LSDs, The End of Ethereum as We Know It?
Liquid Staking Derivatives (LSDs) are to crypto now, what Bitcoin NFTs were to NFTs some weeks ago.
A beam of light, in this cold hard dark winter, towards which everyone is running to in the hope of making it.
The current state of LSDs’ scene has been nothing short of electrifying!
The tokens associated with LSD projects such as Lido Finance and Rocket Pool have experienced a meteoric rise in value over the past two months. Additionally, AAVE has recently entered the LSD arena, throwing down the gauntlet and joining the fray.
As a testament to the remarkable growth of LSDs, the beginning of March has marked a turning point where liquid staking has overtaken DeFi lending to become the second-largest crypto sector.
The reason behind if?
The Shanghai Ethereum Upgrade planned for April 2023.
The adoption of Ethereum Improvement Proposal (EIP) 4895 is set to revolutionize the staking mechanism in the Ethereum network.
Stakers who have been holding their ether since December 2020 for some, will now be able to withdraw both their staked amount and the accumulated rewards, a development that has generated a surge of investor interest in Liquidity Staking Derivatives (LSDs).
So much so that liquid staking saw a 60% surge in total value locked, and became the “best-performing crypto sector this year” !
But while the crypto community is raving about the potential of LSDs and how it could trigger the next bull run for crypto after the Shanghai Ethereum Upgrade, some people have tried to raise the alarm.
For them, among which , a researcher at the Ethereum Foundation, LSDs could endanger the very existence of Ethereum.
In the euphoria of what is to come, their message of caution has turned inaudible.
So in today’s article, we decided to dive into why some think that the combination of LSDs and the Shanghai Ethereum Upgrade could turn into the undoing of Ethereum.
The Merge, Validators and Ethereum Shanghai
All began with the Merge.
In September of 2022, Ethereum shifted from Proof-of-Work (PoW) to Proof-of-Stake (POS). Outside the many perks it brought to Ethereum, among which becoming an eco-friendly blockchain, it welcomed the arrival of validators!
Where once under PoW, block creators called miners had to solve cryptographic puzzles, now, under PoS, validators,-the new cool kids on the block-, are the users responsible for verifying transactions on the Ethereum blockchain.
To become a validator, you need to pledge or stake cryptocurrency as collateral, allowing you to earn the privilege of adding the next block of transactions to the ledger, precisely 32 ETH. The Ethereum Foundation defines staking as “the act of depositing 32 ETH to activate validator software”. Essentially, as long as you stake your 32 ETH and keep a single node connected to the Ethereum network at all times, you can become a validator. Your services as a validator are rewarded with interest on the staked assets.
As validators have lower capital and maintenance costs than miners, the shift to PoS meant that thousands of addresses are now associated with validation, in contrast to the pre-Merge scenario where only a few dozen mining addresses were linked to rewards. At press time, there are 547,467 validators operating on the Ethereum Blockchain and 17,518,946 ETH staked.
On paper, the very large number of validators and validation addresses are an incredible blessing for the Ethereum Blockchain.
They are keys to two major existential features of Ethereum:
- Architectural Decentralization
- Being Censorship Resistant I In blockchain frameworks, censorship resistance ensures that all network regulations are established and enforced impartially by users, and cannot be altered for personal gains by a person or an entity. Within a censorship-resistant blockchain, a user is assured the ability to conduct immutable transactions on a blockchain network without requiring permission from any third party.
No entity, whether it be a nation-state, corporation, or third party, possesses the authority to regulate who can engage in transactions or retain their assets within the network. Censorship resistance guarantees that the network’s governing laws are predetermined and cannot be modified retroactively to conform to a particular agenda.
A neutral, censorship-resistant and decentralized system is theoretically robust enough to be able to deflect attacks from even well-resourced actors.
But for people who fear the impact of LSDs on Ethereum, it is those very existential features that LSDs threaten.
Here’s why.
LSDs & Staking Ethereum
LSD advocates believe that LSDs provide a means of safeguarding Ethereum by enabling users to stake their Ether and earn rewards without having to miss out on more profitable ventures.
The LSD system is pretty straightforward and simple:
- You stake a certain amount of a cryptocurrency, in exchange a platform will issue liquid-staking derivatives, or tokens that represent users’ staked currency. You’re given the same amount in another token based on the type of cryptocurrency you have staked. Example: If you stake 5 ETH on Lido, you get in return 5 stETH.
- Now, you are free to do whatever you wish with these new tokens and engage in DeFi activities such as crypto swaps, providing liquidity, lending, collateral, and more to earn additional yield on top of the staking yield that you earn.
In this system, on top of the approximately 3–5% Ethereum staking rewards you get, you gain an additional X% yield based on your DeFi activity.
Despite some inherent risks associated with LSDs, it’s understandable why validators and their almost inert 32 ETH are drawn towards the tempting call of the LSDs siren.
And if they all fall for the siren call, forewarn some, that will make Ethereum wobble, and maybe, ultimately crumble.
“The Risks of LSDs”
To resume the issue in one sentence: LSDs make Ethereum vulnerable to abuses of power.
The Ethereum Foundation & LSDs
First, it should be clarified that the Ethereum Foundation does not consider itself to be in opposition to LSDs. If you go to the Ethereum Foundation how-to page about staking, LSDs is listed among other staking options.
Although it is to be noted, it is ranked third out of four for best practices in staking, just above centralized exchanges.
Furthermore, Danny Ryann, the Ethereum Foundation researcher who made his opinion clear about LSDs, may have also felt the need to rename his article “The Risks of LSDs”, where once it appeared to have been labeled “The Danger of LSDs”.
Maybe in an effort to mitigate the idea that he was anti-LSDs as a whole.
He also added what some would call a double-edged disclaimer:
“Note, although current LSD protocols such as Lido have a lot of room for improvement, this article does not target short-comings in currently implemented designs. Instead, the aim is to show that LSD protocols have inherent issues when they exceed consensus thresholds.”
Now that it has been established to all that no one in the Ethereum Foundation is anti-LSDs per se, *sigh of relief*, let’s get into why Danny Ryan felt the need to drive home that LSDs inherent issues will potentially doom Ethereum and write with alarms in the last sentences of his analysis that:
These may seem like “tail risks” that are hard to take seriously or that might never happen, but if we’ve learned anything in crypto it’s — if it can be exploited or has some unlikely “critical edge case”, then it will be exploited or collapse much sooner than you think. Time and time again in this open and dynamic setting brittle systems collapse and vulnerable systems are exploited for both fun and profit.
Decentralization & Censorship Resistance
In 2020, Marco Di Maggio, a professor at Harvard Business School was one of the first to raises the alarm about the “tendency towards centralization” of LSDs:
“Network effects will emerge, where more usage around a particular liquid staking protocol increases liquidity and utility as collateral, which further drives adoption of that solution relative to its competitors, […]. As a result, we can expect that only a limited amount of liquid staking protocols can coexist in a meaningful way.”
2 years later, Ryann wrote:
“In the extreme, if an LSD protocol exceeds critical consensus thresholds such as 1/3, 1/2, and 2/3, the staking derivative can achieve outsized profits compared to non-pooled capital due to coordinated MEV extraction, block-timing manipulation, and/or censorship — the cartelization of block space. And in this scenario, staked capital becomes discouraged from staking elsewhere due to outsized cartel rewards, self reinforcing the cartel’s hold on staking.
LSD protocols can minimize governance, upgradability, and other risks over time, but the question of “who” gets to be a part of the Node Operator (NO) set remains. This lever is the primary cause of cartelization.
Deciding “who” gets to be a NO is a matter of two questions — who is added to the set and who is removed the set. This can be designed in one of two ways in the long run — either via governance (a coin vote or other similar mechanism) or via an automated mechanism around reputation and profitability. […]
In the former — governance deciding NOs — the governance token (e.g. LDO) becomes a major risk to Ethereum. If the token can decide who can be a node operator in this theoretical majority-LSD, then the token holders can force cartel activities of censorship, multi-block MEV, etc, or else the NO is removed from the set. […]
In the alternative design — economic and reputation based NOs — we actually end up in a similar, albeit automated cartelization. […]
[…], if any amount of the NOs defect to utilizing destructive techniques such as multi-block MEV or adjusting block release times to capture more MEV, then they skew the profitability target such that honest NOs will eventually be automatically ejected if they do not join in on the destructive techniques.
This means that in either method — governance of NOs or economic selection/ejection — such a pool exceeding consensus thresholds becomes a stratum for cartelization. It’s either a direct cartel by governance or it’s a destructive, profitability cartel through smart contract design.”
To understand this, a critical information about how LSDs work must be given:
When Ether holders pool their Ether in a LSDs protocol, that protocol runs validators on their behalf.
So, according to Ryann, if Ethereum validators as well as holders flock en masse to one or more LSDs protocol which will then allow it or them to exceed critical consensus thresholds such as 1/3, 1/2, and ⅔, whether the selection of Node Operators is based on governance or economics, Ethereum can say bye to decentralization and censorship-resistance and hi to cartelization and abuses of power.
This is theoretical.
It was written more than 8 months ago, months before the Merge and the upcoming Ethereum Shanghai upgrade, so what of it now?
In his analysis, Ryann referred to the Lido Protocol no less than 5 times.
Hinting that most likely Lido had the potential to become the architect of Ethereum demise.
The case of Lido Finance
Looking at Lido’s performance, one can only think that DiMaggio was prescient in his analysis.
As he asserted, the utilization of a specific liquid staking protocol would generate network effects, resulting in an increase in liquidity and utility as collateral. This, in turn, would enhance the adoption of the solution in comparison to its rivals.
As it turns out, his prediction came true.
Today, Lido commands more than 77% of the Ethereum LSD market.
Way behind it stands powerhouse Coinbase at only 16% and even further, at the 3rd place stands Rocket Pool at 3,1%.
While the LSD market commands today almost 43% of staked Ethereum and ~7% of its total supply.
Rated’s data shows that Lido, which now holds 5.4% of the total Ethereum supply, is being operated by 161,587 validators spread out across 30 different node operators. Selection of the node operator in the Lido Protocol is determined through governance.
The issue?
In September 2022, Nansen reported that ownership of Lido’s governance token (LDO) is heavily concentrated, with a handful of large token holders posing a potential threat of censorship:
“For example, the top 9 addresses (excl. treasury) hold ~46% of governance power, and a small number of addresses typically dominate proposals. The stakes for proper decentralization are very high for an entity with a potential majority share of staked ETH.”
Nansen then underscored the necessity for Lido to exhibit adequate decentralization to remain resistant to censorship.
In short, Lido is, to a certain degree, a centralized and censorship-prone entity.
And for Ryann, if this kind of LSDs protocol is able to catch enough traction to exceed critical consensus threshold(s), it becomes downright nightmarish for Ethereum:
“If the token can decide who can be a node operator in this theoretical majority-LSD, then the token holders can force cartel activities of censorship, multi-block MEV, etc, or else the NO is removed from the set.
In fact, the enforcement of such economically monopolistic activies only strengthens the token’s control over the NOs. In the event that the token exercises its monopoly to gain outsized profits through destructive mechanisms, then, in the extreme, NOs would not be nearly as profitable operating independently.
Thus the governance token deciding NOs can become a self-reinforcing cartelization and abuse of the Ethereum protocol.
Governance deciding NOs has another distinct risk which is regulatory censorship and control. If pooled stake under one LSD protocol exceeds 50%, this pooled staked gains the ability to censor blocks (and worse-so at 2/3 due to being able to finalize such blocks). In a regulatory censorship attack, we now have a distinct entity — the governance token holders — that a regulator can make requests of censorship. Depending on the token distribution, this is likely a much simpler regulatory target than the Ethereum network as a whole. And, in fact, DAO token distributions are generally pretty terrible with just a few entities deciding most votes.
In any sort of token governance control over a majority-LSD, we thus rely on the benevolence of the DAO or however control is structured. Relying on such an entity’s benevolence, anonymity, or geographic distribution to prevent attacks is not safe, and we must assume not sufficient in the long run.”
Despite Lido currently having the highest proportion of staked ETH, accounting for 32% of the total, this only equates to 5.4% of the entire Ethereum supply.
Therefore, the concerns raised by Ryann may only be considered “tail risks” as he said it himself.
However, everything could change for Lido and Ethereum with the Ethereum Shanghai Upgrade.
The Shanghai Ethereum Upgrade
As depicted in this graphic from Dune, The Merge and then the announcement of the Ethereum Shangai upgrade has generated great enthusiasm for LSDs.
To such an extent that, as previously mentioned, LSDs have overtaken DeFi Lending to become the second-largest crypto sector. This widespread and rising-at-full-speed adoption, in combination with the Ethereum Shanghai upgrade’s ability to finally “withdraw at will” staked Ethereum, has the potential to entirely transform the Ethereum landscape.
How does the Shanghai Upgrade play out in this situation?
Well, the transition of Ethereum’s consensus mechanism from Proof-of-Work to Proof-of-Stake began with the launch of the Beacon Chain, a PoS chain that coexisted with the PoW Ethereum from December 2020 until “The Merge” in September 2022.
With the introduction of the Beacon Chain, staking became possible on Ethereum, albeit in a one-way direction, where validators could only deposit ETH to the Beacon Chain but not withdraw it.
However, with the implementation of EIP-4895, which is the flagship improvement featured in the Shanghai Upgrade, validators will finally be able to withdraw their staked ETH and the associated rewards earned from staking.
In their analysis on the Ethereum Shanghai Upgrade, Binance Research reports:
“ It could be argued that many groups of individuals had been waiting for Shanghai to stake their ETH, as withdrawals will remove the liquidity risk and uncertainty of an previously undefined lock-up period. […] A wave of new participants who had previously been watching from the sidelines can potentially add a level of buying pressure to ETH, especially if institutional capital can be enticed.”
In addition, there is an expectation that liquid staking will continue to expand.
This is due to the fact that the ETH staking ratio is notably lower than that of other layer 1 cryptocurrencies.
Markus Thielen, head of research and strategy at digital-assets platform Matrixport, told CoinDesk: “Only 14% of ETH is currently being staked vs. 58%, the average for layer 1 coins, [..]. Its likely interest in staking will continue to swell.”
An opinion entirely shared by Venture Capital firm Paradigm, a holder of Lido’s LDO governance.
In their report about staking derivatives, Paradigm researcher affirms that:
“Staking derivatives open the potential to state the vast majority of Ether in circulation. […] Without staking derivatives, we might expect 15–30% of ETH to be staked, […]. However, with staking derivatives, this number could be as high as 80–100%, because there is no additional cost to staking compared to non-staking.”
So what does it mean?
For Paradigm researchers, massive staking of Ethereum could turn into a “virtuous cycle” that would “strictly increase Ethereum’s economic security instead of decreasing it.”
An affirmation with which Ryann would certainly not agree with.
The double effect of the Ethereum Shangai Upgrade as well as LSDs current mass adoption, which are correlated, could turn Ryann’s “extreme scenario” into a reality.
Today, the LSD market is absolutely dominated by Lido, and if the enthusiasm for staking Ethereum in LSDs keeps growing at a high-speed rate and Lido keep on staying way ahead of the race, Lido Protocol could exceed critical consensus threshold(s) leading potentially to cartelization.
Worst even for Ryann, LSD ETH holders somehow stop being Ethereum users:
“[…] some suggest that LSD ETH holders could have a say in governance of their underlying LSD protocol, and thus become a safety backstop on what might be a poorly distributed, plutocratic token.
It is important to note here that ETH holders are not by definition Ethereum users, and in the long run, we expect that there are massively more Ethereum users than ETH holders (people with ETH held beyond the amount needed to facilitate TXs). This is a critical and important fact that informs Ethereum governance — there is no on-chain governance granted to ETH holders or stakers. Ethereum is the protocol that users choose to run.
ETH holders in the long run are just a subset of users, so staked ETH holders are even a subset from there. In the extreme of all ETH becoming staked ETH under one LSD, governance vote weights or aborts by staked ETH do not protect the Ethereum platform for users.
Thus even if the LSD protocol and the LSD holders are aligned on subtle attacks and capture, users are not and can/will react.”
In short, Ethereum could lose its decentralization and censorship-resistance as well as its user base to liquid staking derivatives.
Everything that makes Ethereum, Ethereum.
What’s happening is not really about Lido, but about any LSDs protocols that could be able to dominate the market and exceed critical consensus threshold(s).
In this new Ethereum paradigm that is emerging, cartelization is more than a groundless hypothesis.
It could become a reality.
For Ryann, even if individual Ethereum users and holders were to understand the full impact of their LSD choice on Ethereum, and that ultimately “[…]pooling of capital into this stratum for cartelization puts not only the Ethereum protocol at risk, but, in turn, the pooled capital.”, they will still choose LSDs:
“Thus this appears to suffer from the tragedy of the commons — each individual making a rational decision to stake with the LSD protocol is making a good decision for the user but an increasingly bad decision for the protocol.”
On a closer look though, the rise of LSDs with their inherent risks to Ethereum’s integrity, especially censorship-resistance are just one more issue to deal with forEthereum on top of the challenge posed by MEV bots.
Aka MEV bots are running the Ethereum show.
MEV bots, the Current Threat to Ethereum’s Censorship-resistance
What are MEV bots?
MEV, or Miner/Maximum Extractable Value, is a set of strategies employed by miners or traders to maximize their profits by reordering, inserting or censoring transactions in a blockchain network.
Validators can leverage MEV-boost relays to increase their yields on the Ethereum blockchain. By configuring their mev-boost settings, validators can specify which relays they would like to receive blocks from, and can sell block space to a pool of block builders, resulting in an increase of up to 60% in their ETH staking rewards.
The separation of proposer and block-builder, also known as PBS, is a frequently employed MEV tactic in which validators can choose to delegate their block production duties to the bidder who offers the highest price, thereby raising their annual percentage rate (APR).
But there are two major drawbacks.
MEV bots issues
MEV was originally intended to enhance efficiency for validators and users of the Ethereum network, but it comes with two unwanted side effects: re-centralization and the censorship of transactions and applications.
When validators relinquish control over transaction selection and delegate block construction to MEV-boost Relays, they hand over this control to MEV-boost relay providers who operate as conventional business entities.
These handful of businesses through their MEV-bots will pick and choose transactions as well as disregard them entirely, opening the door to re-centralization and censorship.
A large portion of them derive from the US and thus are subjected to US jurisdiction. This means censoring transactions the government doesn’t approve of, including those deriving from mixing service Tornado Cash, or disallowing transactions from sanctioned addresses under the mandate from OFAC.
Not all blocks built by OFAC compliant relays are censoring, however, all blocks built by OFAC compliant relays will censor when non-compliant transactions are broadcast to the network.
Today, on average 90% of Ethereum blocks are being MEV-boosted.
It’s not far-fetched to say that they are running the show.
On the day of the merge, 10% of blocks only were MEV-boosted, 50 days later, 87% of them were MEV boosted among which 72% were OFAC compliant.
As of now, 87% of current network validators, 474,832 of them exactly, have registered with the Flashbot relay.
But good news for censorship resistance on Ethereum, bad news for regulators, since November there has been a huge shift in the ratio OFAC compliant/Non-OFAC compliant MEV bots used by validators.
Maybe precipitated by the FTX scandal and the need by the community as a whole to distance themselves from anything centralized and regulated.
MEV watch statistics shows that on November 21th, 2022, at their peak OFAC compliant MEV-bots powered 79% of Ethereum blocks. Since then they have slowly but consistently decreased. On March 1st, “only” 38% of blocks were OFAC compliant.
Furthermore, they reveal that since mid-February an increasing number of validators have opted out of using MEV-bot. On February 16th, only 9% of blocks were not MEV-boosted, whereas 10 days later, that percentage had risen to 15%. Since then, an average of 13–14% of blocks have not been MEV-boosted.
However, it’s important to exercise caution with this new development. The reduction in MEV-boost blocks may be a result of a significant influx of new validators attracted by Ethereum Shanghai who have yet to choose or not to operate with MEV-bots. It remains to be seen whether this is just a temporary glitch or a long-term trend. Only time will tell.
Despite these good news, at the end of the day, ~87% of blocks are today MEV-boosted and 41% are enforcing OFAC compliance.
A threat on Ethereum’s decentralization and censorship resistance, that could be exacerbated to unfathomable level by the LSDs challenge that lays ahead.
What Now?
Ryann has a simple answer to this cartelization-inducing LSD conundrum: self-limitation.
In the very last lines of his report, he urges LSD protocols as well as capital allocators, to exercise self-restraint:
“The Ethereum protocol and users can recover from an LSD centralization and governance attack, but it won’t be pretty. I recommend that Lido and similar LSD products self-limit for their own sake, and I recommend capital allocators to acknowledge the pooling risks inherent to LSD protocol designs. Capital allocators should not allocate to LSD protocols exceeding 25% of total staked Ether due to the inherent and extreme risks associated.”
A scenario where capital allocators and LSD protocols alike would give up profit in the name of Ethereum, seems impossible as he himself pointed out.
LSD protocols and capital allocators are facing the unfamous “prisoner’s dilemma”.
As a reminder, the prisoner’s dilemma is a classic game theory situation where two individuals must decide whether to cooperate or betray each other, with the outcome being that if both cooperate they both benefit, but if one betrays the other they gain an advantage while the other suffers a greater loss, and if both betray each other they both receive a suboptimal outcome. If the two rational individuals make self-interested decisions, it may not result in the most optimal outcome for both parties.
Applied to this situation, LSD protocols and capital allocators, if they choose themselves, weaken Ethereum, a situation none of them will ultimately benefit from.
If let’s say Lido “self-restrains” itself, but other LSD players don’t, they lose their leading position and endanger their sustainability.
If some capital allocators restrain themselves while the others don’t, they lose on profit while Ethereum ends up being weakened all the same.
It’s not called a dilemma for nothing.
Unless, as Ryann suggests, everyone works towards protecting the integrity of the Ethereum blockchain, this creates a situation where self-serving choices will automatically create winners and losers, and no one, especially a business, wants to lose on profit.
Unsurprisingly in June 2022, Lido rejected a proposal to set a limit on its growth.
Since self-restraint is not a viable path for LSDs protocols, efforts have been made, especially by Lido protocol to try and mitigate their impact.
To improve the diversity of its validator set, they recently unveiled a new feature called a Staking Router. Lido node operators are typically large staking firms such as Chorus One.
Becoming a node operator on the network currently requires an application process, with the protocol only accepting validator applications for those interested in staking on Polygon.
The Staking Router aims to change this by creating various modules for the onboarding process, enabling more flexibility in the types of validators that can join Lido.
These modules could be selected via community election, concentrate on operating validator sets utilizing layer-2 solutions, or incorporate both.
This is one step in the good direction, and many discussions are on-going to effectively decentralize and make Lido less censure-prone.
Nevertheless, these tweaks do not look like they will be enough to tackle the challenge ahead for LSDs protocols and Ethereum.
The introduction of new strong LSDs competitors like AAVE could be key though.
Maybe the best case scenario, if one day ETH staking ratio rises to ~58% like other layer 1 protocols, is to have as many LSDs as possible that would each be able to draw in enough Ethereum holders that none would ever be able to exceed any consensus thresholds.
But for now, all of this is solely conjecture.
Maybe Ethereum will stroll through it all unscattered.
Maybe it will be a little bruised.
Or maybe it will agonize at the foot of the altar of greed.
In an ever changing landscape like crypto where it’s hard to tell what will happen tomorrow, all bets are off.
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