The Future Evolution and Challenges of the Ethereum Staking Market

The Future of Ethereum Staking Evolution and Challenges Ahead

This article focuses on the overlooked but important factors facing the decentralized staking layer of Ethereum.

Original title: Ethereum’s Future Staking Market

Original author: Ronan

Original source: Medium

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Translation: Lynn

This article focuses on the overlooked but important factors facing the decentralized staking layer of Ethereum.

In this article, I will explore the following topics:

• Ethereum ETF will follow the approval of Bitcoin ETF

• Reward-based Ethereum ETF is a natural extension of non-custodial Ethereum ETF

• Institutional staking will shift towards liquidity alternatives, bringing new challenges to decentralized Ethereum

• The scale of institutional liquidity could be significant

• What does that mean?

• Lido as an effective balance

Before we begin, a big thanks to Steakhouse Financial‘s adcv for their insights and perspectives.

1. Ethereum ETF Will Follow the Approval of Bitcoin ETF

The approval of a spot Bitcoin ETF appears to be almost certain.

Naturally, attention is now turning to the potential for an Ethereum spot ETF. The confidence in the approval of a spot Bitcoin ETF comes from the SEC’s inconsistency in approving futures-based products but rejecting spot-based products.Blackrock applied for an Ethereum spot ETF on November 9, further fueling this attention.

Considering the existence of the Ethereum futures market on the CME and multiple futures-based Ethereum ETFs, the logic for approval seems fairly portable. Even the U.S. regulation of Ethereum is based on a non-security basis.(See thread with images) For various reasons, Gensler or future regulatory bodies are unlikely to deviate from previous approaches.

In fact, the U.S. Securities and Exchange Commission recently excluded Ethereum from legislation concerning the listing of securities on Coinbase.

Read the entire thread

2. Reward-based Ethereum ETF is a natural extension of non-staked Ethereum ETF

Before spot Ethereum ETFs are approved, issuers will compete to find a solution that allows them to earn Ethereum staking rewards. Reward-based ETH is superior to non-reward-based ETH and may attract new investors who have been waiting on the sidelines.

Gwart

Issuers will compete to be the first to enter the market and offer staking rewards. Initially, running their own validators seems impractical due to knowledge barriers, challenges in the node operation business model, and increased regulatory risks.

To be the first in the market, issuers must propose a solution that fits within existing regulatory frameworks and can be approved quickly. Hence, the path of least resistance is for ETF issuers to enter into contractual agreements with third-party centralized staking providers who charge a minimal fee, including a loan agreement.

This is already the case for the 21Shares Ethereum Staking ETF AETH. 21Shares custody its ETH through Coinbase Custody and may lend the underlying ETH to Coinbase Cloud, Blockdaemon, and Figment.

Typical fund structure explanation

AETH has attracted $240.77 million in AUM, equivalent to 121,400 ETH, all of which is staked with a centralized provider. These inflows are completely independent of the yield because a fixed percentage is staked programmatically regardless of the yield.

It seems reasonable to assume that U.S. ETF issuers might enter into loan agreements similar to 21Shares AETH. This programmatic process has the potential to give centralized providers a larger market share compared to decentralized providers, as many custodians offer vertically-integrated staking products (e.g., Coinbase Prime -> Coinbase Cloud) or have existing SLAs with centralized staking providers (e.g., Figment). As a specific example, given that ARK filing was done through 21Shares, it’s reasonable to assume they would use the same providers as the AETH product.

3. Institutional staking will turn towards liquidity substitutes, bringing new challenges to decentralized Ethereum

Smart institutions may consider pledging with providers outside of ETF packaging, who have more favorable cost structures and greater utility. Decentralized protocols like Lido can already be used by existing institutional clients for asset custody, quality control, and regulatory environments. As decentralized protocols, they offer a unified experience and institutional-grade security, but are open to all market participants with any amount of ETH.

On the other hand, a new trend in projects is specifically targeting institutional demands. Specifically, companies like Liquid Collective are building a “liquidity staking solution designed with institutional compliance in mind.” Institutions can mint lsETH, which is pledged by one of three centralized providers (Coinbase, Figment, and Staked) who also manage the project. The idea here has two aspects:

• Liquidity staking is a superior product to regular staking; you retain the monetary properties of ETH and most of the rewards.

• Institutions must pledge with providers that comply with KYC/AML requirements, or they may incur civil and criminal liabilities.

The first point is obvious.

Liquidity staking tokens (LST) can be used as collateral for the entire DeFi ecosystem, the underlying asset in liquidity pools, and avoid withdrawal queuing times.

Furthermore, ETFs and other institutional products benefit from liquidity to be able to manage fund redemptions within a day. For illiquid funds, managing them usually involves pledging a portion of ETH for custody. This poses a greater risk of withdrawal surges, essentially leading to bank runs, and the rest of the ETH being unpledged and dragging down the reward rate during normal operations.

Having access to liquidity staking tokens would make smoother management of redemptions possible and increase the proportion of funds that can be pledged at any given time. In order for this possibility to become a reality, liquidity staking tokens evidently need to have liquidity. Simply offering the tokens is not enough if there isn’t sufficient liquidity available. Currently, the only liquidity staking token with meaningful on-chain and off-chain liquidity available for institutional use is stETH by Lido.

The second point is less clear. Regulated institutions usually face numerous obligations to minimize the risk or possibility of money laundering or facilitating criminal activities. For this, there are KYC/AML obligations to maintain auditable traceability of funds flowing between institutions and their clients. Additionally, there may be higher requirements for so-called “qualified custodians.” In other words, qualified custodians and institutions in general should be able to fulfill their KYC/AML obligations without affecting the choice of assets, LST tokens, or pledge providers.

Even if the staking provider has a contractual relationship with the fund owner or custodian, I do not believe that regulatory authorities would impose new KYC/AML compliance obligations for Ethereum staking. This is because I believe that over time, regulatory authorities will understand that Ethereum staking is a unique computational activity that does not align with the traditional or financial concept of “fund flow”. LST holders and custodians should be able to perform KYC/AML on any assets within their scope of authority and fulfill compliance obligations to mitigate the risk of money laundering or financing crimes.

The concentration of equity in centralized entities brings many different and urgent challenges to the development of the Ethereum blockchain. In summary, the blockchain may suffer from a range of disruptions, and the likelihood of such disruptions increases with different levels of stake market share:

• Preventing reorganization attacks

• Finality delays

• Fork selection

• Threat of coercion

The first two types of attacks undermine the normal functioning of the blockchain, and Ethereum has built-in incentives to deter attackers from attempting these attacks, such as gradually diluting rewards and staking balances for “attackers”. However, when a single node operator’s market share reaches 33% or higher, that participant may start delaying final outcomes, even if the cost of disrupting network operations becomes prohibitive. In cases of higher market share, for example 50%, attackers can effectively fork the blockchain and choose the fork they “favor”. In cases of 67% or higher, the blockchain essentially becomes a delegate database completely controlled by a single party.

These attacks are not just ideological or theoretical, they are at the core of the value of Ethereum as a settlement layer.

The proof-of-stake mechanism on Ethereum enables centralized participants to accumulate significant market share and potentially control the overall stake market share of Ethereum solely through market forces. In other words, centralized entities are already in a favorable position to dominate the staking landscape.

For example, Coinbase, with multiple lines of business (including custodial relationships), can quickly transition these businesses into staking relationships and consolidate its position in the staking field. It is already the largest single validator on the network, holding 16% market share, and operates various acquisition channels such as cbETH and Coinbase Earn for retail customers, as well as Coinbase Cloud and Coinbase Prime for institutional customers.

New capital inflows pose a potential threat to the neutrality of Ethereum or, as described by the Ethereum Foundation, a 0-layer attack on the “social layer” through excessive regulation. Adding an artificial structure where only so-called “KYC/AML compliant” staking providers are “allowed”, even if such compliance is illusory and lacks legal or technical basis, will only accelerate the adoption of staking by centralized participants, hoping to expand their market share through regulatory consolidation and capture.

Centralized entities expanding their market share pose a risk to the staking layer of Ethereum. They have fundamentally different obligations compared to decentralized protocols. Decentralized protocols exist as a layer of smart contract incentives to coordinate activities among many participants.

For example, Rocket Pool’s rETH has nearly 20,000 holders, 9,000 RPL holders, and over 2,200 staking deposit addresses representing unique node operators. Or Lido, a smart contract layer, coordinates over 39 globally distributed node operators, nearly 300,000 stETH holders, and about 41,000 LDO holders.

However, companies have a primary fiduciary duty to their shareholders and obligations to local legal authorities and regulatory bodies. While Ethereum’s decentralization may have some relevance to a company’s business, such as an exchange, it does not supersede these two obligations.

There are other areas where over-regulation can be used as a soft Layer 0 attack, which, even with good intentions, would undermine Ethereum’s neutrality. If Ethereum is to become the world’s settlement layer, it must have high resistance to censorship and a trusted neutrality. These centralized entities, if large enough, will hinder Ethereum’s core objectives.

IV. Institutional liquidity can be quite significant

Due to a lack of institutional interest, some may underestimate the arrival or impact of spot Ethereum ETFs. However, there are some useful precedents in the commodity space that demonstrate the level of interest that exchange-traded products (ETPs) bring to new asset classes. As a financial tool, ETFs and ETPs have been very effective in standardizing and democratizing access for institutional and retail investors. When such instruments enter the channels of institutional allocations, pension funds, or social security contributions, fund inflows will significantly accelerate into the underlying asset class.

The same advantages of a spot BTC ETF also apply to a spot ETH ETF. For example, about 80% of U.S. wealth controlled by financial advisors and institutions can participate and gain widespread legitimacy with regulatory bodies and governments. We can expect that the increase in legitimacy and recognition will drive further demand for Ether outside of ETF packaging. We have already seen signs of increased institutional interest. Intermediaries like Bitwise have heard potential allocation ratios rise from1% to 5%.Brian Armstrong stated that Coinbase will double the number of institutional additions in its Q3 earnings report, reaching 100+.

It is difficult to speculate on the exact amount of funds flowing in from institutions. However, the GLD ETF for gold had$3.1 billion in net flows in its first year. Buying any amount of gold before ETFs was much more challenging than buying BTC/ETH. You had to physically transport and store it, verify and authenticate its purity, and incur high transaction costs dealing with dealers. Gold ETFs represent an improvement in the underlying attributes of the asset and democratize its value proposition to millions of individual investors through massive fund allocations.

Bitcoin and Ether are digital-first assets that can transfer billions of dollars in a matter of minutes. The barriers to entry for physical gold may not exist here. While ETFs may not necessarily improve the fundamental value proposition of Bitcoin or Ether – they may hinder it – ETFs offer a similar level of democratization and access to these asset classes.

The reality is that the vast majority of people on Earth may never own any physical cryptocurrencies themselves, but rather satisfy themselves with some degree of financial exposure through retirement fund allocations or private savings or investments. Regulated financial channels in developed countries already have a high level of penetration and capillary action. ETFs can help individuals lift the veil on asset classes that they might otherwise remain on the sidelines for, and introduce new risk exposure easily within the framework that individual investors are already familiar with (i.e., banks or brokerage firms).

So what does this mean for the staking layer of Ethereum? A large influx of institutional, yield-insensitive funds could result in the total amount of staked ETH being higher than what economic principles suggest, or higher than the probability target based on endogenous variables of the cryptocurrency. Most of this influx is likely to disproportionally flow to centralized providers, both inside and outside of ETF wrappers. Without trustworthy and successful checks and balances, equity becomes further concentrated within centralized entities, which could erode Ethereum’s resistance to censorship and trusted neutrality.

Most of today’s public discourse centers around Lido – whether they control too much stake and the attack vectors that could potentially be introduced in worst-case scenarios. This is an important and valuable conversation. At the risk of redundant and lengthy debates, here are some quick resources that outline i) how much control Lido governance actually has over node operators (if any), ii) how the DAO addresses governance risks, and iii) how the DAO considers expanding governance risks. Node Operators (NOs) form a set that is distributed across the entire validator set.

– Governance Risk: Hasu’s GOOSE submission + Dual governance proposal
– Expansion of NO set: Stake Router + DVT module
– Decentralized Validator Set: Jon Charbs PoG + Grandjean paper

Please also refer to the excellent article on the actual risks of Lido’s dominance written by Mike Neuder of the Ethereum Foundation.

Most of the criticism of Lido is based on a static view of the staking market. It fails to consider the growth trajectory and the actual situation of the staking market. To fully evaluate the staking market, future growth and market dynamics must be taken into account:

• Future growth: Institutional adoption could drive centralization of entities

• Market dynamics: (Liquidity) staking has a strong winner-takes-all dynamic

Most of this article outlines future growth as it is an important aspect that has not been fully discussed. In our digital public space, the driving force of winner-takes-all has been extensively debated but often lacks the context of future growth. Rational market incentives, including maintaining incentives for a decentralized Ethereum network, may not prevent institutions from taking the path of least resistance to bring new capital into Ethereum.

The only effective balance is to increase the market share of decentralized liquidity staking protocols at the expense of centralized market share. While multiple decentralized protocols are likely to gain enough share to form effective support, Lido is currently the only viable choice for maintaining a robust and decentralized Ethereum staking layer:

• It has objectively succeeded in attracting new Ether from holders as the Lido smart contract has transferred over 30% of all staked ETH, with stETH having nearly 300,000 holders

• It has objectively limited the growth of individual node operators as each one uses Lido as the successful acquisition channel for new Ether shares, but cannot increase their individual market share within Lido more than other node operators

• Currently, its governance is objectively minimized and further minimized through dual governance measures

While the Ethereum base layer is designed for “ungovernance” or highly restricted fork choice governance, an intermediate layer with one or more decentralized protocols can fill the necessary gaps that Ethereum cannot. Jon Charbonneau describes it as:

“Specifically, LST governance can manage the additional subjective incentives required for decentralized operators (e.g., different modules may charge different fees). In the long run, a free market economy does not lead to a long tail or uniform distribution of individual stakeholders. The Ethereum core protocol is largely built on this idea: it should be objective and unbiased as much as possible. However, subjective management and incentives are needed to achieve a decentralized set of operators.

While minimized governance is usually desirable, LST may always require some form of minimal governance. Some processes are needed to match the demand for staking with the needs of running validators. LST governance is always needed to manage the objective function of the node operator set (e.g., stake distribution goals, different module weights, geographical goals, etc.). This fine-tuning may be rare, but this high-level goal setting is crucial for decentralization in monitoring and maintaining the operator set.”

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