DeFi vs. regulators: Who's winning?

How the next wave of technology is upending the global economy and its power structures

Oct 17, 2022 View in browser   By Ben Schreckinger With help from Derek Robertson The logo for Ethereum, a blockchain network with the second largest cryptocurrency by market share. | Beata Zawrzel/NurPhoto via Getty Images Decentralized finance is a whole movement premised on the circumvention of gatekeepers, including governments. The U.S. government, of course, does not like being circumvented. So there's a big question emerging as DeFi platforms grow: Will the government wield as much power over DeFi as it does over the current global financial system? U.S. regulators want to play sheriff in the Wild West of decentralized finance, and big banks want to comply with American laws. But many crypto purists — the people who built the underlying technology and remain committed to its original libertarian ethos — are committed to ensuring anyone can access blockchain networks, even people formally blacklisted by governments, a principle they call "credible neutrality." Last weekend, DeFi crossed an important threshold that highlights the practical limits of decentralization and touched off a global round of wrangling over its relationship with Washington. It happened on Ethereum, the dominant blockchain platform for DeFi. On Friday, for the first time, more than 50 percent of blocks — bundles of transactions that get processed and recorded by the network — were being compiled by services that comply with Treasury Department sanctions, according to data from Labrys , an Australian blockchain developer that opposes the compliance practice. The way this all works offers a glimpse into how regulation can insert itself even into an unregulated system. The Ethereum blockchain network as a whole remains largely decentralized and unregulated. But the underlying transactions that it records still need to be grouped into individual blocks and processed — and a growing number of those blocks are being compiled by services that refuse to handle transactions involving Treasury-sanctioned addresses. At the moment, the 50 percent threshold is largely symbolic. While compliant services aren't putting sanctioned addresses into their own blocks, they're also not doing anything to hinder blocks that do include blacklisted addresses, according to Labrys CEO Lachlan Feeney. The effect of this practice — which crypto purists call "soft censorship" — is that transactions from sanctioned addresses have to wait to make it onto a block compiled by someone who is ignoring Treasury's blacklist, which entails nothing more cumbersome than a delay. "One might argue it's just symbolic, but symbols matter," said Martin Köppelmann, the Berlin-based co-founder of DeFi developer Gnosis, who has been agitating for steps to reverse the compliance trend. The effects of compliance could one day become more concrete. If services that control a majority of blocks take things a step further, by refusing to cooperate with others' non-compliant blocks — what purists refer to as "hard censorship" — they could potentially keep sanctioned addresses off of Ethereum completely. So far, the Treasury isn't exactly controlling the playing field: Sanctioned addresses are still able to use Ethereum, even if their transactions may have to wait in line a little longer. Even so, there's a push from purists like Köppelmann to ensure that sanctioned addresses still maintain full access to DeFi systems. (Sanctioned blockchain addresses include those linked to a Russian paramilitary group, Iranian hackers, and Tornado Cash, a tool often used for laundering cryptocurrency.) And key network operators are responding to the concerns. On Friday, the dominant compliant block-building service, FlashBots, announced a new decentralized version of its software at a developer conference in Bogota. The new version is intended to allay concerns about government control. The view of Ethereum's stepped-up compliance from Wall Street and Washington is quite different from that of the crypto purists. For big financial institutions eager to avoid the ire of D.C. regulators, network-level sanctions compliance could make Ethereum more attractive, said Yaya Fanusie, a fellow at the Center for New American Security, a think tank, who focuses on the national security implications of digital assets. "While the die-hard crypto enthusiasts are focused on blockchain as censorship resistance," Fanusie said, "Everyone who is looking at the development of digital assets as a legitimate financial rail is not such an absolutist."   NEW AND IMPROVED POLITICO APP: Stay up to speed with the newly updated POLITICO mobile app, featuring timely political news, insights and analysis from the best journalists in the business. With a fresh look and improved features, the sleek and navigable design offers a convenient way to access POLITICO's scoops and groundbreaking reporting. Don't miss out on the app you can rely on for the news you need, reimagined. Already a POLITICO app user? Upgrade today! DOWNLOAD FOR iOS – DOWNLOAD FOR ANDROID .     lone star litigation CEO of FTX Sam Bankman-Fried testifies during a hearing before the House Financial Services Committee. | Alex Wong/Getty Images Yet another state regulator has joined in the scramble to define crypto. Texas' securities regulator is looking into whether the crypto exchange FTX is offering unregulated securities, according to a Friday court filing reported in Barron's today. In the filing, the Texas State Securities Board's Director of Enforcement Joe Rotunda writes that FTX's yield-bearing crypto accounts "appear similar to the yield-bearing depository accounts offered by Voyager Digital LTD et al.," referring to the bankrupt crypto lender also under investigation in several states whose assets FTX is set to purchase . An FTX spokesperson told the crypto news website CoinDesk in a statement that the company has "an active application for a license which has been pending, and [we] believe we are operating fully within the bounds of what we can do in the interim." If the web of state, federal and private actions around crypto companies' legal status sounds confusing, more or less every actor in the arena would agree with you. Last week FTX chief Sam Bankman-Fried told POLITICO's Sam Sutton that he "would not have thought that I could imagine seeing this amount of engagement and constructive bipartisan work on crypto policy" in recent months, and both Congress and various regulators are pushing for their own solutions — and as these investigative actions increasingly reach billion-dollar giants like FTX, the urgency of enacting them will only increase. — Derek Robertson an art and a (computer) science "Retrofuturism," or the concept of thinking about technological advancements through a previous era's lens, is an old concept — but a popular Instagram artist is giving it a deeply modern twist. The account " An Improbable Future ," created by an artist who identifies him or herself on their website only as "an industrial designer from New York" — we reached out, but didn't hear back by press time — features AI-generated illustrations of future devices with a decidedly 1970s-era aesthetic. Today's creation is a bulky, futuristic-looking cargo van in burnt-sienna livery that recalls a cocktail-strewn rec room. There's a "home audio" setup that appears it could double as a "1984"-style two-way surveillance device. There's a motorcycle that looks half Evel Knievel dirtbike, half "Akira" future-cycle . The account's biography reads "Designed by AI — created & curated by me," putting the spotlight on an overlooked element of the recent mania for AI art creation — that, much as with recent efforts to automate the writing of code , writing the prompts that generate these images in such a way that produces the desired effect is almost an art form unto itself. An industrial designer would understand such a concept better than most, and that's evident in the remarkably unified style across these procedurally generated images. — Derek Robertson the future in 5 links Meta's Horizon Worlds is having a difficult time retaining users. A new kind of warehouse robot could disrupt businesses like Amazon's. Apple's planned VR headset will reportedly include iris scanning technology. It turns out Elon Musk will continue funding Starlink satellites in Ukraine after all… (for now). Get to know the man pushing crypto-world tech vulnerabilities to their — and his own — very limit. Stay in touch with the whole team: Ben Schreckinger (bschreckinger@politico.com); Derek Robertson ( drobertson@politico.com ); Steve Heuser (sheuser@politico.com); and Benton Ives (bives@politico.com). Follow us @DigitalFuture on Twitter. Ben Schreckinger covers tech, finance and politics for POLITICO; he is an investor in cryptocurrency. If you've had this newsletter forwarded to you, you can sign up and read our mission statement at the links provided.   STEP INSIDE THE WEST WING: What's really happening in West Wing offices? Find out who's up, who's down, and who really has the president's ear in our West Wing Playbook newsletter, the insider's guide to the Biden White House and Cabinet. For buzzy nuggets and details that you won't find anywhere else, subscribe today .       Follow us on Twitter Ben Schreckinger @SchreckReports Derek Robertson @afternoondelete Steve Heuser @sfheuser Benton Ives @BentonIves   Follow us

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