What problems might the popularity of Ethereum pledge services bring?

Too much outsourcing of Ethereum pledge will result in only a few large centralized custodians leading the service, the verifier has little interest in the system, and the motivation for correct verification is low.

Original title: “BitMEX Research: Potential Problems Existing in Ethereum Staking Outsourcing”

We studied the idea of ​​outsourcing the pledge in the Proof of Stake (PoS) process to a third-party validator, which may decouple the coin holder from the consensus agent. We explained why this service might become popular because it has some attractions for users, such as issuing tokens and higher returns. We studied Lido, a large staking service that currently accounts for about 18% of Ethereum staking, and talked with one of the main supporters of the Lido staking pool. Our conclusion is that critics of the proof-of-stake system may pay attention to the popularity of these pledge outsourcing systems as one of their main concerns in the next few years.

What problems may be caused by the popularity of Ethereum pledge services?

Overview

This is the third part of our series on the Ethereum Proof of Stake System after calculating penalties and rewards in last month’s article.

The core of the pledge concept is to align the interests of token holders and consensus agents so that they become the same entity. However, there is a potential problem here: coin holders can outsource the pledge process to a third party, thereby denying the consistency of the incentive mechanism and destroying the pledge process to a certain extent. Similar potential problems also appear in proof-of-work (PoW) mining in the form of leased hash rate. You may have heard the saying: PoW miners will never carry out large-scale restructuring and double-spending attacks, because this will destroy their capital investment in Bitcoin mining. Well, if a significant portion of the hash rate is rented, this obvious protection does not seem to exist. Therefore, we believe that if there is a large and liquid hash rate rental market, then there is a possibility of breaking some PoW security assumptions. This problem also exists in the PoS process. In this report, we explain why outsourcing may be more common in PoS-type systems, and therefore may cause more problems. However, you can also say that PoW miners entered the public market through an IPO, causing a similar potential problem for Bitcoin.

We have to admit that in April 2018, we ignored this weakness of the PoS system in the comments below, and we may be wrong.

Another major problem based on the PoW system is that the interests of miners may be inconsistent with the interests of token holders. For example, miners can sell their mined tokens and then only care about short-term, not long-term token value. Another problem is that the hash rate may be rented out, and the tenant has little financial interest in the long-term prospects of the system. PoS directly links the consensus agent with the investment of coins, that is, theoretically connects the interests of investors and the consensus agent.

Financialization

Hash rate renting must have been a popular activity in the past, and this active market still exists. However, in our opinion, this is still a fairly professional product. In contrast, outsourcing the pledge process feels almost like a mainstream financial product, for both retail and institutional investors. Pledge is almost purely financial in nature, rather than hash rate lease with some other operational characteristics. Most large cryptocurrency exchanges provide or plan to provide custodial pledge services. At the same time, pledge seems to be quite suitable as an investment product. Why should someone invest in a normal Ethereum fund or ETP instead of investing in a pledged version and get a higher return? Of course, many people actually need to use Ethereum to pay for Gas. These Ethereum cannot be pledged. However, most Ethereum holders are still speculators and investors. For these investors, they are likely to want pledged products. However, most mainstream investors and holders do not carry out the pledge process themselves, but outsource it.

Tokenization

Entities that perform pledge outsourcing services can also issue tokens to their customers, representing shares in the pledge pool. Staking rewards can then be issued to these token holders. This kind of activity may be very popular in the Ethereum community because users like to get new tokens. These new tokens can be ERC-20 tokens on the Ethereum blockchain, just like Ethereum, but their credit risk is related to the staking pool, and you cannot use them to pay for Gas fees.

The user advantages of this token method are obvious:

  • It provides the owner of the pledge pool with the ability to enter and exit more easily without any lag.
  • It alleviates a potential problem of staking on Ethereum, mainly because the staking yield needs to compete with other yields in the system (for example, the yield you can get on DeFi). This may mean, for example, that the staking yield of Ethereum is too low, so that Ethereum needs to further expand its supply to ensure sufficient security. Through this token method, the pledger can now earn two kinds of income at the same time, thus partially solving this problem. For example, people can deploy staking pool tokens into the DeFi ecosystem to earn more revenue.

Some people believe that when ETH 2.0 goes online correctly, the risks associated with the tokenization of the pledge pool shares can be alleviated. At present, the pledged Ethereum is basically locked and cannot be redeemed. Therefore, selling these tokens is the only way to withdraw from the pledge. Once ETH 2.0 is online, the pledger will have another redemption mechanism. However, after ETH 2.0 goes online, staking pool tokens may still continue to be popular because these pool tokens will still have a faster redemption mechanism that makes them attractive.

Lido

Lido is a project that has realized the tokenization of Ethereum pledge. At the time of writing this article, the fund pool already owns an 18% share of all Ethereum pledges. This obvious centralization problem has worried some people in the Ethereum community.

Lido Square Ethernet pledge token is called stETH, very easy to get the money, people can add Ethernet Square to pledge pool on the Lido site to get the money, stETH can also be purchased on the open market, such as Curve .fi. Theoretically, the value of stETH should not exceed one ETH, because it can always be created with Ethereum and a ratio of 1:1.

What problems may be caused by the popularity of Ethereum pledge services?

What problems may be caused by the popularity of Ethereum pledge services?

When holding stETH, investors can get daily pledge rewards after deducting fees. There are many pledge pools behind Lido, where pledge funds are allocated. Lido itself claims to be a decentralized DAO, with its own token and its own governance process. One can say that these more levels of decentralized systems just confuse the problem of complexity. On the other hand, these levels and complexity make the system more difficult to review, because the authorities may not know which element of the system to target. However, analyzing the decentralized characteristics of Lido DAO is beyond the scope of our analysis.

Interview with Hasu

Below we interviewed Hasu, a cryptocurrency researcher and decentralized staking pool advocate, about Lido:

1. If there is no company and LIDO is decentralized, who will run the Lido.fi website?

The Lido website and infrastructure are currently maintained by p2p.org and Chorus One, the two founding members of the DAO. Another important question may be who owns the brand/trademark. So far, no one owns it, but there are considerations of creating a neutral foundation to own trademarks and other important assets.

2. Who will implement the decision to allocate funds to pledgers? I know that this decision is a vote, but is the implementation of voting centralized?

First, let me clarify some jargon. In Lido, a pledger is a customer who deposits ETH to us to obtain stETH. These ETHs are entrusted to the node operators, and the verifiers are their personal nodes (each verifier can accurately bet 32 ​​ETH, no more, no less).

When the pledger deposits in Lido, they will immediately receive stETH. At the same time, ETH first enters a deposit pool. Once there are enough funds to start a new validator, it will be automatically assigned to a node operator by the smart contract. The probability of being allocated, that is, the so-called whitelist on the node registry, is subject to voting by the DAO. The voting itself is the result of proposals submitted by the sub-government group of the Lido node operator. So far, we have never asked the DAO to reject the proposed candidate, but this can happen.

Many Lido stakeholders recently jointly published an article, half of the mission statement, half of the long-term roadmap, called “The Road to Decentralized Pledge”. It discusses the exact trust assumptions users have in Lido now, and our plan to reduce it to the absolute minimum.

3. There are opinions that Lido will lead to centralization, which is not good for ETH pledge. What is your opinion?

I think the opposite is true-in my article “On Pledge Pools and Pledge Derivatives” by Georgios Konstantopoulos and I, we explained that the ability to issue pledged derivatives (which is much easier than PoW) can create a huge staking pool Network effects. This and other advantages put centralized exchanges in the best position to provide staking.

However, if too many people are pledged on a centralized exchange, the result may be the economic and political centralization of the consensus set, which ultimately hurts the anti-censorship ability of the chain itself. Lido is an attempt to establish a staking pool. It is decentralized enough to minimize this risk, but it is also scalable enough to compete with CEXs.

4. Can stETH be used in DeFi to earn more income?

The best practice now is to put your stETH in the incentive stETH/ETH pool of a decentralized exchange. As long as the transaction ratio of stETH to ETH is close to 1:1, there will be no impermanence losses, only transaction fees and incentives. Now there are such pools on Balancer and Curve.

In addition, there are some positive suggestions to allow stETH to be used as collateral in the lending market, such as Maker, Aave, and Compound. I am optimistic that users will soon be able to use their stETH in various DeFi applications.

5. In the future, do you think there will be people who are unwilling to hold ETH because stETH is better?

This will depend on two factors. First, can we execute our roadmap to make stETH have enough credibility compared to ETH? Secondly, will stETH be accepted by many applications like today’s ETH?

Together, they determine the opportunity cost of holding stETH over ETH. If this cost is low enough, then I believe that stETH is to ETH what US government bonds are to physical dollars-a quasi-risk-free interest rate.

6. Have you thought about ETH pledged exchange-traded products (ETPs)? Many ETP vendors are beginning to be enthusiastic about this idea, because staking seems to be more suitable for ETP, and ETP without staking may lose market share. Maybe stETH can be used to help make ETPs

There is no clear regulation on ETP, but we are very interested in providing stETH to more consumers. This may include products where stETH is escrowed, such as investment trusts offered through traditional brokers. But it can also be a product on the chain with lower risk, such as using stETH pledge, giving up some benefits in exchange for additional insurance.

Another obstacle for traditional investors is the lack of clear taxes when depositing ETH and receiving stETH. We are currently exploring how to clarify this issue for investors and give them the certainty they need.

7. Finally, at a deeper level, will there be a Rollup sidechain that allows payment of fees in stETH?

You can do this, but in my opinion, Rollup users will be able to pay the sorter in any currency they want, including the tokens they are currently transferring or buying. Requiring specific tokens to pay for fees is a bad user experience, and it is not a design pattern that will exist for a long time.

in conclusion

In our view, a large amount of pledge outsourcing is an important potential problem of the ETH 2.0 network. On the one hand, it can be considered to be centralized, with only a few dominant services (such as Lido or large centralized custodians). On the other hand, because the verifier may not have much economic interest in the system, the motivation for correct verification is relatively high. Low. In addition, there are some economic issues. If outsourcing becomes so easy and attractive that almost everyone participates in it, then this renews a traditional criticism of PoS, that is, the reward is not real at all, it is just Same as inflation.

In fact, in the medium term, the outsourcing problem may become a real problem, which is considered centralization on the Internet. If the proportion of pledged coins in these outsourcing systems reaches more than 50%, it may attract criticism. As for whether this potential problem will cause actual network problems affecting users, at least in the next few years, maybe not. However, in the long run, these weaknesses may increase.

Posted by:CoinYuppie,Reprinted with attribution to:https://coinyuppie.com/what-problems-might-the-popularity-of-ethereum-pledge-services-bring/
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