The Myth of Decentralization: Analysis of Lido’s Reality, Beliefs, and Pursuits in the Crypto Field (Part 1)

Ethereum History: Upgrading from PoW in Ethereum 1.0 to PoS in Ethereum 2.0

Since the release of the Ethereum white paper, Ethereum has completed a lot of work, such as developing a universal smart contract platform, expanding the community and ecosystem, etc. However, the development of Ethereum cannot be achieved overnight, so a multi-step development roadmap has been formulated. According to the Ethereum development roadmap, Ethereum has four strategic directions: Frontier, Homestead, Metropolis, and Serenity.

• Frontier: The initial phase of Ethereum, characterized by basic functionality and centralized protective measures, ensures network security. Early mining rewards incentivized the miner community, enhancing resistance to hacker attacks.
• Homestead: Marking Ethereum’s first hard fork, this phase saw the abolition of the canary contract, a move towards improved decentralization, and the introduction of the Mist wallet, enabling users to trade and hold ETH. Ethereum evolved to be more than a tool for developers, welcoming ordinary users into its ecosystem.
• Metropolis: This phase, encompassing the Byzantium and Constantinople hard forks, involved key changes like adjusting block difficulty consensus, increasing mining difficulty, and reducing mining rewards. To facilitate the transition from PoW to PoS, the difficulty bomb was delayed. Constantinople focused on reducing Gas fees, decreasing block rewards, and enhancing smart contract efficiency by allowing contracts to verify hashes of other contracts.
• Serenity: The Istanbul hard fork in this phase reduced pre-coding and code prices, and Gas fees while increasing Ethereum’s TPS to 3,000. The Berlin upgrade focused on optimizing the main network and contracts of Ethereum, covering improvements in Gas efficiency, updates to the EVM code reading process, and DDOS attack protection.

Following the merger of Ethereum’s Beacon Chain with the original proof-of-work chain, the most pivotal update was the transition from the ‘Proof of Work’ (PoW) mechanism to the ‘Proof of Stake’ (PoS)mechanism.

• Proof of Stake: A method for verifying and confirming cryptocurrency transactions, distinct from the Proof of Work approach used by Bitcoin and others. The PoS mechanism relies on the quantity of cryptocurrency a user holds (i.e., their ‘stake’) rather than computational power.
• In the PoS system, network security and consensus are ensured by the staking of tokens by holders. Participants commit a specific amount of tokens to become validators and block producers. Valid validators are chosen based on their staked tokens, making them eligible for token rewards as incentives. Malicious behavior by a validator can result in the loss of a portion or all of their staked tokens as a penalty.

Ethereum’s stake mechanism (Proof of Stake)

In the Ethereum network, staking involves depositing 32 ETH to enable validator software. Validators are tasked with storing data, processing transactions, and appending new blocks to the blockchain. This process will prove the security of Ethereum and in the process, validators will earn new Ethereum rewards. The Beacon Chain, introduced to the Ethereum ecosystem, brought the Proof of Stake mechanism into play. It was merged with Ethereum’s original Proof-of-Work chain in September 2022. The consensus logic and block broadcast protocol introduced by the Beacon Chain currently protect Ethereum.

Stakers contribute to Ethereum’s network security at a verification level by staking their ETH. The Ethereum network compensates stakers with rewards. The staking rewards in Ethereum adhere to the principle of diminishing returns. When fewer ETH are staked, the staking income is higher. However, as more ETH gets staked, the individual staking income tends to decrease. For example, when the total number of staked Ethereum reaches 12 million, the annual rate of return on stakes will be reduced to 4.5%. Broadly speaking, staking represents a crypto-economic model that promotes appropriate participant behavior in the network through a system of rewards and penalties, thereby bolstering its foundational security.

Source of information: public market information

Within the Ethereum network, various entities experience multiple benefits from staking ETH:

• For the Ethereum network itself, the increasing number of staked Ether enhances network strength. An attacker would need to control the majority of validators, requiring a substantial amount of Ethereum, making decentralized staking pivotal in bolstering network security;
• Institutions and individual users can earn staking rewards. The Ethereum network rewards actions that achieve consensus, such as correctly processing transactions into new blocks and validating the work of other nodes.

However, it’s important to note that staking Ethereum involves certain risks. Validators must ensure their nodes are consistently online and in good network health. Downtime or any form of disruption can result in penalties, leading to potential loss of funds:

• After becoming a validator, running your verification node must ensure that it is online for a long time and the network status must be healthy. If the validator is stopped, there will be a risk of forfeiture, resulting in a certain loss of funds;
• Different staking solutions also present code-related risks. Like any new software, the client might encounter bugs. Users and institutions may face issues like offline periods and reduced revenue due to such bugs.

Overall, staking serves as a means to secure proof-of-stake blockchain networks, including Ethereum. Network participants can run validator nodes by staking tokens. Should a node exhibit malicious behavior or unreliability, its staked tokens can be slashed as a form of penalty. It should be noted that the penalty is directly extracted from the staked 32 ETH, and the validator cannot reset the entire validator node by completing or replacing the originally staked ETH. If the staked 32 ETH is deducted When there are less than 16 coins, the validator node will be automatically kicked out.

Looking at the circulation of ETH under the PoS mechanism, as of September 2023, the amount of Ethereum staked accounted for nearly 30%, and its proportion is much higher than the proportion in the Layer 2 direction (less than 2%); among all staked Among the solutions, users or institutions are very fond of Lido. The stake of ETH by choosing Lido accounts for 7.2551% of all Ethereum circulation. This proportion exceeds other circulation stake service providers, such as Rocket Pool, Frax, and StakeWise. In addition, according to the circulation diagram of Ethereum below, from the perspective of users and institutions, the demand for liquidity staking is higher than other stake needs, such as centralized exchange staking, stake pool staking, etc. Please refer to the picture below for details.

Source: Eth Wave (Twitter: @TrueWaveBreak)

Ethereum Staking Solutions Comparison

Each Ethereum staking solution has its characteristics, and institutions or users can choose a suitable staking solution. Some users will choose the staking solution of centralized exchanges to stake Ethereum, while some institutional users will choose other solutions, such as individual staking, joint staking, and other solutions. Staking can be rolled back, allowing institutions or users to earn from their Ethereum holdings with minimal time and effort. The principle of the Ethereum staking scheme of centralized exchanges is to gather a large amount of Ethereum into a fund pool to run a large number of validators. The figure below is a comparison diagram of Ethereum’s separate staking/staking as a service (SaaS)/joint staking solutions.

Source of information: public market information

Given the display of the above three staking solutions, the following table lists the individual staking/stake as a service (SaaS)/joint staking scheme schemes and compares and analyzes the characteristics, requirements, rewards, and risks of different schemes among the three schemes.

Source of information: public market information

Liquidity Staking

Liquidity staking providers take user deposits, stake tokens on the user’s behalf, and provide users with a receipt in the form of new tokens that can be redeemed for the staked tokens (plus or minus a portion of rewards and penalties). This new token can also be traded within DeFi protocols or used as collateral, freeing up liquidity in staked assets. Liquid staking service providers solve this liquidity problem by minting new tokens (representing claims on the underlying staking assets), which can then be traded or deposited in DeFi protocols. For example, users can deposit ETH into the Lido staking pool, receive stETH (staking ETH) tokens as asset certificates, and then deposit stETH into Aave as collateral. Essentially, liquidity staking builds on the existing staking system by releasing liquidity of the staked tokens.

Benefits of Liquidity Staking

• Unleashing Liquidity: Tokens staked in networks like Ethereum are locked and cannot be traded or used as collateral. Liquid staked tokens unlock the intrinsic value held by staked tokens and can be traded and used as collateral in DeFi protocols.
• Composability in DeFi: By representing receipts of staked assets as tokens, they can be used in various protocols in the DeFi ecosystem, such as lending protocols and decentralized exchanges.
• Reward opportunities: Traditional staking provides users with the opportunity to earn rewards for validating transactions. Liquid staking allows users to continue to earn these rewards while also earning additional benefits through various DeFi protocols.
• Outsourced infrastructure requirements: Liquidity staking providers enable anyone to share in the rewards of staking without having to maintain complex staking infrastructure. For example, liquidity staking still enables users to share in block rewards even if they do not have the minimum 32 ETH required to become an independent validator on the Ethereum network.

Risks and Limitations of Liquidity Staking

• Slashage Risk: Users of liquid staking services are essentially outsourcing the maintenance of running validator nodes. If the service provider acts maliciously or unreliably, there is a complete risk of funding being cut.
• Private Key Leakage: Depositing tokens with a liquidity staking service provider puts these funds at risk if the node operator’s private key is leaked or if the protocol has any smart contract vulnerabilities that lead to exploitation.
• Secondary Market Volatility: The price of liquid staking tokens is not tied to the underlying assets they represent. While they may trade at the same price or at a very slight discount most of the time, they may fall below the price of the underlying asset during times of liquidity crunch or unexpected events. Since the trading volume of staked tokens is typically lower than the trading volume of the underlying asset, market shocks can also have a large impact on the volatility of staked tokens.

Staking Ecology and Current Situation

Ecological participants: Focusing on the Ethereum protocol, the stake ecology can be subdivided into multiple roles: Ethereum protocol, client software, MEV, stake service providers, and custody stake. Each role and identity plays a role in the staking ecosystem of Ethereum, but each role plays a different role. The following table briefly summarizes the various roles in the Ethereum staking ecosystem:

Source of information: public market information

According to DefiLlama, a total of $21.788 billion (11.52m ETH) is staked, with the top three liquidity staking service providers by TVL being Lido, Rocket Pool, and Binance. Among them, in Lido, a total of more than 8.9 million ETH are staked, accounting for 77.28% of the market share, which is much higher than other competitors. In the past 30 days, Stader and Liquid Collective have grown the fastest, with increases of 85.31% and 43.17% respectively; in the past 30 days, only two liquidity staking service providers have experienced a decline in TVL, Coinbase, and Ankr fell slightly by 1.8% and 2.17% respectively. However, overall, in the subdivision of ETH liquidity staking, the overall trend is still on the rise in the past month.

Source: DefiLlama

Moreover, overall, the short-term net inflow of ETH liquidity stake funds is greatly affected by emotional factors. For example, in June 2022, as crypto industry sentiment reached recent lows due to factors such as Terra, incremental funds staked in ETH liquidity also reached their lowest levels in 2022. Judging from the past two years, due to the impact of unexpected events, the amount of capital inflows from ETH liquidity staking will fall rapidly, but positive capital inflows will remain. After the short-term pessimism is released, the inflow of ETH liquidity staking will rebound quickly and sharply. This reflects that long-term holders will still increase their ETH liquidity staking positions. Although short-term holders are greatly affected by emotions, they are still very interested in the crypto industry and will allocate a certain amount of ETH liquidity staking positions. level.

Source: DefiLlama

In the ETH Staking ecosystem, the roles of all parties cooperate to jointly build the prosperity and development of the ETH Staking ecosystem. Relevant subdivisions include lending protocols, decentralized exchanges, stable currency protocols, Restaking, and many other fields. Liquidity staking protocols have become one of the largest DeFi categories by TVL, with a total of over $20 billion issued. The above-related assets and DeFi products have a profound impact on the entire DeFi field, and their status as collateral is becoming increasingly prominent, which is affecting the existing asset pools of loan protocols, stablecoin issuers, and decentralized exchanges. The following is a brief ecological analysis of the ETH Staking field:

• Staking Liquidity Staking Agreement: The process in which investors stake their assets in exchange for liquidity. In return, investors will receive equity tokens for claiming mortgage assets at a ratio of 1:1. Similar to Liquidity Provider (LP) tokens in decentralized exchanges. Liquidity-staked tokens can be redeemed at any time, allowing investors to retrieve their original tokens without waiting for a lock-up period. Representative projects: Lido, Rocket Pool, Frax, etc.;
• Restaking: EigenLayer is a Restaking protocol that allows ETH stakers and validators to use their staked ETH to secure other networks. The network has access to a large pool of staked capital and validators in ETH, and in return pays ETH stakers additional revenue for their services. The external benefits brought by EigenLayer can significantly increase the game-theoretic optimal amount of staked ETH from 33% to more than 60%. Liquid staking tokens stETH, RETH, and cbETH are also currently supported;
• Lending protocol: ETH’s related stake tokens are one of the important assets in the Ethereum DeFi ecosystem. At the same time, LST-type assets can increase lending rates or subsidize borrowing rates. However, it should be noted that LST-type assets have certain risks of decoupling. Representative projects: MakerDao, Spark, AAVE, Compound, etc.;
• DEX: LST serves as collateral and needs to be linked to ETH. Liquidity staking protocols require deep liquidity pools on the DEX to allow for fast swaps between LST and ETH. Representative projects: Uniswap, Curve, Balancer, etc.;
• Structured LST products: Due to the high correlation and higher potential volatility of LST products and ETH products, a variety of structured products have been developed. For example, in the direction of interest rate swaps, interest rate swaps can convert floating interest rates into fixed interest rates and vice versa. Interest rate derivatives help to hedge the risks of interest rate fluctuations of different financial institutions; in addition, the aggregator allocates equity among multiple protocols, diversifying protocol risks and further decentralizing the network; and, index-type products, stable currency protocols Various types of structuring have also gradually attracted the attention of users and institutions in the market. Representative projects: Pendle, IndexCoop, Lybra, Prisma, Asymetrix, etc.

Source of information: public market information

Among all ETH staking-related projects, Lido is currently the largest liquid staking protocol. Users and institutions can stake tokens and receive daily rewards without locking tokens or maintaining related infrastructure. Users can stake ETH and obtain stETH stake certificates. The following will provide a detailed analysis of the representative project Lido.

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