Ethereum is continuing its devolution into a permissioned, censorship-prone system.
Ethereum’s planned merge to proof-of–stake will erode decentralization in this system, mainly due to staking derivatives and incentives already playing out. Though we are seeing this currently happen with Ethereum, the incentives described here could be applied to other proof-of-stake Layer 1 blockchains that have smart contracts at the base layer. I’m going to attempt to dive into this as clearly as possible, but first there are several definitions we need to get out of the way.
Proof-of-stake: Proof-of-stake is a type of consensus mechanism used by blockchain networks to achieve distributed consensus. It requires users to stake, or lock up their ether (ETH), to become a validator (block producer) in the network.
Validators: Validators in Ethereum’s proof-of-stake are similar to miners in proof-of-work. They order transactions and create new blocks so that all nodes can agree on the state of the network.
Staking Reward: In return for locking up your tokens, you receive a reward of 4.4% APY on Ethereum.
The Merge: Currently, Ethereum has both a proof-of-work and proof-of-stake chain running in parallel. While both chains have validators, only the proof-of-work chain currently processes users’ transactions. Once the merge is complete, Ethereum's blockchain will shift fully to the proof-of-stake chain, called the Beacon Chain, making mining obsolete. There is no set date for this.
MEV: Maximal extractable value (MEV) refers to the maximum value that can be extracted from block production in excess of the standard block reward and gas fees (transaction fees) by including, excluding, and changing the order of transactions in a block.
Lido: Lido is a staking pool offering a liquid staking solution for ETH and other proof-of-stake (POS) chains. You stake your ETH with Lido and they give you stETH (a derivative token) in return.
Problems with Centralized Monetary Systems
Before getting into the mechanics of how Lido’s protocol will likely lead to Ethereum centralization, we should discuss why centralization in these systems is bad in the first place. The original goal of Bitcoin was designed to transfer value between participants in the network, without the need for a third-party intermediary. It was created to be a permissionless system, that allows anyone to become a part of the network and contribute to its upkeep. Decentralization is key to keeping the system permissionless, and to allow any party to transact.
In a centralized system, a cartel of block producers (validators or miners) can decide whose transactions are processed. This means, whoever is in control of the production of blocks can blacklist or censor addresses based on their views. For systems with lofty goals, such as Ethereum, this means your internet property rights, and/or monetary value could be stripped in this system at the whim of a few. Now, I’m not making the argument that this means Ethereum is doomed to go to zero. However, if it becomes a centralized system it cannot be deemed a trustless asset or money.
For nation-states and those looking for a neutral reserve asset, this will undoubtedly remove Ethereum from that category. You would see the same issues arise that we are seeing today; sanctions can be employed to those nations or institutions that do not understand this. Furthermore, in a centralized blockchain, you will also see most of the value accrue to VCs, whales, governments and institutions. Wealth inequality will be a massive problem, as such systems suffer from the Cantillon effect.
Proof-of-stake, Staking Derivatives and Centralization
So how does Ethereum’s merge to proof-of-stake lead to centralization? To answer this question, we have to first look at the problems potential stakers face when deciding if they should lock up their Ethereum.
The first problem for a potential staker is that if you stake your ETH to become a validator, you can’t use your locked-up ETH for any other economic activity. This means you cannot use it to transact, earn a yield in other DeFi protocols, borrow against it, etc.
The other, arguably bigger problem, is that there are real costs to staking in ETH. First you must have 32 ETH, and can only stake in multiples of 32 ETH, which at the time of this writing is equal to $96,000. Even if you do have 32 ETH, you still have hardware and bandwidth requirements and are at risk of having your funds “slashed” if your validating node experiences downtime. Slashing is meant to keep validators honest, but there may be expensive lessons for technical performance issues.
Lido emerged as the solution to these problems. They allow users to have no staking minimum, and allow stakers to still have liquidity while locking up their ETH for a reward. When stakers lock their ETH with Lido they receive stETH tokens, which can then be used for other economic activities. stETH, a staking derivative, is pegged to ETH at a 1:1 ratio by Lido. Lido users receive a current APR of approximately 4% (as opposed to 4.4% for running their own validator), however, an ecosystem around stETH has developed where users can earn additional yield on their stETH. This yield for stETH on certain DeFi protocols is >5% (example: Curve has a pool offering 6.99% variable APR on stETH). This sounds great for users, however, we can already see how there are strong monetary incentives for delegating your stake to Lido versus running your own validator.
Of course, other staking pools can create their own staking derivatives, and we have seen other protocols such as Rocket Pool do this. What we have come to find is that staking derivatives are hugely affected by network effects. With Lido having a large head start on every other staking pool, their share of liquid staking has reached ~88% at the time of this writing, up from ~75% just a few months ago.
Lido's Staking Pool Dominance
How and why did Lido become such a dominant force so quickly here? The answer lies in the explosion of stETH in DeFi protocols such as Curve, AAVE, and Maker. This cycle is virtuous and self-serving. The more liquid stETH is on these platforms, the lower the opportunity cost of staking, which leads to more ETH being staked with Lido which then increases the stETH liquidity. This deep liquidity in stETH incentivizes the user to stake with the market leader.
Additionally, as staking with Lido continues to scale, their ability to generate rewards that can be passed to the user increases. This is apparent through their approved proposals to join forces with Flashbots and Paradigm showing they are at the forefront of MEV research. A gap in APR will emerge due to the leader’s ability to generate greater MEV than smaller pools.
'The Merge' adds priority fees and MEV (maximal extractable value) to validators’ rewards. The market leader has the ability to spend the most on talent to develop practices/software to extract the most MEV from the re-ordering, inclusion or censoring of transactions. Per Lido, this is expected to nearly double their current staking APR. They will continue to centralize power if and when they are able to meaningfully generate more MEV than their nearest competitor.
With 'The Merge' coming, up to 64 million total ETH will be available to be staked and become activated within one year. Lido’s size and network effect gives them a major advantage in absorbing this potential inflow as well. In order to prevent validating parameters from changing too rapidly, the Ethereum protocol only allows four new validators to be activated per epoch (every 6.4 minutes). With so much ETH available to be staked post-merge, this is expected to create a very long waiting queue for new stakers to become validators. This means that staking pools with a small number of currently active validators are at a huge disadvantage in the APR they can pass on to their users. With Lido at such a huge scaling advantage, their existing users will only experience a small temporary decrease in APR compared to their competitors. This further cements their status as staking pool leader.
Lido has >25% of all staked ETH, and as mentioned before stETH represents ~88% of staking derivatives. Right now staking derivatives only represent about 30% of all staked ETH; however, the incentives mentioned above show how this number can easily explode. It is not hard to imagine how >80% of all ETH can be staked with Lido.
Lido's Control of Ethereum
So now that we have established how Lido remains the leader and is poised to take on a much larger share of ETH, we can start to dive into how this creates problems for Ethereum as a whole. Right now for their services, Lido charges a 10% fee on staking rewards. This has now become the norm for staking pool fees. If Lido becomes a monopoly here, they will have full reign over the staking pool fee market. This pricing power will cause long-term massive wealth inequalities (if you believe Ethereum will survive long-term and become a multi-trillion dollar asset, as many ETH maxis do).
Lido was promoted as a decentralized staking pool; in contrast to centralized exchanges however, Lido is one of the most centralized protocols in terms of their governance token allocation. LDO is the governance token that gives rights to Lido DAO’s treasury (which currently receives half of the 10% staking fee). Lido DAO also decides key parameters for Lido such as fees, upgrades and voting for validators (Lido DAO voted node operators receive the other half of the 10% staking fee). The governance token LDO allows holders to vote on any proposal in Lido DAO. A massive 75% of LDO was allocated to the founding team, early investors, developers and VCs. Additionally, the top 100 holders own >94% of LDO. If Lido monopolizes staked ETH and validation, this is effectively creating an oligarchy with full control over fee pricing and validator selection.
You may also imagine a scenario down the line where due to Lido’s monopoly, LDO may not just affect governance of Lido DAO, but will also affect Ethereum governance. In such a scenario where Lido has all the staked ETH, they can essentially hold the network hostage over any decision they do not align with. Of course, Ethereum nodes could fork, but with most of the economic activity now being performed with stETH, the economic majority will continue to support the Lido chain. This is one of the huge disadvantages of proof-of-stake versus proof-of-work. In proof-of-work, the top miners are not necessarily the top economic powers in the system, while in proof-of-stake they are.
Even if you believe that Lido is currently a set of good actors, it is extremely naive to believe that this oligarch will not become corrupt over time, and/or influenced to censor transactions. With Lido providing staking solutions to other L1s, their influence may extend well beyond Ethereum. This only further emphasizes how and why Bitcoin is in a league of its own. Decentralization and incentives matter if we want a free and open monetary system.