate uses of mixers: https://www.linkedin.com/pulse/what-legitimate-use-cases-using-mixer-tara-annison/ but in the case of Tornado Cash, there was overwhelming evidence that North Korea, and other bad actors, were using it for nefarious purposes, and as a result it was targeted by OFAC for inclusion on the SDN list.
Many Ethereum validators responded by connecting to OFAC compliant relayers — entities who only supplied them with blocks that did not include any addresses which were on the OFAC SDN list. This initially led to a notable spike in censoring activity on the chain with, at one point, around 70% of all blocks validated being OFAC compliant.
This has since decreased and now sits at around 40%: https://www.mevwatch.info/ which means that anyone looking to transaction with Tornado Cash can still get their transaction processed but it will likely be sat in the mempool for longer until a non-OFAC compliant relayer or validator picks it up.
Validators can currently choose from a suite of relayers, some offering OFAC compliant blocks and others prioritising rewards and the tenet of decentralization and no censorship. However a recent announcement from BloXroute stated that they were moving all their relayers to OFAC compliance and would block any transactions including SDN listed addresses. There has also been some suspicion that some Bitcoin mining pools are secretly censoring blocks without their pool participants approval or knowledge.
https://github.com/eth-educators/ethstaker-guides/blob/main/MEV-relay-list.md
It remains unclear whether regulators will seek to take action against validators who process transactions including SDN listed crypto addresses — they haven’t yet but that’s no future guarantee!
However this could very well be a slippery slope with regulators pressing validators and miners to block transactions involving other parties they deemed ‘illicit’ or ‘unfavourable’. This could be an opposing political party in a dictatorship, women or other marginalised groups in a country which deems them as inferior, activist and journalists who seek to share information and truths in an oppressive regime, and any other number of people and groups who seek to challenge the status quo. It would be a challenge against the very foundations of crypto and what Bitcoin was created to achieve — a decentralized financial system which couldn’t be shut down or censored by any individual, entity or government. In line with this, many within the crypto industry are calling for credible neutrality and no censorship at the protocol level e.g for miners and validators, and instead any compliance based actions to sit at the application level only.
To draw a comparison with the cloud-provider world. There is no (public) information to suggest that cloud providers like AWS or GCP have ever been held responsible for the actions of their customers in any sanctions related activities. Should this change then arguably the likes of visa and mastercard who provide the rails for credit and debit cards, freehold building owners, travel providers such as TfL and anyone else who provides infrastructure in the broadest sense could be held liable for a sanctions individual or entity making indirect use of their offering.
