Regulatory Supervisory Nodes: Public Blockchain Enemy No. 1

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One of my favorite blogs is written by the Prysm Group. This is a team of highly accomplished PhDs that research the application of economic theory to blockchain governance

It’s a must-read blog for blockchain enthusiasts who enjoy economic theory and its practical application.

Recently, I was surprised to hear that the Prysm Group announced that it is working with the Federal Reserve Bank of Boston. Together they are researching the potential role, structure and benefits of “supervisory nodes” in blockchain networks

Though supervisory nodes have not garnered much attention yet, they are one of the most controversial topics in the crypto law space today. 

In fact, the implementation of supervisory nodes by regulators could single-handedly determine how crypto evolves in the coming years.

Read on to learn how supervisory nodes are likely to impact the future of the crypto ecosystem. 

The appeal of supervisory nodes 

The term ‘supervisory nodes’ can mean different things to different people. So before I get started, let me clarify that I am discussing supervisory nodes as defined by the Prysm Group. 

Supervisory nodes are nodes in a blockchain network with the ability to monitor, audit, flag, hold and stop transactions. 

They are designed to give certain actors better visibility and control over blockchain-based activities. 

For private networks, supervisory nodes provide the potential to maintain stability and safety on a network by giving managers the ability to monitor participants and control how the blockchain is used.

This is attractive to enterprises running permissioned blockchain networks because it enables them to take advantage of the technological benefits of blockchain without having to completely relinquish control over their networks. 

For the same reasons, supervisory nodes are likely to be a hit with law enforcement officers and regulators.

Regulators have already made it clear that they see crypto as a threat

The anonymous and decentralized nature of blockchain makes it nearly impossible for regulators to monitor and control how cryptocurrencies are used. 

To help combat this, regulators have introduced a number of rules to help them regain control over global crypto transactions. 

From multiple KYC AML laws to the recent FATF travel rule, many attempts have been made to eliminate the anonymity of crypto transactions. But so far, regulators’ influence has been limited to just the on and off-ramps of crypto (ie. exchanges where crypto is being traded for fiat.)

But now, supervisory nodes could potentially give government actors the ability to monitor and control activity from within the blockchain. Regulators could use this to block transactions and/or flag “bad actors”.

Regulators assert that additional control would enable them to more effectively crack down on terrorism and money laundering. 

But there’s good reason to be wary of such supervisory nodes in public blockchain projects. Here’s why…

How supervisory nodes undermine blockchain

It’s understandable for a private company to want to control activity on their blockchain. They might not gain all of the benefits of decentralized blockchain, but at the end of the day, it’s their network so it’s their decision. 

When it comes to public blockchains, however, it’s an entirely different issue.

In public blockchains, supervisory nodes have the potential to completely undermine a network’s trust, privacy, and resilience. 

For any Insider, you know that each of these features is fundamental to blockchain.

First, let’s discuss trust. 

In a decentralized structure, there is no central manager or central authority that guides or approves activity on a blockchain. As a result, you do not need to trust any users or managers of a blockchain in order for it to work.

However, if you introduce a supervisory node to a blockchain, the need for trust comes back in full force.

What will be monitored? How will the information be used or stored? Who determines what makes a “bad actor”? Who decides what are acceptable uses of the network and what are not? 

Whoever controls the supervisory node will have the ability to control the entire network and determine how it develops. Users must “trust” in the managers’ incentives and ability to effectively manage the network.

Closely linked to the issue of trust is that of privacy

As you know, in a fully decentralized blockchain, most transactions are transparent but anonymous. The developers of a blockchain cannot hand over their users’ information, because there is no private information stored. 

But with a supervisory node in place, regulators could require that a KYC check be passed before transactions can be completed for example. 

This would ultimately eliminate anonymity from transactions on the blockchain.

Finally, there is the issue of resiliency.

One of the most innovative aspects of a decentralized blockchain is that there is no central point of failure. 

In a decentralized network like Horizen, which has over 30,000 nodes, if one node is compromised, a network won’t feel it. Even if a whole group of nodes goes down, this won’t seriously affect the blockchain. 

With supervisory nodes, however, it’s a very different story.

In the worst-case scenario, you could have a supervisory node in place that needs to approve all transactions. 

If that were the case, it wouldn’t matter how many nodes the blockchain had. All someone would have to do is take out the supervisory node and they could bring the entire network to a halt. As they say, you’re only as strong as your weakest link. 

This is arguably the most critical element that blockchain is designed to avoid. 

As a result, supervisory nodes not only go against the ideological basis of decentralization but can also pose extreme risks for a network from outside attackers.

What does this mean for Crypto Law Insiders?

Insiders should be aware of the ongoing tension between decentralized projects and the government regulators looking to control them. 

This is especially the case when it comes to financial transactions. 

Crypto is a threat to the existing monetary system, so it’s no surprise that the Fed would be interested in ways to more effectively control the system. 

From the outside, the prospect of using supervisory nodes for regulatory purposes might appear to be a less abusive form of government control. In fact, some might point out that certain countries outlaw cryptocurrencies altogether, whereas the Fed just wants to introduce a minor checkpoint. For your protection, of course.

But the truth is, supervisory nodes are far from being minor tweaks to a network. 

As soon as you have one person or group that is able to wield this kind of control over a network, then you lose decentralization, trust, privacy, and the resilience that comes from not having a single point of failure. 

This completely undermines the fundamentals of decentralized blockchain, eliminates the potential benefits and increases the risk.

Remember this when you see new proposals for supervisory nodes to combat anything from money laundering to terrorist financing. 

These are not designed for your protection. 

Dean Steinbeck

Dean Steinbeck

Dean Steinbeck, Managing Director of Crypto Law Insider, is the leading authority on legal issues related to cryptocurrency and blockchain technologies.