The crypto community is stirring up an anti-censorship storm. Will Ethereum fall into a regulatory dilemma?

Ethereum is facing an anti-censorship storm. After the crypto mixing service Tornado Cash was sanctioned by the US Treasury last week, the crypto community began to worry that the Ethereum beacon chain would damage the ecosystem in order to cooperate with the sanctions. V God also said that if the regulatory authorities use this as an opportunity to conduct a protocol-level review of Ethereum, he would regard this as an attack on ETH. This week, Ethereum ecosystem developers discussed the topic of Ethereum merger regulation on Twitter.

Crypto exchange Coinbase CEO Brian Armstrong said in a tweet on Wednesday that the company would rather exit the Ethereum staking business than censor the network to comply with sanctions. He prefers not to censor transactions to and from sanctioned addresses after the blockchain transitions to proof-of-stake.

In a tweet, Ethereum developer Lefteris Karapetsas asked Coinbase, Kraken and other centralized exchanges what they would do if the U.S. government asked them to comply with sanctions and block transactions associated with blacklisted Ethereum addresses. This issue has become a hot topic in the crypto community following last week’s sanctions on Tornado Cash.

The centralized exchange is one of the largest validators on Ethereum’s Proof-of-Stake (PoS) chain, which is currently in test mode but will soon become the main network as the platform’s developers are planning to ditch the current Proof-of-Work (PoW) consensus mechanism.

“If regulators asked you to conduct an audit at the Ethereum protocol level with your validators, you would: A) comply and audit at the protocol level B) shut down staking services and maintain network integrity,” Karapetsas wrote on Twitter on Sunday.

Three days later, Armstrong responded: “This is a hypothetical that we hope we don’t actually face. But if we did, I think we would choose option B. We have to look at the bigger picture. There may be a better option (C) or a legal challenge that could help achieve a better outcome.”

Armstrong also expressed support for Tornado Cash developer Alexey Pertsev, who was arrested in the Netherlands last week. “No developer should be arrested for releasing open source software, even if that software is used by bad actors,” the Coinbase CEO tweeted.

But Armstrong said that whatever his thoughts on sanctions against open source technology, one thing is clear: "We will always obey the law."

In a proof-of-stake blockchain, validators lock or stake their tokens in a smart contract to guarantee that they act honestly. For validating correctly, they are rewarded with new tokens. If they fail to validate correctly, their stake may be "slashed" by the protocol.

Some centralized exchanges that already hold user tokens also offer to stake their customers’ ETH in a larger staking pool to share staking rewards. JPMorgan said Coinbase will benefit greatly from its staking business after Ethereum switches to PoS.

However, recent government efforts to control decentralized cryptocurrency projects and impose sanctions, including the arrest of Pertsev by Dutch police, suggest that exchanges may face a difficult choice: impose sanctions at the protocol level or confiscate their staking profits.

Eric Wall, chief investment officer at Arcane Assets, believes that the community must force centralized exchanges to exit staking entirely before it is too late.

Wall tweeted: “Let Coinbase, Kraken, Bitcoin Suisse, etc. understand that complying with OFAC is not an option. It will result in all their customers’ stake being slashed and their business ending. If they are not going to support censorship resistance, have them reduce their stake now. I can’t believe how hollow the Ethereum community’s response to this is.”

Twitter user eric.eth responded, “I agree with Eric. We should let people know that as a community we (stakers) will burn the stake of any entity that attempts to censor transactions, for whatever reason. Ethereum PoS simply does not need large staking entities to survive. If they do not abide by the spirit of the entire community, they will be kicked out and lose customer funds.”

Lane Rettig, a former Ethereum core developer, said on Twitter, “You have one job: censorship resistance. If you can’t do that one thing, then none of this is meaningful and we should all pack up and go home.”

Cryptocurrency lawyer Geoff Costeloe believes that centralized staking entities have no choice but to comply with government censorship orders.

Luke Youngblood , a developer at DeFi protocol Moonwell who worked on Coinbase’s ETH staking product, disputed this statement. He wrote: “One thing you may not know is that all of Coinbase’s retail Ethereum validators are operated outside of the US (for tax purposes). So not only do they struggle with censorship, but it’s also difficult for US regulators to censor the exchanges.”

What crypto people are worried about is that centralized entities may eventually be forced to censor transactions at the Ethereum network protocol level in the future. Some community users are worried that Coinbase may succumb to regulatory pressure and exclude certain transactions from new Ethereum blocks. According to Dune Analytics data, Coinbase will become the third largest Ethereum validator, accounting for more than 14.7% of the market share of all staked ETH.

It may not only be the Ethereum merger that is coming, but also the anti-censorship storm is growing. The Ethereum merger may open up a channel for regulatory intervention, and a huge struggle around regulatory review has begun. When regulation comes, should we cater to the review or stick to the spirit of the Ethereum community?