Here’s why Ethereum 2 staking is risky and increases centralization

Ethereum 2 is at least four years delayed, but co-founder Vitalik Buterin promises it’ll launch soon. When it does, proof-of-work (PoW) will be phased out and replaced with proof-of-stake (PoS) — a change that comes with a costly barrier to entry for most miners, in turn allowing risky Ethereum 2 liquid staking to become more popular.

Since 2009, Bitcoin validators have relied on a simple proof, “work,” to verify that a miner deserves the coinbase reward. Payable every 10 minutes to the miner who properly hashes a block of valid transactions, the coinbase is an enviable 6.25 BTC ($210,000) subsidy. These rewards and associated transactions fees paid over $15 billion to Bitcoin miners over the past 12 months ⏤ the largest security budget of any blockchain in the world.

Any common laptop, PC, or microcomputer can run a full Bitcoin node and validate all transactions using proof-of-work. The cheap cost of operating a fully validating node has decentralized hundreds of thousands of Bitcoin nodes across the globe, over 15,000 of which are online at any moment.

Since 2014, Ethereum has used a similar PoW, paying billions for miners to secure its blockchain. Operating 24/7 for over a decade, proof-of-work is the oldest and most tested method to secure a blockchain.

Developer Tim Beiko confirmed yet another delay in April, stating the Ethereum Merge would most likely occur in the fall of 2021.

Abandoning this model, ETH 2 will reduce mining and transition to proof-of-stake. Instead of “work,” users will rely on ETH validators to prove the size of their “stake” and validate blocks of transactions. Ethereum 2 will pay validators 3-10% annual yield as compensation for casting these votes.

How much does it cost to activate a set of validator keys in Ethereum 2? The answer is a staggering 32 ETH ⏤ an $80,000 sum that excludes billions of people from any hope of ever becoming a validator.

Because only the wealthy can afford to participate in Ethereum 2 as an independent validator, everyday users must pool their funds together and delegate their votes.

Moreover, pooling functionality is not natively supported within the Ethereum 2 protocol, so most people must centralize their funds with private companies or projects.

Lido’s liquid staking is an irresistible siren call

This brings us to Lido DAO (LDO), the largest custodian of ETH 2 liquid staking. Unlike on-chain ETH 2 staking, Lido depositors do not lose access to most of their money. Instead, Lido immediately reimburses their staked ETH with a proprietary token, “stETH” (meaning “staked ETH”). With stETH and ETH allegedly pegged 1:1 by Lido, users can earn staking rewards without actually staking all of their money.

“Liquid staking” simply refers to the bargain offered by Lido; deposit your ETH with us, get another marketable token back: stETH. Access to this instant “liquidity” from one’s staked ETH explains the namesake: liquid staking.

Possessing $11 billion or one-third of all ETH 2 liquid stakes to date in custody, Lido has suddenly become one of the most important security vulnerabilities of Ethereum 2 — even though it is not a part of Ethereum 2 at all.

There are several reasons Lido has grown so large.

  • Financially, staking ETH into Lido’s DAO is irresistibly attractive. Lido reimburses depositors ETH with stETH, allowing users to earn staking rewards without actually staking all their money.
  • Even better, users may instantly wrap stETH into wstETH, withdraw that wstETH, and sell or re-stake wstETH on secondary markets.
  • Even better, wstETH accrues 3.5% annual interest automatically — a pass-through yield offered to depositors by Lido from ETH 2’s official, variable 3-10% yields.

Altogether, Lido’s depositors believe that they can stake their ETH, redeem most of it back as stETH immediately, wrap it, and then proceed to use wstETH to make even more money while they wait.

However, the risks to on-chain Ethereum get worse off-chain at each step of this process. The 1:1 ETH-to-stETH peg could break; Lido or DeFi protocols could fail. ETH redemption times could delay, hackers could exploit bugs, and criminals could coerce decision-makers.

The risks don’t stop there — flash crashes or liquidity cascades could occur. Validation delegations could become a cabal, DeFi platforms could lose funds, and mercenaries could flash-loan ETH to themselves for key votes.

Is Lido’s growth an omen of centralization?

Read more: ConsenSys lawsuit reveals JPMorgan owns critical Ethereum infrastructure

Ethereum 2 encourages centralization with custodians

Drawn by incredible benefits of instant liquidity, automatic yields, and the ability to leverage stETH for even higher yields across DeFi, Lido DAO has amassed billions of dollars worth of staked ETH. Its deposits have ballooned 17x within 12 months.

The outcomes from Ethereum 2’s liquid staking incentives are predictable. First, ETH 2 validating power is becoming extremely centralized. Exclusionary by design, Ethereum users with less than $80,000 in ETH can only hope for centralized custodians like Lido to cast votes on their behalf.

Second, risks are multiplying. Users must entrust their ETH to a custodian, violating the most basic principle: “Not your keys, not your coins.” They’re also exposed to stETH-to-ETH redemption risks like delays, mispricings, or even denials. Not to mention the threat of hackers, liquidity cascades, and smart contract risks. Last, they’re exposed to treasury and governance decision-making risks by non-Ethereum projects.

Liquid staking programs like Lido and its competitors RocketPool, Coinbase Staking, Binance Staking, and Kraken Staking carry enormous uncertainties. Ethereum 2 users should educate themselves while making important decisions like whether or not to deposit their ETH with centralized decision-makers.

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