Breaking down Ethereum’s evolution and its impact on crypto markets

ETH Price

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(As of April 20, 2022 @ 17:09:35 UTC. ETH price % change over 24 hours.)

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It has been a rollercoaster month so far in the world of Ethereum. On April 11, the first successful shadow fork of the Ethereum mainnet spurred optimism around a coming Merge, but expectations were tempered a few days later when Ethereum core developer Tim Beiko speculated that the shift to proof-of-stake (PoS) is no longer likely to come in June as many had hoped.

Much has already been written about the delay, why it happened and whether proof-of-stake is still on the horizon for 2022 (Beiko says it is). But all of this speculation around timelines is a bit of a sideshow (in which I, admittedly, have indulged).

So on to what actuallymatters.

- Sam Kessler

New security, new problems

I wrote in last week’s newsletter that most Ethereum users won’t notice much of a change after the Merge. The network’s underwhelming network speeds (around 16 transactions per second, compared to Solana’s over 2,000 transactions per second) and high gas fees will remain mostly unchanged.

The Merge will, however, introduce an entirely new system for keeping the network secure, and with this new system come new threats of network centralization.

Enter, Lido, the liquid staking pool that might be on track to dominate the entire Ethereum staking ecosystem. If some skeptics are to be believed, the solution which makes it easy for anyone to stake on Ethereum might be the largest threat to the network’s security yet.

Centralization on Ethereum

Centralization can be interpreted in a variety of ways, but in this context, we’ll use it to refer to the ability for a small group of actors to sway a blockchain network in one direction or another – controlling anything from how the network is upgraded, to determining what transactions are or aren’t processed.

Blockchain centralization should be considered along a spectrum. It would be unfair to call Ethereum “centralized” just because there are fewer nodes operating the network (about 6,000) in comparison to Bitcoin (about 15,000). But at the same time, it’s difficult to call Ethereum completely “decentralized” when 20% of the initial supply of ether – 12 million ETH, or 10% of today’s supply – went to the Ethereum Foundation and a small group of early contributors.

There are many vectors by which a network like Ethereum might be considered “centralized,” but centralization is most pressing in the context of network security.

In today’s proof-of-work system, miners secure the network by devoting computer power to validating transactions. In return, miners get some of the fees generated whenever transactions are processed. They also receive a small amount of ETH that gets minted with each new block.

Cheating – e.g., sneaking in a fake transaction that moves tokens from one wallet to another – would require 51% of all of the network’s “hash power.”

Over time, Bitcoin and Ethereum have turned crypto mining into a multibillion-dollar industry, leading to the development of specialized computer hardware for the specific purpose of mining cryptocurrency (known as ASICs).

With so many expensive, highly specialized machines competing for network rewards, it is no longer profitable for most people to mine ether (or BTC) on their own computers.

Instead, a majority of mining activity has fallen into the hands of a small number of pools – groups of miners who work together to mine blocks in exchange for a share of all the group’s aggregate rewards.

While unlikely, just three pools on Ethereum could theoretically work together to sabotage the network by amassing more than 51% of its hash rate.

Proof-of-stake and centralization

In addition to dramatically decreasing the environmental toll of Ethereum, proof-of-stake has been framed as a way to improve decentralization.

Rewards will no longer flow to those with the most compute power. Instead, anyone who “stakes” 32 ETH is eligible to be randomly selected to verify each block and receive rewards. If a staker tries to sabotage the network, her stake can get slashed, meaning she loses some of her valuable ether.

Sabotaging the network via a 51% attack requires amassing more than half of all staked ether – a sum which, in today’s market, would amount to tens of billions of dollars. By the time a staker has managed to obtain that much ether, sabotaging the network wouldn’t make sense since it would (in theory) devalue that staker’s holdings. Even if an attacker's motivation is not financial, the upfront costs in Ethereum's PoS system are designed to render attacks infeasible.

PoS systems are not inherently less centralized than PoW. I wrote in this newsletter a couple of weeks ago about how the delegated proof-of-stake (DPoS) Ronin blockchain, which was exploited for over $600 million last month, was left vulnerable when a small group of stakers were left securing the entire system.

In Ronin’s system, five compromised passwords were essentially all it took to drain more than half a billion dollars into the hands of an attacker (controlled by North Korea, apparently).

But this is not an apples-to-apples comparison with Ethereum. Anyone will theoretically be allowed to stake on Ethereum’s PoS system, whereas Ronin’s small set of DPoS validators were handpicked by the chain’s creators.

Less centralized variations on the DPoS theme have been employed by other blockchains like Solana (DPoS holds a lot of advantages over PoS when securing a smaller network), but Ethereum’s developers say they are trying to make Ethereum as decentralized as possible by opening staking up to anyone.

Despite these ambitions, Ethereum’s PoS Beacon Chain – which is currently running in parallel with the PoW mainnet and will eventually merge with it – has shown that even more organic forms of centralization remain a threat.

Liquid staking on Lido

In the early days of the Beacon Chain at the start of 2021, it seemed as if centralized exchanges like Coinbase and Kraken might be poised to dominate Ethereum staking by making it easy for their massive user bases to pool their ether and earn staking rewards.

While centralized exchanges are indeed playing a large role in the ETH staking game, the largest staker on Ethereum’s PoS Beacon Chain by far is Lido, a so-called liquid staking pool that has amassed a massive 30% share of all staking activity on Ethereum, according to Etherscan.

With over $35 billion staked on the Beacon Chain, how has Lido – a single staking solution – amassed $10 billion in ether?

Staking on Ethereum is costly and confusing for most users. Most people don’t have 32 ether (about $90,000) lying around to stake and setting up a node incorrectly (or even with shoddy Wi-Fi) can incur slashing, or the loss of one’s funds.

Staked ether is also illiquid. Until the Merge, ether staked on the Beacon Chain will be impossible to unstake, meaning it can’t be sold or used to earn interest via decentralized finance (DeFi).

Lido launched in December 2020 to make it easier for anyone to earn rewards for staking. If you give any amount of ether to Lido, the platform will bundle it up with ether belonging to others and hand the full sum (at least 32 ETH) over to one of Lido’s trusted node providers – a service that specializes in setting up validators. This enables you to earn some rewards (around 4% annually) for securing the network without the need for 32 ETH or any special expertise.

Lido is called a “liquid” staking solution because it gives out staked ether (stETH) – a 1:1 derivative of ether – to users who stake with the platform. This stETH accrues interest to match staking rewards, and although users will be unable to unstake ether until the Merge, they can sell their stETH back to the market if they’d like to cash out.

On top of earning staking rewards, it has become extremely common to use stETH to participate in DeFi activities like lending and borrowing to earn even greater yield.

As stETH has grown into a hugely popular DeFi primitive, or building block, more users have flocked to Lido. Although Lido started to see competition soon after it launched, it has dominated competitors, such as Rocketpool and Stkr, and now controls nearly 90% of the fast-growing liquid staking market.

A bid for decentralization

Over time, Lido has raised alarm bells among those who think it risks centralizing Ethereum’s PoS chain. By the looks of it, Lido might be on track to control over 50% of all staked ether, meaning the platform, which is governed by a community of LDO token holders, could have a stranglehold over the entire network.

By Lido’s own account, “75% of new stakers who joined in the last 30 days have done so via Lido.”

“While this validates our mission to democratize staking in Ethereum,” Lido said last week in a blog post, “some people have expressed concern that this level of success can make Lido a centralizing force.”

In the post and an accompanying Twitter thread, Lido explained how it is working to progressively decentralize its platform.

Most of Lido’s proposals center around reforming how the platform’s community delegates staking power to validator operators.

Although Lido doesn’t deploy validator nodes itself, it has spread staking responsibilities among about 20 handpicked node operators. Lido’s community could, theoretically, decrease this number should it so choose, though the community currently caps the max amount of ether a given partner is allowed to stake.

One of Lido’s proposed steps toward decentralization involves adopting “Distributed Validator Technology” (DVT) to group validators into independent committees that propose and attest to blocks together. According to Lido, this will “greatly reduce the risk of an individual validator underperforming or misbehaving.”

Lido also plans to introduce a scoring system to reward validator performance and says it plans to add governance mechanics to prevent changes from being rushed through the Lido decentralized autonomous organization, or DAO.

While Lido’s frank admission that it needs to decentralize will be welcomed by many, it is unlikely to appease critics who think the pool is little more than a rent-seeking monopolist – hoarding as much staking power as possible so it can mandate a cut for itself (a percent of staking rewards always goes back to the Lido protocol).

Others are concerned about what Lido’s massive growth might mean for network security, leading to calls that it pledge never to amass more than 50% of all staked ETH.

According to Hasu, a researcher at investment firm Paradigm who recently stepped in as a strategic advisor to Lido, such demands are misguided. In a blog post Hasu co-authored last year with Paradigm CTO Georgios Konstantopoulos, the pair argued that Ethereum staking is destined to become a winner-takes-all situation. Eventually, they say some giant will inevitably come along and amass a majority of the stake on Ethereum by making it easy for average ETH holders to secure the network in exchange for predictable rewards.

By teaming up with Lido, Hasu seems to think it is the pool best-poised to become this giant.

In their blog post, Hasu and Konstantopoulos note that a key strength of Lido is in the convenience of the stETH token. Why ever hold ETH when you can hold basically the same thing – stETH – and earn staking rewards at the same time?

José Maria Macedo, a partner at Lido investors Delphi Digital, struck a similar tone in a conversation with CoinDesk. “I think overall Lido wins just because of the network effects of the liquid staking derivative,” he explained.

“Ultimately you want to stake your ETH and have a derivative that has the most integrations possible, and I think [a centralized staking provider] is never going to get integrated into DeFi,” he explained. “If you stake with Binance and all you can do is have [ETH] locked in Binance – versus getting some stETH [from Lido] and being able to use it on Aave to lever up, or being able to use it to mint DAI on Maker – I just think [Lido] is always going to be a better product.”

Though Macedo isn’t as confident as Hasu that liquid staking will have a single winner, he agrees that Lido’s dominance is preferable to that of a centralized staking provider with no concept of community governance.

“Although there will always be a market for centralized solutions – since people will want simplicity – I think all things considered, [Lido] is better than the alternative,” Macedo said.

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Disclaimer: All profits made from CoinDesk’s Eth 2.0 staking venture will be donated to a charity of the company’s choosing once transfers are enabled on the network.

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Validated takes

North Korean hacking groupLazarus is connected to the Ronin Network’s $625 million exploit, according to U.S. officials.

The long-awaited Ethereum Merge will likely come after June 2022, according to Ethereum core developer Tim Beiko.

Singapore-based cryptocurrency trading platform KuCoin launched a $100 million Creators Fund.

Communication protocol Ethereum Push Notification Service (EPNS)raised $10.1 million in a Series A funding round at a $131 million valuation.

A new Ethereum token standard promises to end NFT “rug pulls.”

- Sage D. Young

Factoid of the week

Consensus 2022, the must-attend crypto and blockchain experience of the year, is heading to Austin, Texas, from June 9-12. This is the only festival showcasing and celebrating all sides of the blockchain and crypto ecosystems and their wide-reaching effect on commerce, culture and communities.

Register now for the lowest price.

Open comms

Valid Points incorporates information and data about CoinDesk’s own Eth 2.0 validator. All profits made from this staking venture will be donated to a charity of our choosing once transfers are enabled on the network. For a full overview of the project, check out our announcement post.

You can verify the activity of the CoinDesk Eth 2.0 validator in real time through our public validator key, which is:

0xad7fef3b2350d220de3ae360c70d7f488926b6117e5f785a8995487c46d323ddad0f574fdcc50eeefec34ed9d2039ecb.

Search for it on any Eth 2.0 block explorer site!

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