Understanding the impact of the OFAC sanctions on Block Builders

The blockchain and cryptocurrency industry has seen tremendous growth in recent years, with the rise of decentralized finance (DeFi) and non-fungible tokens (NFTs) leading the charge. However, as the industry continues to grow and mature, it has also become a target of increased scrutiny from regulators, particularly the Office of Foreign Assets Control (OFAC).

In recent years, the OFAC sanctions have become a growing concern for businesses operating in the blockchain and cryptocurrency space. For the OFAC, there is a growing concern about the potential use of these networks for illicit activities such as money laundering and the financing of terrorism. To address these concerns, the OFAC has imposed sanctions on individuals and companies that it considers a threat to national security.

OFAC sanctions are a set of economic and trade restrictions imposed by the US government on individuals, companies, and countries deemed a threat to national security. These sanctions can have a significant impact on businesses operating in the blockchain and cryptocurrency space, including Block Builders.

In August and November of 2022, the OFAC sanctioned Tornado Cash, a decentralized application on Ethereum that provides financial privacy to its users by mixing their funds with others. The OFAC designated Tornado Cash as a “mixer” or “tumbler” and imposed sanctions on the project and its developers, citing concerns that the platform could be used for illegal activities such as money laundering and financing terrorism.

The OFAC sanctions on Tornado Cash have created a situation where block builders must comply with the sanctions, leading to censorship practices on the block-building level. This action by the OFAC has led to compliance among many US-based companies, causing ripples in the Ethereum ecosystem. For Block Builders, the impact of OFAC sanctions can be substantial. They have found themselves unable to access US financial markets, use US-based services, or conduct business with US customers. This can lead to significant financial losses and reputational damage. In some cases, Block Builders may even face legal penalties for non-compliance with OFAC regulations.

But who are these block builders?

Before we talk about block builders, let’s first go back to the foundation of blockchain to first understand what a block is.

As we all should know, a blockchain can be defined as a distributed database that holds a constantly expanding list of records known as blocks. These blocks are containers holding a record of transactions on the blockchain. Each block features a cryptographic hash of the previous block, a time stamp, and information related to transactions. They are securely linked through cryptography.

In the world of blockchain technology, blocks are created through mining. They can be constructed either by the proposers (validators) themselves in what is known as Vanilla building or by specialized entities that can reap the benefits of MEV from the blocks they build.

The recent introduction of MEV-Boost has given validators the opportunity to profit from the MEV in their own blocks by participating in the Proposer-Builder-Separation (PBS) mechanism and outsourcing their block-building responsibilities for compensation.

Hence…

Block builders are experts in the field who have access to advanced transaction-bundle ordering algorithms and proprietary order flows, which are transactions that are only submitted to a single builder.

Validators have the choice between Vanilla building and utilizing MEV-Boost. The latter opens the door for them to participate in the external block market. By delegating the block-building process to block builders through MEV-Boost, validators empower these specialized entities to make the decision on which transactions should be included in a block.

In return, block builders make a “proposer payment” (often referred to as an MEV-Boost payment) to the validator. This creates a market for blocks, as various block builders compete to have their blocks added to the chain, thereby transferring the profits from MEV from the block builders to the validators.

Block proposers typically earn proposer payments from block builders, in addition to the block rewards which now only consist of transaction fees since the merge. It is therefore economically reasonable for validators to participate in PBS and delegate the responsibility of block content to a more specialized party.

So, why are we concerned about these block builders?

Blockchain block builders play a critical role in the cryptocurrency economy. They are responsible for maintaining the integrity and security of the blockchain network, as well as verifying transactions and adding them to the blockchain ledger.

Without blockchain block builders, the cryptocurrency economy would not be able to function as it is designed to. Block builders help ensure that the blockchain remains decentralized and secure, which is key to the success of cryptocurrencies like Bitcoin and Ethereum.

They help improve the scalability and efficiency of the cryptocurrency economy by developing and implementing new technology solutions. This includes solutions for improving transaction processing times, reducing energy consumption, and enhancing the overall security of the blockchain network.

To assess the impact of censorship on block builders, it is necessary to perform a quantitative evaluation of their censorship practices. This can be done by analyzing the percentage of blocks that are rejected by block builders, the frequency of rejected transactions, and the reasons for rejection. Additionally, data can be collected on the types of transactions that are most frequently rejected and the reasons for rejection. To avoid going down that rabbit hole, I’ll leave an article here that perfectly explains that.

Now, Block builders may censor transactions for legal implications or to maintain competitiveness in the market. Some builders may operate under the policies of their preferred relays, which can impact their censorship practices. Larger builders can be analyzed using probabilistic methods to determine if they are censoring.

The Binomial Distribution of Tornado Cash blocks per 1000 blocks is shown with a probability of 1.418% of TC blocks. Builders such as Beaverbuild and BloXroute builders have built more non-censored blocks than expected, while BuildAI and builder0x69 have built fewer non-censored blocks. The dominant strategy for some builders may be to only construct non-censored blocks to focus on transaction fees. However, building censored blocks may be the most economically rational choice for builders if they believe the current validator is also using a censoring relay.

Using game theory, one possible explanation for the occurrence of censored blocks is that building censored blocks may be the most economically rational choice for builders. If a builder opts for censored blocks, there will likely be no relay that will reject them, resulting in the builder’s expected outcome of profits minus costs.

However, if a builder chooses to create non-censored blocks, they must speculate that the current validator is also using a non-censoring relay, or the block will be wasted. Building censored blocks may also be less computationally expensive than building two separate blocks, and therefore may be the dominant strategy for some builders.

In general, the censorship practices of each actor within a blockchain protocol can have a cascading effect on one another, and it is beneficial to analyze various scenarios using game theory to better understand the issue of censorship.

So, yes!!! The impact of these sanctions on Block Builders is significant!!!

Consequences of OFAC sanctions on Builders

The OFAC sanctions can have several consequences for them, including:

• Reputational damage — Block Builders’ reputation can be severely impacted if it is found to be operating in violation of OFAC sanctions. This can lead to a loss of trust from clients, partners, and stakeholders, which can have a negative impact on the company’s financial performance.
• Financial losses — OFAC sanctions can result in significant financial losses for Block Builders, as builders may be prohibited from doing business with individuals or companies that are subject to sanctions. This can limit Block Builders’ ability to generate revenue, which can have a long-term impact on the company’s financial performance.
• Compliance costs — Block Builders must ensure that it is in compliance with all applicable laws and regulations, including OFAC sanctions. This can require significant time and resources. They must implement processes and systems to monitor for potential sanctions violations and ensure that it is in compliance with all applicable regulations.
• Legal liability — Block Builders can face legal liability if it is found to be in violation of OFAC sanctions. This can result in significant fines and penalties, as well as legal costs and the possibility of criminal charges.

However, despite these challenges, Block Builders can emerge stronger and more resilient by proactively managing their risk, adopting technology, and engaging in stakeholder education and advocacy.

First, Block Builders can mitigate their risk by conducting thorough due diligence on their customers, suppliers, and business partners, and by implementing internal controls and processes that comply with OFAC regulations. This includes using tools such as blockchain analytics and sanctions screening software to monitor transactions and detect potential sanctions violations.

Second, Block Builders can adopt technology to automate and streamline their compliance processes, reduce the risk of human error, and improve the efficiency and transparency of their operations. This can include using blockchain and smart contract technology to automate compliance processes, such as sanctions screening and customer onboarding, and to enhance the security and privacy of their transactions.

Finally, Block Builders can engage in stakeholder education and advocacy to raise awareness of the impact of OFAC sanctions on the blockchain and cryptocurrency industry and to build support for regulatory changes that would make it easier for them to operate in this space. This can include participating in industry groups and advocacy organizations and engaging with policymakers and regulators to promote a more balanced and pragmatic approach to OFAC regulation.

They can implement measures to monitor for potential sanctions violations, such as conducting due diligence on clients and partners and implementing compliance systems and processes. Additionally, Block Builders can seek the advice of legal counsel and regulatory experts to ensure that it is in compliance with all applicable laws and regulations, including OFAC sanctions.

Conclusion:

The OFAC sanctions on Tornado Cash have sparked a conversation about the role of block builders in the blockchain ecosystem and the potential for censorship. The censorship practices of block builders are a critical concern in light of the increasing importance of blockchain networks for secure and decentralized financial transactions.

While the regulatory environment for blockchain and cryptocurrency is rapidly evolving, it is important for Block Builders to remain vigilant and proactive in addressing these challenges to ensure that its business remains successful and compliant with all applicable laws and regulations.

It is also important to continue monitoring the practices of block builders to ensure that they operate in a transparent and fair manner, and do not abuse their position as gatekeepers of information on the blockchain.

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