Why Ethereum's dominant liquid staking protocol is debating whether to reduce its influence

Quick Take

Lido Finance has amassed a dominant position in the business of Ethereum 2.0 staking.
Now its community is debating whether to scale back — for the benefit of Ethereum’s security.

Lido Finance has quickly risen to dominate the business of Ethereum 2.0 staking, thanks to its popular “liquid staking” service.

But now, in response to concerns that it could present a security risk to Ethereum, the community is debating whether it should curtail that dominance.

The discussions began on May 21. Since then, a post on the Lido research page, titled “Should Lido on Ethereum be limited to some fixed % of stake?” has been soliciting comments from community members about the pros and cons of limiting Lido’s share of staked ETH.

The firm’s Ethereum 2.0 (ETH2) staking pool currently accounts for almost 32% of the ETH deposited onto the so-called Beacon chain — the network that will transition Ethereum to a proof-of-stake consensus blockchain.

The debate is ongoing and will last until June 21. After that, there will be a one-week voting period. The outcome of the vote could lead to changes in the way Lido grows over time.

It could also have profound implications for the future of Ethereum.

Lido’s liquid staking empire

Lido is a DeFi protocol for liquid staking — a process that involves receiving tokens in exchange for staking crypto assets.

Instead of proof-of-work miners, proof-of-stake blockchain networks rely on validators. Instead of expending computing power, validators lock up, or stake, tokens in a network smart contract. While they are staked, it is not possible to trade those assets.

Liquid staking, a service that Lido has pioneered, is supposed to effectively unlock them. Customers give Lido cryptocurrency to stake and in return, it provides a derivative token tied to the underlying staked asset that is freely tradable on other DeFi protocols.

On Ethereum, Lido users receive a token called staked ETH (stETH) in exchange for the ether that they give Lido to stake on the ETH2 Beacon chain. The derivative token mirrors the price of ether and can be deposited on decentralized lending platforms like MakerDAO and Aave. (The asset happens to be in the spotlight right now due to liquidity crises faced by crypto lending firm Celsius and the hedge fund Three Arrows Capital, both of which were known to be large holders of stETH.)

Lido accounts for 90% of the liquid staking market. Its own rise to prominence has come on the back of concerns that allowing centralized exchanges to dominate the ETH2 validator set could lead to centralized control of the network. Kraken, a centralized exchange, controls the second-largest share of ETH2 deposits.

At first, decentralization advocates saw Lido as a suitable foil for centralized actors that would help make sure they did not come to dominate the ETH2 landscape. Now some in the community see Lido itself as a threat to the decentralization of ETH2.

What are the concerns?

Lido’s business works by routing its customers’ ETH to a set of validators who do the actual staking on the Beacon chain. These validators will earn 5% of the staking rewards on ETH2 while stETH holders get 90% and the final 5% is reserved for the Lido DAO treasury.

According to Ethereum Foundation researcher Danny Ryan, Lido’s large share of staked ETH is a “centralization attack on PoS” because the company is potentially in a position to exert influence on its validators to serve its own interest.

Specifically, Ryan and other critics fear that Lido’s governance system could be used to manipulate the Ethereum ecosystem.

The governance entity for Lido is called Lido DAO. The DAO has a token called LDO, which has a total supply of one billion. Holders of LDO can vote on proposals that other community members bring.

But LDO token distribution is highly concentrated: 100 wallets hold about 95% of the supply. And quorum for a new proposal only requires the participation of enough holders to represent 5% of the token supply.

In theory, people with large LDO token holdings could force governance actions for their own benefits that could have significant on-chain implications.

Hardening Lido’s governance

Lido’s governance has become a major discussion point within the Lido research forum post on May 21. Besides the fact that quorum only requires 5% of the token supply, only 50% of that small number is needed for a vote to pass. Voting usually lasts three days.

In theory, an attacker or a group of attackers could take advantage of this setup to stage a governance coup on Lido to pass malicious proposals. At the time of writing, it would cost about $28 million worth of coins to acquire 5% of the token supply.

Some community members posting in the forum have suggested changes to the Lido governance architecture, such as introducing so-called time-lock protocols and providing stETH holders veto power.

Time-lock protocols act as a freeze on governance decisions after a vote. This interim period would in theory allow the community as a whole to examine the governance action to make sure any malicious proposals aren’t enacted.

Some have also argued that granting veto rights to stETH holders would help to dilute the voting power held by LDO token holders. The idea is that this veto power could allow stakers to nullify the actions of a few actors who are able to push through a malicious proposal.

On June 10, Lido DAO issued a new governance proposal that would put in place a dual governance arrangement between LDO and stETH token holders. The proposal, if passed, will grant veto powers to stETH holders against the execution of any adversarial Lido DAO vote within a selected scope. The proposal also includes a timelock component to allow time for stETH holders to form a quorum for a possible veto on any voting outcome from the Lido DAO.

This new proposal is advocating for checks and balances in both directions. As such, there will be penalties for LDO holders who push governance agendas deemed detrimental to Lido and ETH. The same will also hold true if stETH holders abuse their veto power to block the outcome of legitimate votes.

The people behind the proposal say it will reduce Lido’s governance scope while also helping to align incentives between the Lido DAO and stETH holders.

Winner takes most?

Some people who oppose a move to limit Lido’s share of the ETH2 staking market argue that it is only a Band-Aid solution. They say other platforms will simply fill the void left by Lido and grow to become just as dominant.

This gets at another fundamental debate about the future of Ethereum: whether or not the ETH2 derivative staking market should be “winner takes most.”

Some people say Lido or any other entity should not be stifled if they grow to dominate the staking pool. The argument here is that free-market operations should be allowed to proceed even if it leads to the emergence of monopolies.

Of course, many of the same people say that a decentralized, non-custodial platform should control such a monopoly rather than a centralized exchange. By this logic, if Lido self-limits then another decentralized entity will have to pick up the slack.

Opponents of this view say that if Lido’s current dominance goes unchecked, the platform will have already become too big by the time Ethereum transitions to proof of stake, an event called “the merge.” At that time, they argue, the increased competition will not be able to dilute the control that Lido will have over the ETH2 staking pool.

These concerns are further exacerbated by delays in the schedule for the transition. Every postponement of the process offers more time for Lido’s dominance to continue to grow.

The merge delayed

The merge is important for Lido and for stETH holders because it serves to fulfill the promise of the platform’s liquid staking. This premise revolves around yield from staking on the Beacon chain and earnings for LDO token holders, the former of which will remain an IOU until the transition is completed and withdrawals activated on ETH2.

Though a date for the merge has still not been set, the network has gone through some preparatory testnet merges. The Ropsten testnet merge happened on June 3, combining the proof-of-work and proof-of-stake codes into one for the testnet chain.

But the transition has faced numerous delays. The latest one was the decision to postpone the “difficulty bomb.” One of three core elements of the merge, the difficulty bomb is supposed to render proof-of-work mining impossible on ETH2 by increasing the complexity of the cryptographic process required to process transactions.

Fears over the merge delays have contributed to some turbulence for stETH, as its price has recently decoupled from ETH. This decoupling has caused trouble for the likes of Celsius, with the platform pausing withdrawals amid a growing liquidity crisis.