Paradigm Base Layer Neutrality Study: Impact of Sanctions and Censorship on Blockchain Infrastructure
Original title: "Paradigm: In-depth analysis of the impact of sanctions and censorship on blockchain infrastructure"
Original author: Rodrigo Seira, Amy Aixi Zhang, Dan Robinson, Paradigm
Original compilation: Skypiea, the way of DeFi
On August 8, 2022, the U.S. Department of the Treasury’s Office of Foreign Assets Control (OFAC) will cooperate with Tornado ; Certain Ethereum addresses associated with Cash, an open-source privacy protocol on Ethereum, were added to the list of Specially Designated Nationals and Sanctioned Persons (SDN List). Since the announcement of this sanction, many participants in the encryption base layer have expressed concern that they may be required to monitor or review blocks involving SDN-listed addresses to comply with the sanctions, compromising the neutrality of the base layer and compromising its integrity and core functionality . However, we believe that under current OFAC guidance, base-layer actors are not required to monitor or vet these addresses as part of a risk-based sanctions compliance program.
Specifically, while the sanctions law raises new legal issues for the application of decentralized blockchain systems and smart Tornado Cash sanctions and blockchain address sanctions should not require blockchain technology infrastructure providers, including builders, mining pool operators, relayers, searchers, orderers, and validators to monitor or review transactions involving sanctioned address transactions.
A problem raised by the application of mainly financial and transaction-oriented economic sanctions is the behavior of the encrypted block production base layer - even when sanctioned addresses are involved — whether it amounts to "facilitating" a transaction, or processing or "contributing" or providing funds, goods or services to or for the benefit of any Sanctioned Party or a Sanctioned Party.
We believe that publicly recording the order of data blocks at the infrastructure layer is no more "facilitative" than the existing communication infrastructure that routes financial information around the world on a daily basis Transact, deal with sanctioned parties, contribute or provide services, whether through Internet service providers, routers, network switches, email and chat programs, DDoS filters and other network security protocols. In our view, the fact that cryptographic base-layer infrastructure decentralizes by distributing essential functions to independent actors makes it even less likely that each actor's behavior will reach this threshold.
Furthermore, requiring a cryptocurrency's base layer to monitor or review blocks threatened by sanctions compliance obligations could lead to network reorganizations and forks thus threatening to the viability of the ecosystem. Traditional communications and Internet infrastructure have long recognized similar risks. The outcome would harm national security interests by advancing the development of offshore blockchain technology and hindering efforts to track encrypted transactions, an outcome that runs counter to OFAC’s stated goals and President Biden’s executive order issued in March.
Sanctions are a tool to deter hostile actors, not to disrupt technological infrastructure or public goods. This holds true for encryption as well as other technologies. For example, it is widely believed that the public switched telephone network and the switching centers that allow global telephone communications do not filter communications and exclude sanctioned persons. The same argument applies to the infrastructure of the Internet, such as Transmission Control Protocol/Internet Protocol (TCP/IP) and Internet Service Providers (ISPs). Crypto's base layer is no exception.
We hope that the analysis in this article will ease the uncertainty plaguing industry players and clarify the scope of sanctions compliance obligations. We first describe the base layer of encryption and its actors (Section 1), and then discuss OFAC's legal authority (Section 2). We then discuss why we believe that OFAC compliance obligations to date have not required base-layer participants to monitor or review public records of the order of data blocks (Section 3), with the unexpected implications of applying sanctions compliance obligations to base-layer participants. Consequences (Section 4), and the historical treatment of other technology infrastructure by US regulators (Section 5).
1. The "base layer" of Crypto
Blockchain can be viewed as a A timestamp service that allows data to be ordered in a canonical manner. A fundamental feature is that anyone can submit a chunk of data to be time-stamped and recorded in the blockchain. This could support ledgers for digital assets like Bitcoin, among other applications including trustless protocols that eliminate counterparty risk and new social coordination mechanisms.
Like the telephone network, at the heart of the base layer of encryption is the communication protocol and technical infrastructure as a public good. Its key function—publicly recording the order of data blocks—is analogous to the role we expect the base layers of Internet infrastructure to play, disseminating information freely and accurately to the public. In order to maintain its utility, the base layer of encryption must also maintain its neutrality.
While the key functionality of the blockchain is simple, the infrastructure to deliver it in a distributed, scalable and secure manner is becoming increasingly complex, And it is constantly changing as the ecosystem grows and new technologies are developed. Many blockchains have assigned processes to various base layer participants with specialized roles, including builders, pool operators, relayers, searchers, orderers, and validators.
Each base layer participant plays a specific role in the ordering and attestation of new blocks. But as we explain further below, we believe that the actions of these base-layer players should not be construed as dealing with sanctioned persons or facilitating transactions. Compared with traditional infrastructure such as Internet Protocol, blockchain further decentralizes core computing functions by distributing them to participants who play specific roles. We believe that decentralization makes the actions of each individual base layer participant less likely to require scrutiny than in traditional infrastructure.
2. The US government has legitimate national security interests in imposing sanctions in the field of digital assets
Sanctions can be an important tool in protecting America. One of OFAC's key tasks in responding to threats from hostile actors such as North Korea is to enforce "economic and trade sanctions based on U.S. foreign policy and national security objectives."
Once a party is identified on the SDN list, "U.S. persons" are prohibited from "transacting" with them and the sanctioned party is "owned or controlled" by the U.S. All property and interests in property within or subject to U.S. jurisdiction may not be "assigned, paid for, exported, revoked or otherwise dealt with". The ban also prohibits facilitating transactions, including providing "services" to any such parties.
OFAC has a history of imposing sanctions in the digital asset space. OFAC first sanctioned blockchain addresses in November 2018, when it added several bitcoin addresses controlled by Iranian nationals to the SDN list. OFAC also recently sanctioned Blender.io, a centralized custodial cryptocurrency mixing service run and controlled by a few identified participants.
However, OFAC broke new ground in August by making Tornado Cash bytecode or smart contracts (a specific, widely used copy of the Tornado Cash protocol) Ethereum addresses stored on Ethereum are added to the SDN list. Previously, additions to the SDN list were wallet addresses owned or controlled by sanctioned individuals or entities. As mentioned above, Blender.io also operates under centralized control.
Since E.O.13694 allows the U.S. Department of the Treasury to take action only against the property and interests in property of "persons" or "entities," OFAC's actions against smart contracts -- its The core, just lines of bytecode -- has been questioned by legal analysts and has been the subject of recent litigation.
3. Sanctions laws should not require participants in the cryptographic base layer to review public records of data block order
In this section, we analyze two potential sources of direct sanctions liability: (a) enforcement actions targeting persons subject to U.S. jurisdiction for conducting or facilitating transactions, or dealing with sanctioned parties on the SDN list and (b) potential additions to the SDN list itself. We conclude that, under current OFAC guidance, a risk-based sanctions compliance program does not require a base layer of encryption to monitor or review blocks of data that may include sanctioned addresses.
(a) Crypto's base layer should not be the subject of law enforcement actions that publicly record the sequence of data blocks involving sanctioned addresses
When OFAC adds a party to the SDN List, any property or interest in property in the United States or within the "ownership" or "control" of that sanctioned party in the "United States." person" must be "blocked" and not "assigned, paid for, exported, withdrawn or otherwise dealt with". IEEPA makes it illegal to violate these prohibitions and "procure" others to do so.
Against this backdrop, OFAC has taken the position that "facilitating" sanctions violations is prohibited. This includes "the provision of funds, goods, or services by or for the benefit of any person, or the blocking of property and interests in property." OFAC understands these prohibitions broadly to include U.S. persons who are directly or indirectly involved Situations where a non-U.S. person is "facilitated" or "supported" in a transaction by a sanctioned country or party.
Notwithstanding OFAC's broad powers, we believe that participants in the cryptographic base layer do not need to monitor or review what might be included as part of their risk-based compliance program Part of the data blocks of sanctioned addresses. At no time will any individual base layer participate in "owning or controlling" property or an interest in property of a sanctioned person. These terms are not defined in OFAC's implementing regulations or enforcement actions, and thus should be based on simple terms requiring the authority to "hold property within one's own authority" or to "govern" or "manage" property. However, base layer participants lack this influence or power over digital assets.
Crypto's base layer participants also cannot "block" property or interests in property of sanctioned parties. The fact that certain participants may be forced to censor blocks does not mean they have the ability to limit the underlying property.
The censorship applied to the base layer of encryption amounts to an inability to report transactions; not the ability to "block" it. Regardless of the actions of any individual participant, whether or not a transaction is confirmed will depend on a broader global network consensus. For example, a transaction screened by one base layer participant could be picked up by a non-censored participant anywhere in the world, or cause a network fork, as discussed further below.
Nor will any individual base layer participant transfer blocked property by acting out their role in the public record of the block order, even if a subject is involved Sanctioned address. As clarified in OFAC's implementing regulations, the prohibition on "assignment"40 of frozen property is aimed at the transfer or alteration of legal rights to property, and historically excluded the operation of technological infrastructure (such as telephone networks). 41 While some actors in the base layer of cryptocurrencies (such as miners) collect fees from users, these fees are similar to Internet network fees or telephone service fees.
We also believe that interpreting the actions of encrypted base layer actors as handling blocked property, facilitating its transfer, or providing services to sanctioned parties is different from previous OFAC regulations and enforcement history are inconsistent. OFAC regulations state that "facilitation" does not include activities of a purely clerical or reporting nature, nor does it include further trade or financial transactions. The core functionality of the Crypto base layer - the public and decentralized record of the order of data blocks - should be treated as such. In addition, to our knowledge, OFAC typically takes enforcement action when a subject is also responsible for other culpable conduct, such as using a financial institution as an agent.
For these reasons, we believe that as part of a risk-based sanctions compliance policy, base layer actors need not monitor or review Block, nor should it be the subject of sanctions enforcement action for failure to do so. In its guidance, OFAC recommends using a "risk-based approach" to designing a compliance program. OFAC states that “there is no single compliance program or solution that fits all situations or businesses... [and] [a] membership in the virtual currency industry will depend on a variety of factors, including the type of business involved, its size and complexity, products and services offered, customers and counterparties, and geographic locations served.” Given that the operational roles of base-layer participants do not, in most cases, involve contact with customers or counterparties, risk-based contracts The regulation program does not require monitoring or review of data blocks involving sanctioned addresses.
While the Financial Crimes Enforcement Network (FinCEN) guidance is not binding on OFAC, this view is supported by FinCEN's determination that Bitcoin miners are not money services businesses, "Because these activities neither involve 'receiving' nor 'transmitting' convertible virtual currency and are not transfers of funds" and FinCEN's findings that "if the person only: a) provides the delivery, communication, or network accessing services to support funds transfer services, then that person is not a funds transferr.” In fact, FinCEN has rightly recognized that the function of miners is to “verify the authenticity of blocks of transactions,” not to execute transactions.
(b) Crypto's base layer activity does not meet criteria for addition to SDN list
Crypto's base layer operators should not be added to the SDN list for failing to review data blocks containing sanctioned addresses. OFAC’s addition of base-layer participants to the SDN list requires discovery that they are “individuals” or “entities” that “provide material assistance” or “provide financial, material, or technical support” to anyone engaging in sanctioned cyber activity.
Such findings are unlikely because first, many base layer activities are not performed by "people" or "entities" but by software that executes automatically code executed. In these cases, there is no reason to specify them, since no "person" or "entity" takes any action.
As recent examples show, when OFAC has historically designated parties under the "material support" provisions of various executive orders, it has designated malicious Actors, such as providing sensitive technology to designated parties or secretly transferring funds on their behalf. This differs from the function of the cryptographic base layer, which provides neutral, open-source software to verify and publish information to the blockchain. As a result, base layer activity differs in kind from what OFAC has previously found sufficient to constitute material support.
(c) Crypto's base layer operators are processing information that is outside OFAC's jurisdiction under IEEPA
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There are also statutory restrictions on the application of IEEPA to the input or output of information indicating that activities at the encryption base layer do not fall within the scope of the sanctions regime. E.O. 13694 and most modern sanctions are enacted under IEEPA, a 1970s U.S. federal law that empowers the president in times of national emergency.
However, IEEPA is limited in several key ways, including the output of "information". In 1988 and 1994, the U.S. Congress passed a series of acts known as the Berman Amendments to limit the powers of the President, collectively stating that OFAC cannot regulate "the import from, or export to, any country of... any information or informational material.” This limitation of rights exists “regardless of the format or medium of transmission.”
Despite OFAC's attempts to narrow the scope of immunity codified by Congress, recent rulings by U.S. courts suggest that the text of the statute does not support OFAC's narrow reading of the Berman Amendment. So, along with the points above, it can be further argued that the job of the cryptographic base layer is simply to process information - even if that information has value - and thus is not subject to sanctions issued by the US under IEEPA.
4. Base Layer Sanctions Compliance Obligation Results
In this section we will Discusses the disruptive and counterproductive consequences of forcing base layer actors to monitor and screen blocks of data under the threat of sanctions compliance obligations.
The degree of network censorship produced by base layer actors screening data blocks involving sanctioned addresses will depend on important technical nuances beyond the scope of this paper. Nonetheless, abandoning the neutrality of a blockchain's core operating feature could undermine a blockchain's key consensus mechanism.
For example, if certain review validators take the stance of refusing to attest to previous blocks, which included transactions with sanctioned addresses, the network could fork. Censoring validators would oppose non-censoring validators by denying the existence of transactions with sanctioned addresses, and the network would split into two conflicting realities. Alternatively, users can "fork" those validators by choosing not to use them if they disagree with the decision of the majority of validators to review transactions. Whatever the reason, a network fork would be highly disruptive and undermine the fundamental value proposition of blockchain technology, which is to provide a universal record of the order of blocks of data.
Such sanctions-driven cyber fragmentation will ultimately harm U.S. national security interests. Fear of sanctions enforcement could lead base layer players such as validators and miners to go offshore. This would limit US influence over technological development and negatively impact the US economy and US hegemony. These consequences run counter to the goals of President Biden, who said in an executive order in March that "the United States is interested in ensuring that it remains at the forefront of the responsible development and design of digital assets and the technologies that underpin new forms and technologies of payments. International Finance capital flows in the system."
Furthermore, such a response would make it more difficult to monitor base-layer actors, including those acting as ingress and egress. As more activity moves offshore, regulators will have less visibility into exchanges and validators as they will have fewer reporting obligations, making it harder for U.S. regulators to track and trace illicit funds. These services would be diverted to other jurisdictions or captured by parties that might confront the national security interests of the United States and its allies.
Indeed, the precedent set by the United States here is likely to be followed by other countries, including those whose values differ from ours. If the U.S. censors the base layer, other countries may choose to do so. This could lead to foreign laws driving scrutiny of cryptocurrencies in the US, or, alternatively, each country having its own "compliant" version of cryptocurrencies, run by validators in that country, and completely segregated from other countries' versions. The current internet avoids this fate, and with a few exceptions, it's good for all of us.
5. The importance of maintaining technical infrastructure neutrality is widely recognized
Crypto base layer An obvious analogy for this is the underlying infrastructure of the Internet. ISPs use protocols such as TCP/IP to collect and send packets of information between users. Just as base-layer neutrality is necessary for encryption to function effectively, it is critical to allow uncensored information flow at the bottom of communication networks.
From an architectural standpoint, the web benefits from pushing discretion to the fringes and keeping the core uncensored so that information can flow freely. Thus, maintaining network integrity is another reason to resist disrupting global communications through jurisdictional policy decisions, even when there is strong consensus on certain issues, such as sanctions against North Korea. In the way Internet messaging functions today, policy decisions have been made to balance network integrity with national interests. In contrast, Internet censorship through practices such as "packet filtering" has been associated with oppressive and authoritarian regimes. For blockchain infrastructure, there are other places that are better suited to adjudicating transactions. U.S. regulators should be consistent in their approach and recognize that keeping the base layer of encryption neutral is critical.
6. Conclusion
OFAC identifying blockchain addresses to the SDN list should not require Any base layer participant reviews transactions involving sanctioned addresses. OFAC regulations require the implementation of a risk-based compliance program tailored to the specific activities of the relevant base layer participants. Given that the role of the Crypto base layer is essentially to publicly record the order of blocks of data, participants should not be required to screen blocks containing sanctioned addresses.
Implementing sanctions compliance obligations at a base level can also have counterproductive national security implications and drive the offshoring of critical technologies that enable track and trace to protect the nation Crypto transactions at the core of interest have become more difficult.
Cryptocurrency holds great promise for America and the world. Over time, we believe industry and regulators can work together to realize America's ideals of free speech, privacy, and financial freedom.
Acknowledgments
Special thanks to Katie Biber, Henley Hopkinson, Linda Jeng, Emily Meyers, Michael Mosier, Georgia Quinn, Rebecca Rettig, Gabriel Shapiro , Justin Slaughter, and Sheila Warren for review and feedback.
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