CoinShares: The Risks of Centralized Staking and Short-Term Solutions

Written by: Luke Nolan, CoinShares Researcher

Compiled by: Mary Liu, BitpushNews

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

Currently, validators are staking about 22% of the current ETH supply (27 million ETH), with an estimated waiting time of about 10 days to join the queue (down from a peak of about 45 days in June 2023). Although the queue length data from the timestamp in the chart below does not go back far enough to visualize this, it is worth noting that in the days leading up to the Shanghai upgrade (which enabled staking withdrawals), the exit queue was briefly larger than the entry queue (17 days vs. 8 days) (April 2023).

Users wishing to stake ETH have several options, which can be categorized into two main types: they can stake ETH individually (at the cost of reserving 32 ETH) or rely on liquid staking providers, which allow staking with less capital, often with no minimum ETH requirement.

Among all staking providers, Lido currently holds the largest market share (about 32%), followed by Coinbase, which accounts for about 8%.

Centralization Risks and Their Implications for Security

Despite the queue being full (though it is rapidly decreasing), the amount of staked ETH has been continuously rising, and Lido shows no signs of slowing its dominance over other providers. Some industry insiders have pointed out that Lido is on track to control 1/3 of staked ETH, which raises alarms regarding centralization risks.

First, having such a large number of validators under one providing platform is not a good sign for a decentralized blockchain, as ideally, block production should occur in a decentralized manner. Furthermore, if Lido were to be subject to a governance attack and malicious actors controlled Lido validator nodes, the necessary amount of staked ETH as a percentage of the total staked supply would exceed 33% to prevent chain finalizing delays. Through malicious actions or lack of proof, attackers could cause severe issues for the entire network, such as double finalizing, where after being selected as block producers, attackers could generate two or more conflicting proposals, voting twice with over 33% control, leading to the chain forking into two separate blockchains, with serious consequences.

The risk of Lido being attacked is relatively low (as operator nodes are distributed among about 30 companies), but it should not be taken lightly. The Ethereum community has had extensive discussions about the need for measures to avoid any governance or other attacks, but Lido has yet to formulate any official plans, and some community members have even expressed opposition, seemingly not viewing this as a real threat. Lido DeFi expansion lead Seraphim made the following statement:

Another risk to Ethereum's decentralization is Lido's "cartelization," a term widely used in discussion forums to describe activities that could further entrench its monopoly. By reaching a critical consensus threshold (such as the aforementioned 33%), Lido node operators could theoretically engage in block timing manipulation and coordinate MEV extraction, leading to substantial rewards (relative to other providers), thus forming a monopolistic dominance in reward distribution. This means Lido has a clear competitive advantage, and users have little incentive to stake elsewhere.

Lido's dominance in market share partly stems from its first-mover advantage (deep liquidity and long-validated stability) and attractive annual interest rates compared to other liquid staking providers. It is reasonable to expect that as this niche market matures and more competitors scale up, there will be competition to capture market share. So far, there is little data to support this hypothesis, as new validators continue to flock to Lido in large numbers.

Addressing Future Scenarios for Liquid Staking

The next area to discuss is the overall growth in the number of validators and the potential impact this could have on the network's 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.

Despite the aforementioned rapid decrease in the validator queue, which is expected to reach 0 in the coming weeks/months, the demand for staking is rising again, and there is a non-zero possibility that the queue may remain full for the foreseeable future. Dankrad stated 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. Generally speaking, if Ethereum wants to become a highly scalable network, pursuing hardware upgrades is not the right direction.

If the staking queue remains full and we reach higher levels of staked ETH, a further issue may arise, which Dankrad referred to as an "untested economic regime"—the market value of staked ETH becomes greater than that of unstaked ETH.

Similarly, the likelihood of this scenario occurring is very low, but not zero, so solutions to avoid this situation should be explored. It is important to remember that there is an inverse diminishing relationship between the percentage of staked ETH and the annual interest rate percentage received by validators.

As the number of validators increases, it is expected that validators will begin to exit, as the opportunity cost of occupying capital for yields below 2% is not worth it. One risk of doing so is that entering and exiting liquid staking providers is easy—only individual stakers can truly occupy large amounts of capital. Particularly, economies of scale favor providers like Lido, and as yields decrease, the associated hardware costs may not become a barrier to stopping staking.

The U.S. benchmark federal funds rate is at a multi-year high, increasing the opportunity cost of occupying funds in ETH staking. Given that people can still choose to purchase U.S. Treasury bonds with yields around 4.0-5.5%, we seem to be reaching some form of balance related to staking demand (as evidenced by the rapid decline in the queue). The risk profiles of typical ETH stakers and typical Treasury bond investors differ, but if U.S. Treasury yields decline (as the dot plot suggests, which could happen sometime next year), staking demand will certainly rebound.

Solutions (Short-term)

Long-term solutions remain unclear—just as the dynamics of liquid staking were not fully understood when staking was introduced, any solutions included in hard forks must consider how they may change dynamics in the future.

However, short-term solutions are being formulated.

Dapplion proposed EIP-7514, which modifies the validator attrition limit from an unlimited increasing number 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 50%, 75%, or 100% of staked ETH. This assumes a scenario where the activation queue remains full and staking demand is not affected by the aforementioned "self-balancing" diminishing relationship.

As noted above, modifying the attrition limit to a hard cap would significantly slow the growth of active validators. If the situation remains unchanged, as the active validator set increases, the expected attrition limit will continue to rise, accelerating our pace to reach higher levels of staked ETH (as a percentage of the total).

This proposal does not address any of the fundamental issues we have discussed, but it provides the Ethereum developer community with sufficient time to propose genuine solutions to the issues of staking dynamics. Dankrad and other Ethereum community members have suggested several potential long-term solutions, such as:

• MEV destruction
• Increasing the maximum effective balance for validators
• Reducing the attractiveness of staking rewards (by decreasing issuance rewards)
• Lowering the entry barriers for liquid staking providers (to incentivize decentralization)

These proposals would fundamentally alter one or more dynamics of the entire network and could trigger significant second-order effects, thus requiring careful planning and consideration.

Overall, it seems unlikely that the queue will remain perpetually full, and we will reach a higher level than other PoS blockchains, with staking accounting for approximately 40-45% of the total supply. If this level is reached, theoretically, there would be no potential negative impacts, except in terms of scalability (increased messaging and the network's ability to adapt to this situation). In the future, we will need to explore the proposed long-term solutions in more detail, as well as the upcoming upgrades to Ethereum that will fundamentally affect how the network operates.