Will DeFi Protocols survive this attack on freedom? The unexpected happened
Date: 2022-08-22
Crypto is about freedom…in theory
There is a common misconception in crypto regarding DeFi protocols.
As the proper name implies, DeFi is the group of decentralized protocols that enable trustless, censorship-resistant, and permission-less financial markets, on which anyone, anywhere, can finance themselves or finance others (paying or getting paid yields for doing so), without the need of any middlemen with obscene fees that drain the return of your investment, in the case of lenders, or makes your payment even bigger, in the case of borrowers.
DeFi protocols solves this, by eliminating these middlemen — commonly known as banks, escrows, etc. — representing the ultimate financial market where no one is left aside and anyone can profit from.
Censorship-resistance, DeFi’s greatest feature…allegedly
Censorship-resistance is a term used to describe the ability of individuals or groups to bypass government controls on information. It is often used in reference to the internet, as a way to access information that may be banned in one’s country. Censorship-resistance can also be used to describe the ability of people to resist dictatorships and other forms of government control.
The rise of censorship-resistant technologies has coincided with the rise of decentralized finance (DeFi). These applications are designed to be censorship-resistant, meaning that they can’t be shut down or censored by governments.
DeFi protocols have the potential to revolutionize finance by giving individuals more control over their own money.
However, this view seems to be very naive nowadays, as many supposedly censorship-resistant protocols are all but that, with examples like:
- DyDx: DyDx is a DeFi protocol that offers decentralized finance products and services. The platform enables users to trade, borrow, and lend cryptocurrencies in a secure and trustless manner. DyDx has been operational since 2017 and has gained a strong reputation in the DeFi space. However, it seems that DyDx is far more centralized than expected. For instance, several address blocks have occurred, banning users from using the platform without notice or proper explanations.
- Aave: After the Tornado Cash blacklisting, an anonymous user sent 0.1 Tornado Cash ETH to known public addresses as a protest against the sanctions. As you cannot reject transactions in a blockchain, these addresses received the money, thereby becoming blacklisted addresses (these include Shaq or Jimmy Fallon, among others, lol). One of those addresses, Justin Sun, commented on Twitter that by receiving that 0.1 ETH he had been banned from using Aave, a supposedly decentralized DeFi protocol. He was later unbanned… for whatever reason (maybe for the fact he is Justin Sun?).
DeFi protocols pride themselves on being the censorship-resistant version of finance. However, when put to the test, the most important DeFi protocols are quick to apply censoring practices to comply with OFAC regulations.
Disregarding the matter of whether should DeFi protocols comply with OFAC, which is a totally different question, the relevant one is, if DeFi protocols end up being censorable…
what’s the point of DeFi in the first place?
And even more importantly, is censorship at the protocol level (Ethereum) possible?
Well, the answer is somehow…complicated, and, sadly, perfectly possible. In other words, the actual Ethereum chain can be censored.
But how is this possible?
To be censorship-resistant you have to be decentralized. Broadly speaking, if the protocol you are using is truly decentralized, it cannot be censored. In other words, it can be prohibited by law, but it cannot be shutdown, thus being able to still make use of it, at your own risk and consequences.
This is the reason why decentralization is so important, it not only represents a key security feature of the distributed system, but also protects it from censorship. Also, upcoming regulation suggests that the more decentralized your protocol is, the harder is to be considered a security, which is a huge no-no for any blockchain project.
Bottom line, being decentralized is a must, not a feature.
But how do we evaluate decentralization in a protocol? The truth is, centralization can appear at multiple levels, even at the most basic core of the blockchain, so decentralization is still a really hot topic in the industry, as many, including myself, argue that actual blockchains aren’t decentralized, or at least not as much as they should.
To further explain this concept, let’s dive into Ethereum.
The post-Merge Ethereum protocol-layer problem
Ethereum is generally considered decentralized, almost no one argues the contrary. Adding to this, many of the upcoming hard forks (also known as The Merge) will increase the degree of decentralization, especially after the transition from Proof-of-Work to Proof-of-Stake.
Mining (PoW) is considerably expensive and energy-intensive, which induces mining to concentrate in ‘Mining Pools’ that harness the necessary power to compete and gain the right to propose the new block. Explicitly, three mining pools have more than 50% of the total hash-rate of the Bitcoin network.
With PoS, the entry barrier to becoming a validator (the equivalent of a miner in a PoW) is lower (although some argue that staking protocols also tend to centralize as the more coins you stake the higher the chances you have to win the right to the next block).
However, it will be with future updates that decentralization will be further enhanced, so few people argue that Ethereum is centralized. However, not everything looks as it seems, as at the protocol level things are starting to look severely centralized, especially after the Merge.
Currently, it looks like over 66% of the beacon chain validators will adhere to OFAC regulations (OFAC is actively demanding certain transactions to be censored), including validators like Lido Finance, Coinbase, Kraken, and others.
In short, what this means is that, in the event they do adhere to OFAC regulations, we could be witnesses to transaction-level censorship.
That is, validators, who are in charge to include pending transactions in blocks to approve them, could be engaging in censorship activities, thereby committing the ultimate censorship action one can do in a blockchain, censoring not in DeFi protocols, but at the core, at the platform level.
Protocol-level censorship is unheard of and could represent the ultimate proof that blockchain is far off from the initial vision it was conceived for, and it is just a glorified centralized database that engages in the same censorship practices that any other centralized system.
This would be the end of crypto.
In my opinion, not all considerations are being thought off when regarding the Merge, and it seems safe to say that Ethereum is at great risk of becoming the one thing it was born to fight against, a centralized and censorable system.
Proposer/builder separation, PBS, the key to solving this?
Proposer/Builder Separation, also known as PBS, is one of the ways to prevent censorship at the protocol level — Vitalik, the founder of Ethereum, is openly against any kind of censorship.
Although it is a fairly complex matter that will require another article to get into details, in a very simplified manner, PBS is a proposal to separate those in charge of building blocks from those in charge of building them.
In case you aren’t aware, a blockchain is a really marketing-like way of describing a database of transactions, that are put into blocks (groups) and proposed to be accepted. Once accepted, they are final and immutable, which is the core reason why blockchains are so valuable.
To carry out this block validation, a distributed network of nodes — miners in PoW, validators in PoS — compete to be the node selected to put the next block, thereby receiving a reward for it, previously achieving global consensus across the whole network of nodes that the block is, indeed, valid.
Disclaimer: This is an extremely simplified description of how blockchains work, it is much more complex than that.
However, nodes not only aspire to earn revenues from the block reward and fees, but they also have other ways of achieving higher revenues, with examples like DEX arbitrages or liquidations.
Consequently, this increases the pressure and competition between validators, making it ever harder to become a validator and remain profitable. This, of course, incentivizes centralization, which aggravates censorship in case those centralized validators enforce censorship practices.
PBS potentially solves this, as proposers just propose the block with the highest bid and aren’t capable of viewing the internal transactions anymore, preventing censorship.
Builders, on the other hand, will have a strong motive to not engage in censorship practices, as by doing that they are increasing the chances of missing out on high-fee transactions that have to be censored, thereby potentially building less lucrative blocks that won’t be selected.
In short, PBS incentivizes censorship-resistant block building and proposal, making censorship at the transaction level economically unprofitable.
There is only one path to success
A censorable blockchain is a useless technological product, as that would represent a glorified version of the status quo, which is pointless and, by no means, justifies the vast amount of money inflows the space receives.
If we really want to change the world with crypto, the core features must be upheld and enforced; only then can we really disrupt the tech space and change the world.
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