There’s a lot to talk about this week: US sanctions on Tornado Cash, privacy on blockchains and Ethereum before and after the “Merge.” I also included a personal note at the end. Enjoy!
Last week, the US Treasury and Office of Foreign Asset Control (OFAC) sanctioned Tornado Cash, a cryptocurrency mixer on the Ethereum blockchain, and forty-something wallets that have interacted with it. US persons are now banned from using the service. Mixers (aka tumblers or blenders) are pieces of code on the Ethereum blockchain that provide a privacy service that works as follows:
Users can deposit money into the smart contract and then withdraw some or all of it at a later date to other addresses in other amounts. It’s sort of like a shared bank account that anyone (including 17-year old JPEG buyers and North Korean cybercriminals) can use to cover their tracks and gain privacy on a public blockchain. The sanctions on this tool are a major turning point for crypto.
The core value proposition of blockchains is that they’re censorship resistant; that no government or private company can block or control them. That’s why blockchain databases are (inefficiently) decentralized across thousands of computers; that’s why they sacrifice key qualities (like privacy, speed, cost, flexibility and convenience) compared to traditional databases.
Well, despite that, the US government just threw a wrench in the idea of censorship resistance. They sanctioned code and wallets on Ethereum and for the most part, it worked.
Tornado Cash is technically still running but good actors have been deterred from using it. Developers can copy the Tornado Cash source code and redeploy it to the blockchain under a new name and address that isn’t sanctioned, but it’s probably futile. Uncle Sam can just sanction the new copies, which good actors won’t want to use anyways.
OFAC and the Treasury’s moves throw cold water over an animating premise of crypto. Governments, we learned, do have leverage over Ethereum despite its censorship resistant design. Crypto’s links to the traditional financial system make it vulnerable. If blockchain databases are censorable by governments and bad in most other respects, what’s their value proposition exactly?
We keep hearing that blockchains will compete with and displace the traditional financial system, but by design, all activity on Ethereum, Bitcoin, Solana and other leading databases is viewable by anyone with an internet connection. There may be technical reasons to make blockchains public by default, but as a casual user, it seems odd and uncomfortable that my pseudonymous wallet might be linked to my real-world identity, exposing my assets and transactions.
If you want privacy in crypto, you have to opt-in to privacy and your choices are limited. You can either keep your activity on a centralized exchange like Coinbase or Binance (not on the blockchain), use a layer-two (L2) scaling solution that has built-in privacy or use a mixer and potentially mingle funds with terrorists and cybercriminals. That any of this is required for robust privacy in crypto seems crazy to me.
Unsurprisingly, US sanctions have drawn attention to competing blockchains like Monero and Zcash that have better or default base-layer privacy and newer privacy tools that don’t mingle funds with strangers.
The Merge (I)
Ethereum is set to slash its energy consumption by 99% this September. It will achieve this by changing the consensus mechanism with which decentralized database maintainers (aka ‘miners’) decide on legitimate transactions to add to the blockchain. The consensus mechanism is changing from proof-of-work, which uses an enormous amount of energy to validate transactions, to proof-of-stake, which locks up massive amounts of capital instead.
As everybody knows by now, proof-of-work blockchains like Bitcoin are extremely energy intensive. Bitcoin consumes about 0.5% of the world’s electricity to maintain the shared ledger of transactions (more than many European countries). Ethereum consumes about a third of that amount. The “merge” will essentially zero this energy consumption, differentiating Ethereum from other blockchains and making it more politically acceptable.
That’s great, but ultimately, Ethereum’s success doesn’t depend on energy consumption. It depends on whether the database and the goods and services built on it add economic value to society. And the jury is still out on that question. The stars of the last crypto boom — pyramid schemes, regulatory arbitrage, speculative asset bubbles, and loans for levered trading — weren’t particularly productive.
The Merge (II)
People are also excited about the merge because of its potential to make ethereum deflationary. Under the current proof-of-work system, miners are paid with transaction fees and new units of ethereum created with each block added to the chain, such that the total supply of ETH slowly rises. Under proof-of-stake, some number of ethereum tokens will be ‘burned’ (destroyed) every year so that net issuance is slightly negative, with approximately 0-1% annual deflation.
This is supposed to be good, but it’s not.
If the value of the supply of ETH stays flat or grows and the currency is deflationary, holders stand to gain a real return for doing nothing at all. Deflationary ETH holders will see rising purchasing power without creating value for society. Deflationary monetary policy will reward free riders and rentiers.
In an ideal world, who should benefit from a growing economic pie? Productive workers, entrepreneurs that create valuable goods and services and the debt and equity investors that finance them — not unproductive currency hoarders.
In any case, for most Ethereans, ETH the token is as much a currency as an investment vehicle to gain investment exposure to the database and the applications built on it, a way to go long the ecosystem. In this sense, deflationary monetary policy can be thought of as a kind of share buyback, a tax-efficient mechanism for distributing income back to the owners of a company. I’m no lawyer, but it seems like this might raise regulatory risks for the token in more conservative jurisdictions.
Deflationary monetary policy is linked with crypto’s misguided idea that things are valuable just because they’re scarce. In reality, the long-term value driver of ethereum (and all other cryptocurrency) is demand. And demand, of course, depends on utility. Do people need or want the Ethereum database? Does it solve problems? Are useful products and services available on it? That’s what will drive value, not deflation…
Six Months of Common Sense
I hope you are enjoying this newsletter, which recently turned six months old! As a development economist and policy nerd, I never imagined I’d write a crypto newsletter. And yet somehow, it became a burning passion project. The origin story is funny, so I thought I’d share it here.
As crypto prices peaked late last year, I met a blockchain gaming executive in London that needed someone to ‘fix’ the ‘tokenomics’ of their hyperinflating game economy. I had no idea what play-to-earn was but as a Venezuelan, I had strong intuitions about unbridled monetary issuance and its effects. After playing and researching their game, it was obvious to me that they were running a textbook pyramid scheme. The only nuance was that it was wrapped in a “game” and complicated reward mechanics.
Needless to say, I wasn't going to start consulting for pyramid schemes so I turned down the gig and recycled the memo into a blog post titled Are Play-to-Earn (P2E) Games Pyramid Schemes? I published it on a brand new substack with zero subscribers, expecting just friends and family to read it. Then somehow – don’t ask me how – Bloomberg columnist Matt Levine got his hands on the piece and linked to it in the Things Happen section of his newsletter, which made it blow up with thousands of views.
After that unexpected banger, I kept writing. I followed with Fiat Hyperinflations in the Age of Crypto, a piece about how stablecoins might change hyperinflationary dynamics and then discovered El Salvador and it's crazy plans for the so-called bitcoin-backed volcano bond. The most popular newsletter so far was on the government’s insane and short-lived idea of issuing the tokenized instrument through a Tiny State-Owned Energy Company nobody has ever heard of.
I haven’t felt this electrified by a hobby since 2016-18, when I regularly blogged about Venezuela’s collapse as it spiraled into hyperinflation. Crypto is also crazy and exhilarating and unpacking it feels right in the same way.
I have fewer subscribers than I’d like, but it doesn’t matter. Writing Common Sense has been incredibly gratifying. The reception from journalists, commentators and crypto insiders has been fantastic. I got to go on my favorite podcast (coming soon!) and have been interviewed and quoted in a bunch of places (links below). Anyways, thanks for reading! And thanks for subscribing! It means a lot. - Frank
Articles with quotes:
New York Times - A Poor Country Made Bitcoin a National Currency. The Bet Isn’t Paying Off.
Wall Street Journal - El Salvador’s President Went All In on Bitcoin. Then It Tanked
Wall Street Journal - El Salvador Bets on Bitcoin Mania
CNBC - El Salvador’s $425 million bitcoin experiment isn’t saving the country’s finances
Foreign Policy - Colombia’s Left Finds Its Footing
Nikkei (Japan’s WSJ) – El Salvador headwinds, bitcoin price drop hurts credit
Local Papers in El Salvador (selection) –
CoinDesk / Yahoo Finance - El Salvador Defends Bitcoin Bet Despite 50% Loss on its Investment
CoinDesk / Yahoo Finance - Will El Salvador Default on its Sovereign Debt in 2023?
Hey Frank - You say you have fewer readers & subscribers than you would like, but I think you're just getting started. Have only been reading for a short period of time but have already learned a lot from you -- am sure many others feel the same way.