A Good Summary of Ethereum in the PoS Era

As discussed earlier, Ethereum has been running a Proof of Stake (PoS) protocol for a year now, which has exposed some unanticipated side effects  It’s an exciting experiment, though I’d worry about having a lot of money at risk. 

As an old Illiac IV programmer used to say, “the fun of software is finding out what it does.”

So how is Ethereum doing, overall?

Margaux Nijkerk and Sam Kessler have a good summary in Coindesk’s Consensus Magazine [1].

First of all, the entire point of the exercise was to cut power consumption and emissions.  In this, PoS is a smashing success: “Ethereum’s energy consumption has fallen 99.9%” [1]  Whatever else happens, Ethereum is no longer a ridiculous energy hog that it once was.

Second, like most Nakamotoan cryptocurrencies, Ethereum was highly “centralized”, with a handful of large operations dominating the execution of the PoW protocol. This is not what Nakamoto envisioned, and, worse, isn’t all that different from the bad-old conventional financial systems.  (Except Nakamotoan cryptocurrencies are vastly less scalable than conventional currencies….)

The new PoS has a different mechanism, but has ended up equally “centralized”.  A handful of large operations do most of the validations. So, PoS is “no change” on this dimension.

It’s beginning to look like distributed systems naturally tend to become “centralized”. Who would have expected that?  (Every network scientist in the world.)

But there is more. PoS adds some wrinkles that PoW doesn’t have, because the validators are charged with organizing incoming transactions into blocks, which are submitted for validation.  This process can be optimized in various ways, and sure enough, validators have been optimizing for their own profits. 

This “maximum extractable value”, MEV, process isn’t an official part of the protocol, but it has become ubiquitous.   Worse, it appears that one company has a de facto monopoly on the process.

And worse yet, the sorting and sifting is also an opportunity for “censorship”, and, sure enough, this mechanism has been used to implement US sanctions.  This is definitely not what Nakamoto intended!

A fourth trend is a side effect, the emergence of a large market in third party staking.  I.e., the staking process has been securitized, letting people buy tokens that fund the actual staking process.  This isn’t formally part of the protocol, but it is a pretty predictable outcome.  I mean, if there is anything Etherheads understand, it is tokenization! 

 I’m not enough of an economist to really guess exactly what risks and benefits this extra-protocol layer may have.  But it is true that the basic protocol demands a large minimum stake, which I think is supposed to filter out speculators.  By contrast, the liquid staking tokens have no such filter, which means they enable mass speculation is Ethereum staking.  For better or worse.

Perhaps it is worth noting here that in the original PoS protocol it was difficult to cash out your stake, and these third party tokens were a lot more liquid.  The protocol was updated to make withdrawals easier, but the change had little effect on the liquid staking tokens. People seem to like speculating without the need to do any work in return!

And finally, the PoS protocol not only ties up Ether in stakes, it actually deliberately shrinks the supply of tokens (down .24% in the year).  This was supposed to be “deflationary”, raising the exchange rate of Ether against other assets.  The exchange rate against the USD has been largely unchanged over the period.   Once again, Nakamotoan economics hasn’t actually worked. 

So, the score in this list is, 1 absolute win, 2 major unexpected side effects, and 2 unchanged/no effect.

As is often the case, optimizing for one feature (reducing power consumption) has had unanticipated effects on many other features.

The good news is that Ethereum is so useful that most users have just carried on, regardless of the fiddling with the basic protocol. I’m pretty sure that most people never thing about validation, or for that matter, power consumption.

I guess the bad news is that the side effects are a warning that there may be unexpected gotchas in the future.

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1. Margaux Nijkerk and Sam Kessler (2023) The State of Staking: 5 Takeaways a Year After Ethereum’s Merge. Consensus Magazine,  https://www.coindesk.com/consensus-magazine/2023/09/25/the-state-of-staking-5-takeaways-a-year-after-ethereums-merge/

Cryptocurrency Thursday

Ethereum Milestone: More Than 50% Compliance with Sanctions

This summer, Ethereum finally switched over to the Proof of Stake validation protocol.  The selling point of this change is, of course, that PoS consumes far less electricity than Nakamoto’s Proof of Work.  But PoS is more “centralized” than PoW, and the current implementation of has mechanisms that can allow validators to “censor” transactions.

This year the U.S. Treasury Department’s Office of Foreign Assets Control (OFAC) sanctioned Tornado Cash for trading with prohibited entities.  Blockchains based on Nakmotoan PoW have no ready mechanism to implement such “censorship” (though there are plenty of other pinch points), but the new Ethereum does, sort of.

Which has generated plenty of fiery rhetoric, and more than a little curiosity whether trying to filter out Tornado Cash would actually work.

If I understand correctly, one way it works is at the point of so-called “relays”, which are basically marshalling yards for new blocks.  In the new Ethereum, a transaction is submitted to such a relay, which sorts and packs transactions into batches, and then pushed the block out to the blockchain to be confirmed.

The upshot is that a relay can simply ignore some transactions.  In the face of sanctions, relays operated by organizations subject to US law can simply not process transactions involving sanctioned parties.  Whether they will do so was an open question, as was just how much difference that might make.  Anyone can run a relay, after all, and some are designed to ignore OFAC.

So how is this Ethereum “censorship” actually working?

Apparently, it’s working.

In fact, it looks like in one 24 hour period, more than 50% of the blocks were processed by OFAC compliant relays [1]. With one thing and another, this means that the sanctions are having a growing effect on Ethereum transactions, in that it is becoming more difficult to violate sanctions via Ethereum.  Or, as fundamentalist Nakamotoans put it, “Ethereum doesn’t seem to show any signs of censorship resistance for now”. [1]

The “transparency” of the Ethereum blockchain makes it possible to get a view of whether relays are really enforcing sanctions or not.   Which is useful, because the organizations running relays seem to be weaseling about what is going on.  Nijkerk provides several indecipherable statements from such organizations, which seem to be trying to comply with sanctions while promising not to do so.

At this time, there are a handful of relays that are enforcing the sanctions (as far as we can tell), and they have been extremely popular. I.e., the reported “51%” reflects the popularity of relays that implement the policy.

If so, we are seeing that a lot of people want to use a network that follows these rules, or at least want to stay in good graces with the US government by not mixing with prohibited traffic. So, given the freedom to choose, people are choosing to comply.

Obviously, this situation could change if users shift their traffic to non-complying relays, or the relays change.  So, we’ll have to see.

But for now, for better or worse, it seems that Ethereum PoS is, in fact, partially “censoring” sanctioned traffic.

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1. Margaux Nijkerk (2022) Censored Ethereum Blocks Hit the 51% Threshold Over the Past 24 Hours. Coinbase,  https://www.coindesk.com/tech/2022/10/14/censored-ethereum-blocks-hit-the-51-threshold-over-the-past-24-hours/

Cryptocurrency Thursday

Summer Season in Vitalik’s Happy Republic

Every so often, it’s enlightening to scan the headlines in cryptoland.

In Emperor Nakamoto’s Happy Kingdom, cryptocurrency is decentralized, uncensorable by states or “the man”, and a hedge against inflation.  At least, that’s the way it is supposed to be.  The reality is baffling.

Exchange rates against fiat currency have been down all year, despite significant inflation world wide.  It turns out that Bitcoin actually does behave like gold—which may be a hedge against geopolitical jitters, but generally isn’t a good inflation hedge.

We see an endless series of frauds and oopsies that frequently boil down to the fact that some component of the end-to-end system is, in fact, centralized. 

So, for instance, a domain name service built on Ethereum’s decentralized blockchain is out of service because the name registration has expired [4].  Because the one person who can do it is in prison.  (For sanctions busting in aid of North Korea.)  So, this “Web 3.0” service is not only just as centralized as any other name service, it depends on one person to fill in the paperwork.  Even bad old “centralized” services generally have backup signatories. Sigh.  More on this case below.

In another case, a football trade between teams in Brazil and Argentina paid via a “stable coin”[2].  Aside from the publicity, part of the point was to tunnel through currency regulations and beat the official exchange rates in inflation-ravaged Argentina.  As it turned out, cryptocurrency may be “impossible to regulate”, but football clubs aren’t.  After the crypto transaction, the club will be required to convert to fiat after all, and the overall deal was not really a bargain, or immune from government regulations.

Elsewhere in Latin America, El Salvador is still all in on its state-sponsored Bitcoin project.  While El Salvador doesn’t “print” Bitcoins, it does control its wallet and other infrastructure.  It has also intervened in the markets in many ways, including boosting development projects, tax incentives for foreign investors, and so on. Whatever the results, this whole project is not really following the prime principle that “Bitcoin’s True Value Is Separation of Money and State [3]”, is it?

And most shocking of all, First Citizen Vitalik’s Happy Republic is embroiled in a massive controversy over enforcing government sanctions [1].

Actually, it’s a huge mess. The Tornado Cash gang has provoked governments by flagrantly violating economic sanctions, to the point where a developer is in prison and the US government has sanctioned an Ethereum address.  The latter is being enforced by some on-shore (i.e., law abiding) organizations, including Coinbase (which has its own controversies). 

These unprecedented moves to “censor” specific users has provoked a strong reaction in Vitalik’s happy republic.  I mean, the whole point of using an inefficient and expensive blockchain is because it is supposed to be “neutral” and censorship resistant, right?

Unfortunately, the only thing that can be done about this “censorship” is…to censor the censors.  (?!?)  Adding to the complexity is the impending shift to Proof of Stake.  The counter censorship will involve disciplining the offending institutions (who are, remember, guilty of obeying the law) through the built-in “slashing” mechanism.  If I understand correctly, this cunning design let’s some stakeholders confiscate the stake of other stakeholders.

So…we may soon see First Citizen Vitalik unilaterally confiscating the assets of investors in the name of…Freedom?  Decentralization?  Protecting Ethereum’s brand?

I think I can be forgiven if I am confused. The political economics here is murky, to say the least.  And frankly, I don’t know how this would even work. It is very possible that Ethereum could split into multiple competing versions. If that happens, it can’t be great for Ethereum or all the stuff that is built on top of it.

I’m pretty sure that a filter-versus-filter war will be insanely confusing and destructive and probably won’t accomplish the intended aims.  Nor will forking multiple versions of Ethereum.

How is Ethereum going to square this circle?

One things for sure: with this foundational crisis, I think Ethereum has vaulted into the lead to win this year’s Crypto Tulip of the Year award!

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1. Nic Carter (2022) If Ethereum Starts Slashing, It Burns. Coindesk,  https://www.coindesk.com/layer2/2022/08/25/if-ethereum-starts-slashing-it-burns/
2. Andrés Engler (2022) Two Soccer Teams Transfer a South American Player Using USDC, But There’s Collateral Damage. Coindesk,  https://www.coindesk.com/business/2022/07/29/two-soccer-teams-transfer-a-south-american-player-using-usdc-but-theres-collateral-damage/
3. George Kaloudis (2022) Inflation Hedge or Not, Bitcoin’s True Value Is Separation of Money and State. Coindesk,  https://www.coindesk.com/business/2022/08/28/with-inflation-still-top-of-mind-does-bitcoin-have-anything-to-say/
4. Elizabeth Napolitano and Margaux Nijkerk (2022) Web3 Domain Name Service Could Lose Its Web Address Because Programmer Who Can Renew It Sits in Jail. Coindesk,  https://www.coindesk.com/tech/2022/08/26/web3-domain-name-service-could-lose-its-web-address-because-programmer-who-can-renew-it-sits-in-jail/

Cryptocurrency Thursday