Ethereum Staking: Navigating Centralization Risks in a Proof-of-Stake Ecosystem

By Michael @ CryptoEQ | CryptoEQ | 13 Jun 2024


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Intro

The transition of Ethereum from a proof-of-work (PoW) to a proof-of-stake (PoS) consensus mechanism marks a significant evolution in its blockchain architecture. This shift, while promising in terms of efficiency and scalability, introduces new complexities and risks, particularly concerning the centralization of the validator set. Leading voices in the Ethereum ecosystem, such as Hasu, the strategy lead at Flashbots, and Vasily, co-founder of Lido, have delved into these nuances, shedding light on the intricate balance between maintaining security and decentralization.

Understanding Decentralization

Who runs the network and controls the coins/supply?

In the current paradigm, founding entities wield significant influence over network upgrades. Any proposed changes necessitate the acceptance and subsequent implementation by the network's validators. This mechanism underscores the pivotal role of validator count and distribution.

With few validators, particularly if a founding entity controls a significant portion, the said entity gains the power to single-handedly introduce changes. Conversely, increased validator count and dispersion across diverse entities democratize protocol amendments. This dynamic demonstrates the direct correlation between the number of validators and the level of decentralization in the network.

In most instances, there is a central figure or core team behind the project that has a tremendous amount of influence. For example, the Ethereum Foundation, C.Z. of Binance, and Charles Hoskinson of Cardano. The power and control of these groups should be considered as this can lead to strong levels of decentralization. Ideally, more power is held in the hands of network participants as opposed to a select few insiders.

Pre-launch Token Allocations Source: Messari

In addition, it is just as vital to acknowledge who controls the supply. Specifically in PoS systems where a greater stake means more influence within the application. For the same reason, if large stakes are held by only a couple large players, how decentralized can a blockchain be?

Who Makes the Decisions?

At the beginning of a project's life cycle, central authorities simply have to make unilateral decisions in order to survive. But as time goes on, power and decision-making responsibilities can be passed along through more equal coin distribution, voting mechanisms, and democratic governance models. All of these details are key when evaluating various blockchains. A sole authoritative body could potentially go against the interests of the user majority.

Can the Chain Be “Turned off/reset?

Some platforms have experienced outages and network issues. Solana, for example, suffered from numerous outages in 2022. In September 2021, Solana validators grouped to reset the chain due to network problems. Although having these validators is helpful to make improvements, it also signifies the dominant central authority of many chains. An even clearer example was when Binance halted the BNB Chain in October 2022 following a hack. This was a clear example that the centralized company controlled the chain.

Is It Accessible to Run or Participate in the Network?

Almost anyone can buy the coins and tokens of these projects, but what about other ways to participate? Not everyone has the expensive equipment or know-how to mine efficiently. You would also need in-depth technical knowledge to interact with or make proposals to a project’s development teams. In PoS systems, users need a minimum stake which is another barrier to entry. The higher the participation cost, the less diversity to participate in running the network. Thus centralizing the blockchain or dApp.

Does the Chain or dApp Have Emergency Powers?

Some blockchains/dApps have ‘back door’ capabilities in case of a bug or catastrophic network event. Although this is common with newly released projects, it is important to check the fine print as a chain develops over time. A well-established chain with emergency powers may be a cause for concern for those seeking applications with decentralized qualities. One prime example in 2023 was the Maker/Oasis "counter exploit," in which Jump Crypto worked with the government and Oasis, a separate front-end for the boring and lending protocol, Maker, to upgrade smart contract code in order to claw back hacked funds. While ethics can be debated, this was one of the most brazen examples of individuals being able to change and/or "trick" the code to their advantage or by decree of a government agency. 

Balancing Stake Rates and Security

One of the pivotal discussions revolves around finding an optimal stake rate. The trade-offs between a high and low stake rate are multifaceted, involving considerations around network security, incentive alignment, and the potential for centralization. A high stake rate might enhance security by increasing the economic cost of attacking the network but could also lead to centralization if only a few entities control a significant portion of the staked Ether (ETH). Conversely, a lower stake rate might foster decentralization by lowering the barrier to entry for solo stakers, yet it might compromise security.

Proposals by Ethereum developers Casper and Ansgard aim to address these challenges by adjusting the issuance curve to maintain a target stake rate of 25%. These proposals raise concerns about their impact on solo stakers and the role of liquid staking derivatives (LSDs) like those offered by Lido. Lido's strategy to optimize for solo stakers and enhance permissionless participation through the Community Staking Module is a proactive step towards mitigating centralization risks while promoting a diverse validator set.

Implications of Ethereum ETFs and Institutional Involvement

The potential introduction of Ethereum exchange-traded funds (ETFs) represents another dimension influencing the staking landscape. ETFs could drive substantial capital into staking, primarily from institutional investors seeking regulated and liquid exposure to ETH. Vasily emphasizes that these investors prioritize safety, liquidity, and regulatory compliance. This institutional demand could push more conservative staking providers to cater to these requirements, potentially impacting the staking ecosystem's dynamics.

Hasu posits that ETF investors might stake ETH regardless of yield levels, focusing more on securing their exposure to the underlying asset. This indiscriminate approach could further influence the staking rate and validator set composition, underscoring the need for careful consideration of centralization risks.

The Concept of "Restaking" and Its Impact

Restaking, a concept gaining traction in Ethereum circles, involves validators participating in multiple roles or tasks to earn additional rewards. While theoretically promising, Hasu expresses skepticism about its practical impact on validator yields. He suggests that creating significant value through restaking activities might be challenging, and its potential to influence the overall yield of the Ethereum network remains uncertain.

Nonetheless, Lido's strategy to position stETH (staked Ether) as the preferred collateral for restaking activities and integrate with Layer 2 ecosystems demonstrates a forward-thinking approach. These efforts aim to enhance the utility and value proposition of stETH, ensuring its relevance in an evolving staking environment.

Centralization Risks and Mitigation Strategies

The overarching concern in Ethereum's PoS transition is the risk of centralization. As staking dynamics evolve, the concentration of staking power among a few entities could undermine the decentralized ethos of Ethereum. Lido's initiatives to promote solo staking and permissionless participation are crucial steps in addressing these risks. However, continuous vigilance and adaptive strategies are essential to ensure a balanced and secure network.

Institutional players and individual stakeholders alike must engage with leading Ethereum liquid staking providers to understand their roadmaps and explore partnerships that align with decentralization goals. Monitoring developments in Ethereum's issuance policies and staking dynamics will be critical in navigating the changing landscape.

Moreover, the potential impact of Ethereum ETFs on staking necessitates proactive strategies to accommodate this influx while safeguarding the network's integrity. Exploring restaking opportunities, while mindful of centralization risks, could offer additional avenues for enhancing staking rewards and participation.

Collaborating with Ethereum Layer 2 protocol teams will also be vital. These ecosystems can provide scalable solutions that integrate with staking activities, further diversifying the validator set and mitigating centralization risks. Lido's focus on Layer 2 integration highlights the importance of leveraging these technologies to maintain a decentralized and robust Ethereum network.

Conclusion

Ethereum's shift to proof-of-stake presents both opportunities and challenges. As the ecosystem adapts to this new paradigm, striking a balance between security, decentralization, and efficiency will be paramount. By understanding and addressing the centralization risks inherent in staking dynamics, the Ethereum community can ensure a resilient and inclusive blockchain future. Engaging with key stakeholders, monitoring policy developments, and leveraging emerging technologies will be crucial steps in navigating this complex landscape.

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Michael @ CryptoEQ
Michael @ CryptoEQ

I am a Co-Founder and Lead Analyst at CryptoEQ. Gain the market insights you need to grow your cryptocurrency portfolio. Our team's supportive and interactive approach helps you refine your crypto investing and trading strategies.


CryptoEQ
CryptoEQ

Gain the market insights you need to grow your cryptocurrency portfolio. Our team's supportive and interactive approach helps you refine your crypto investing and trading strategies.

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