The transition from Proof of Work (PoW) to Proof of Stake (PoS) is Ethereum’s most anticipated milestone since its inception. Instead of using the energy-costly PoW to extend the blockchain, PoS allows users to stake their ETH and operate block-producing nodes called validators.
The first step towards PoS in Ethereum was launching a standalone network that can come to consensus, called the Beacon Chain. In return for providing security to this system, stakers are rewarded with new ETH from inflation. In the future, the Beacon Chain and Ethereum as we know it will merge, allowing stakers to also earn the transaction fees and Miner-Extractable Value (MEV) that currently go to PoW miners.
Ethereum’s PoS protocol does not provide stakers with some of the functionality they have come to expect in other PoS implementations like Cosmos, Tezos, and Polkadot. The rationale behind that is to incentivize decentralization, but we posit that the market will always step in to make staking more efficient and convenient. So it is important to ensure that the solution that has the most private benefit to stakers also leads to a healthy systemic outcome for Ethereum as a whole.
In this post, we explore the problems that ETH stakers experience today. We then show how staking pools and staking derivatives solve these problems for stakers while, counterintuitively, also increasing the effective security of the network.
To solo stake in Ethereum, a user has to deposit 32 ETH to the ETH2 Deposit Contract, along with specifying two key parameters:
Critically, the public key and withdrawal credentials do not need to be controlled by the same entity.
The user is then expected to operate an ETH2 validator node and sign on blocks when it’s their turn, or get penalized for not following the protocol.
The efficiency and convenience of a staking protocol can be broken down into the following properties, along with their Ethereum implementation:
|Minimum amount needed to stake: This determines the barrier to entry.||A minimum of 32 ETH is required, and people can only stake in 32 ETH multiples.|
|Delegation: Can stakers outsource the work of running the physical validator node, or do they have to do it themselves? If delegation is impossible, hardware and bandwidth requirements can prevent some people from staking.||There is no in-protocol way to delegate stake to other validators.|
|Lockup: How long does it take to withdraw staked funds? Longer lockups tend to increase the security of the protocol, but also make it less attractive for stakers due to lower flexibility and higher opportunity costs.||Today, stakers cannot withdraw ETH from the Beacon Chain at all. After withdrawals have been enabled, the lockup period for unstaking will be 27 hours.|
|Returns: How much do stakers earn over time? The higher the returns, the more people will stake, leading to higher security.||Stakers on the Beacon Chain currently earn inflation rewards. After the merge, they will also earn transaction fees and MEV. The inflation rewards depend on how much ETH is currently staked. More staked ETH implies less inflation rewards per validator and vice-versa. Today ~4m ETH is staked, leading to an annual return of 7.8%.|
These properties represent significant hurdles for stakers. All else equal, they would prefer to be able to stake any amount of ETH, delegate the operation of their infrastructure, and withdraw their staked ETH instantly. If possible, they would also like to use their staked ETH in other applications, as has become standard procedure in decentralized finance.
Below, we discuss
On its face, a staking pool works similarly to a mining pool in PoW, but due the nature of PoS it can offer additional benefits to its customers:
Staking pools can either be centralized or decentralized, each with their own set of tradeoffs.
The exchange simply needs to:
Since the exchange does the staking, the user does not need to run any infrastructure. Offering instant liquidity is very easy for them as well, since they already have large liquid ETH reserves. Given how valuable customer acquisition and liquidity is to the exchange business, they can offer this service at no additional cost to the user.
Now that we have established the differences between solo and pooled staking, as well as how centralized staking pools work, we will explore the architecture of a decentralized staking pool, using Lido as an example.
From the user’s perspective, things are very straightforward: They deposit ETH into an Ethereum smart contract, and receive stETH as a receipt. The stETH token’s balance adjusts over time to reflect the distribution of staking rewards that accrue to the contract. That means, 1 stETH will always represent 1 ETH staked.
From Lido’s perspective, each time 32 ETH is buffered on the Ethereum smart contract, the DAO selects a new validator from a governance-controlled registry. It then calls the deposit contract, assigning the 32 ETH to that validator’s public key, and uses the LidoDAO’s withdrawal credentials.
There are two questions that need to be answered here:
We have already established that stETH is a claim on staked ETH and any rewards accruing in the smart contract. This is also called a staking derivative.
Staking derivatives will have a major impact on the entire Ethereum ecosystem, including ETH stakers, regular ETH holders, the competition between pools, and even Ethereum itself.
Stakers: The main benefit for stakers is rehypothecation, which allows them to stake while simultaneously using the principal in other applications, similar to how Uniswap’s LP tokens can be used as collateral across DeFi. This greatly lowers the opportunity cost of staking.
Non-staking ETH holders: If stETH can be used as collateral to borrow ETH, it can unlock demand to borrow ETH to use it in leveraged staking. This would push up the rates for supplying ETH1, ultimately benefiting all ETH holders with higher interest rates.
Competition between pools: The existence of stETH grants its pool an important network effect. This network effect creates a strong incentive to stake with the market leader, which indicates that ETH staking derivatives could follow a power-law or winner-take-all distribution due to the liquidity moat and network effects associated with them. As a result, it is possible that stETH will replace ETH in many use cases, and potentially even replace ETH altogether.
Ethereum: There exists a popular argument that staking derivatives lower the security of PoS because they separate block production from staking and slashing. This is also known as a principal-agent problem, and can lead to scenarios where the block producers may not be incentivized to follow the protocol since they have nothing at stake.
However, this argument has to be weighted against the benefits: If staking derivatives lower the cost of staking, they could lead to far more (or even all) ETH being staked. Note that this is a perfect example of a virtuous cycle: the more liquid stETH becomes, the lower the opportunity cost of staking, which leads to more ETH being staked, which in turn further deepens the liquidity of stETH, and so on.
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.
To show why this leads to higher economic security, consider the following attack scenarios:
We can conclude that if staking derivatives can increase the number of ETH staked above 60%, they would strictly increase Ethereum’s economic security instead of decreasing it.
Decentralization is often seen as an invisible benefit that comes at a higher price, and as a result users are often not willing to pay for it (see e.g. Binance Smart Chain vs Ethereum debate). This line of thinking does not apply to decentralized staking pools, because they have three critical advantages over their centralized counterparts.
These benefits are so large, that the leader in pooled staking will likely be a decentralized / non-custodial staking pool. If said pool is sufficiently governance-minimized, it could possibly win the entire market without causing any systemic risk for Ethereum.
Staking pools and their staking derivatives are subject to similar market realities as MEV extraction, in the sense that their existence is inevitable. As long as there is a private benefit to creating and using them, they will exist and flourish. However, if the right solution wins and is sufficiently adopted, it can lead to systemic benefits for Ethereum as well.
Due to stETH’s vast network effect and the fact that decentralized pools can be both non-custodial and possibly earn more revenue from MEV, we see it as likely that a single such decentralized pool can win the whole market.
As a result, we should be focused on making sure a non-custodial and robust version of stETH wins the market instead of a centralized one, to ensure a good systemic outcome.
Paradigm owns LDO tokens
Disclaimer: This post is for general information purposes only. It does not constitute investment advice or a recommendation or solicitation to buy or sell any investment and should not be used in the evaluation of the merits of making any investment decision. It should not be relied upon for accounting, legal or tax advice or investment recommendations. This post reflects the current opinions of the authors and is not made on behalf of Paradigm or its affiliates and does not necessarily reflect the opinions of Paradigm, its affiliates or individuals associated with Paradigm. The opinions reflected herein are subject to change without being updated.