There’s a lot of confusion on this subject so I thought this would be worth posting.
After the merge, US based validators (PoS stakers) may be prevented from validating OFAC sanctioned transactions (e.g. tornadocash) if the US government decides so. Currently it is unclear whether this is the case. Anyone exposed to these sanctions will err on the side of caution to avoid jail time. Example – ethermine have been censoring TC sanctioned transactions for a week already (Bitfly who own ethermine will also be operating validators after the merge).
There is a very large portion of stake that would be exposed to these sanctions including some very large centralised actors such as Lido, Coinbase and Kraken. These 3 alone hold roughly 45% of all staked eth. There is not enough time for all of their stakes to exit the network due to the exit queue mechanism. If lido and coinbase both try to exit it would take about 2 months for all the validators to be removed from the list of validators. Until you’re removed from the list you are expected to validate and are subject to penalties if you don’t.
These validators will be forced to either 1. violate OFAC sanctions, 2. censor the transactions, or 3. abstain on blocks with sanctioned transactions. The board of Lido, Coinbase etc. are not going to prison for the good of Ethereum so we can safely rule out option 1 – despite what they may say on twitter. If they take option 2 and censor, their stakes will get slashed (they lose 50% of their customer’s funds) and their validators get kicked off the network. If they take option 3 abstaining, they will also bleed out due to a penalty called inactivity leak, losing 50% of customer funds, and get kicked off. Inactivity leak is normally a very minor penalty, however if more than 33% of validators are inactive it gets much more severe (because this prevents block finality) and after 21 days, 50% of funds are lost and you are kicked off. Because so many validators will be exposed to the sanctions it is highly likely the severe leak penalty will be applied.
The 4th option is to fork into a censored ethereum chain. It is very likely that their customers will start screaming for this when they see their eth stakes melting due to penalties (slashing/leaking). Ok, so what you might ask, if they want to run off let them.
The problem is the stablecoins. If US validators fork off into censored-eth, the supply of USDC/USDT will have doubled, but Circle and Tether collateral has not. The stablecoin operators will have to choose a chain to support with their collateral. Unfortunately, it is again very likely that Circle, and probably Tether also, will opt to support the censored chain – this is because, as we all know, a lot of the money in the market comes from the USA. Stablecoin operators are already in the spotlight and they would likely see even more intense scrutiny if they were to instead support the uncensored chain. Both Circle and Tether are exposed to US law.
On whichever chain the stablecoin operators abandon, the entire defi system will immediately implode. Stables are used for collateral almost everywhere you look. They will become worthless on the chain they abandon.
Unfortunately the OFAC sanctions have come at the perfect time for this to be a problem It is too late to prevent this because of the exit queue system in place for validators, and the merge only being a month away. The only way to 100% guarantee this scenario does not play out is for the merge to be delayed again AND for Lido, coinbase and Kraken to voluntarily exit their stakes. An issue with this is that their boards are legally obligated to act in the vests interests of their companies (and not their customers, or ethereum). Lido essentially shutting their business down flies directly in the face of this fiduciary obligation. It’s hard to say how that will play out.
So we may be left with an uncensored eth that is in tatters because the stablecoins have abandoned that chain, and a censored chain that is essentially subject to the will of the US government – something Ethereum was specifically meant to avoid.
Right now the best thing we can do is look for ways to prevent this. I would start by campaigning for Lido etc to exit their stakes ASAP to prevent this situation. And unfortunately would ask the eth devs to push the merge back one last time for the greater good.
