Centralized Concerns about Staking Being Prepared or Groundless Worries?

Centralized concerns about staking prepared or groundless worries?

Source: CoinShares Researcher Luke Nolan

Translation: LianGuaiBitpushNews Mary Liu

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Foreword

There has been a lot of discussion about the potential impact of Ethereum staking and different staking levels (as a percentage of the total ETH supply) on the future of the entire network.

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Currently, validators are staking approximately 22% (27 million ETH) of the current ETH supply, with a queue time of around 10 days to join (compared to a peak of about 45 days in June 2023). Although the queue length data in the timestamp of the following figure does not go back far enough to see this intuitively, it should be noted that in the days leading up to the Shanghai Upgrade (when staking withdrawals were enabled), the queue for exiting briefly exceeded the queue for entering (17 days vs 8 days) (April 2023).

Users who want to stake ETH have multiple options, which can be summarized into two main categories: they can either stake ETH individually (at the cost of reserving 32 ETH), or rely on liquid staking providers, which allow staking with less capital and usually have no minimum ETH requirement.

Among all the staking providers, Lido currently has the largest market share (around 32%), followed by Coinbase with around 8%.

Centralization Risk and its Significance for Security

Despite the queue being full (although it is currently rapidly decreasing), the amount of staked ETH has been continuously increasing, and Lido has shown no signs of slowing down its dominance over other providers. Some industry insiders have pointed out that Lido is about to control 1/3 of the staked ETH, which raises concerns about centralization risk.

Firstly, for a decentralized blockchain, having such a large number of validators under the control of a single platform is not a good sign, as ideally, block production should be decentralized. Furthermore, if Lido were to be subjected to a governance attack and malicious actors gained control of Lido’s validator nodes, the necessary percentage of staked ETH to prevent chain finalizing delays would exceed 33% of the total staked supply. An attacker could cause serious issues for the entire network through malicious or lack of proof actions, such as double-finalizing, where after being selected as a block producer, the attacker could generate two or more conflicting proposals, vote twice with more than 33% control, and cause the chain to fork into two separate blockchains, with severe consequences.

The risk of Lido being attacked is low (operator nodes are distributed among about 30 companies), but it should not be taken lightly. The Ethereum community has had many discussions and believes that measures should be taken to mitigate the possibility of any governance/other attacks, but Lido has not yet formulated any official plans, and community members have even expressed some dissenting opinions, seemingly not considering it a real threat. Lido DeFi Expansion Lead seraphim made the following statement:

Another risk of Ethereum’s decentralization is the “cartelization” of Lido, a term widely used in discussion forums to describe activities that could further consolidate its monopoly position. By reaching critical consensus thresholds (such as the aforementioned 33%), Lido node operators theoretically can engage in block timing manipulation and coordinated MEV extraction, resulting in substantial rewards (relative to other providers) and thus forming a monopolistic dominant position in reward allocation. This means that Lido has a clear competitive advantage and users have little incentive to stake elsewhere.

Lido’s dominant position in the market share partly comes from its first-mover advantage (deep liquidity and long-term verified stability) and attractive annual interest rates compared to other liquid staking providers. It is reasonable to expect competition for market share as the niche market matures and more competitors scale up. So far, there is little data supporting this assumption as new validators continue to flock to Lido.

Future scenarios for addressing liquid staking

The next area to discuss is the overall growth of validator numbers and the impact this may have on network performance and underlying characteristics. About two weeks ago, Ethereum core developer Dankrad Feist published a blog post outlining his concerns about the future of liquid staking.

Although, as mentioned earlier, the validator queue is rapidly decreasing and is expected to reach 0 in the coming weeks/months, the possibility of staking demand rising again and the queue remaining full in the foreseeable future is non-zero. Dankrad suggests that if the queue remains full, it would mean “by May 2024, 50% of all ETH will be staked, and by December 2024, 100% will be staked.”

From a technical perspective, the increase in the number of validators puts increasing pressure on the peer-to-peer network as the processing speed between nodes increases proportionally with the number of active validators. If we reach a level of 2 million active validators, node operators may find themselves needing to upgrade their hardware. In general, upgrading hardware is the wrong direction if Ethereum wants to become a highly scalable network.

If the staking queue remains full and we reach higher levels of staked ETH, there may be a further issue, as Dankrad calls it, an “untested economic regime” – where the market value of staked ETH becomes greater than the market value of unstaked ETH.

Again, the likelihood of this scenario occurring is very small but non-zero, so solutions to avoid such a situation should be explored. It is important to remember that there is an inverse decay relationship between the percentage of staked ETH and the percentage of annual interest rates received by validators.

With the increase in the number of validators, it is expected that validators will begin to withdraw because the opportunity cost of capital occupied for a yield below 2% is not worth it. One risk of doing so is that entering and exiting liquidity providers for staking is easy – only individual stakers can truly occupy a large amount of capital. In particular, economies of scale favor providers like Lido, and as yields decline, the associated hardware costs may not be a barrier to stopping staking.

The benchmark federal funds rate in the United States is at a multi-year high, increasing the opportunity cost of capital for ETH staking. Given that people can currently choose to purchase US Treasury bonds with yields of approximately 4.0-5.5%, we seem to be reaching some form of balance related to staking demand (the rapid decline in the queue proves this). The risk profile of a typical ETH staker and a typical Treasury bond investor differs, but if US bond yields decline (as the chart indicates, possibly sometime next year), staking demand will certainly rebound.

Solution (Short-term)

The long-term solution is still unclear – just as the dynamics of liquidity staking were not fully understood when staking was introduced, any solution that will be included in a hard fork must consider what dynamics it may change in the future.

However, a short-term solution is being formulated.

Dapplion proposed EIP-7514, which modifies the limit on validator attrition from an unlimited increase in quantity to a hard cap (16, 12, 8, 6, or 4). In short, this reduces the number of new validators that can join each epoch (6.4 minutes), significantly increasing the time required to reach milestones such as staking 50%, 75%, or 100% of ETH. This assumes a scenario where the activation queue remains full and staking demand is not affected by the aforementioned “self-balancing” decay relationship.

As shown above, modifying the attrition limit to a hard cap significantly slows down the growth of active validators. If the situation remains unchanged, with the increase in the set of active validators, the expected attrition limit will continue to rise, accelerating the rate at which we reach higher levels of staked ETH (as a percentage of the total).

This solution does not address any fundamental issues we have discussed, but it provides the Ethereum developer community with enough time to come up with real solutions to the dynamics of staking. Dankrad and other Ethereum community members have proposed some potential long-term solutions, such as:

• MEV destruction

• Increasing the maximum effective balance for validators

• Reducing the attractiveness of staking rewards (by reducing issuance rewards)

• Lowering the entry barrier for liquidity staking providers (to incentivize decentralization)

The above solution will fundamentally change one or more dynamics of the entire network and may trigger significant second-order effects, so careful planning and consideration are required.

Overall, it seems unlikely that the queue will be permanently full, and we will reach a higher level than other PoS blockchains, approximately 40-45% of the total supply as a percentage of stake. If this level is reached, theoretically there will be no potential negative impacts, except for scalability (the increase in messages and the network’s ability to adapt to this situation). In the future, we will need to explore in more detail the proposed long-term solutions and the upcoming upgrades to Ethereum, which will fundamentally affect how the network operates.

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