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Liquid Staking Derivatives Pose ‘Significant Risks’ to Ethereum 2.0: Report

LSD Protocols May Make Ethereum Vulnerable to Abuses of Power After Shift to PoS

Liquid Staking Derivatives Pose ‘Significant Risks’ to Ethereum 2.0: Report

Protocols that offer liquid staking derivatives, like Lido and Rocket Pool, could undermine the integrity of Ethereum after its transition to proof-of-stake, according to a researcher at the Ethereum Foundation.

If any protocol were to stake a majority of the Ether in circulation, it would become vulnerable to censorship demands and other abuses of power blockchain technology was developed to circumvent, researcher Danny Ryan wrote in a blog post titled “The Dangers of LSD.”

“Liquid staking derivatives (LSD) such as Lido and similar protocols are a stratum for cartelization and induce significant risks to the Ethereum protocol and to the associated pooled capital when exceeding critical consensus thresholds,” the report said.

Lucrative Ways

When Ethereum completes its transition to the proof-of-stake consensus mechanism later this year, its security will be guaranteed by “validators” who stake their Ether to the network, allowing them to run block-producing nodes and earn staking rewards.

But there’s a hitch: staking their Ether prevents them from using it in other, potentially more lucrative ways. Although stakers will be compensated in Ether, transaction fees and miner-extractable value, they could likely get better returns on their Ether by depositing it in high-APY DeFi protocols.

Liquid staking derivatives offer a solution to that conundrum. Ether holders can pool their Ether in a protocol that runs validators on their behalf. Those holders are then assigned protocol tokens meant to represent their staked Ether, and those tokens can be used in other DeFi protocols as if it were Ether.

Proponents see it as a win-win situation — a way to secure Ethereum by staking one’s Ether without locking it up and losing out on more lucrative opportunities.

Danny Ryan, a researcher at the Ethereum Foundation, disagrees.

The largest liquid staking protocol Tuesday was Lido, with more than $8 billion in total value locked, according to Defi Llama. Lido and similar protocols should limit the amount of Ether they stake, Ryan argued in his blog.

Centralization Tendency

“Liquid staking derivatives (LSD) such as Lido and similar protocols are a stratum for cartelization,” Ryan wrote. “LSD protocols should self-limit to avoid centralization and protocol risk that can ultimately destroy their product.”

Marco Di Maggio, a professor at Harvard Business School and former researcher at Terra Labs, detailed the risk — liquid staking derivatives’ “tendency towards centralization” — in a blog post in 2020.

“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,” he wrote. “As a result, we can expect that only a limited amount of liquid staking protocols can coexist in a meaningful way.”

Governance Token

Staking derivatives open the potential to state the vast majority of Ether in circulation, Venture Capital firm Paradigm, a holder of Lido’s LDO governance token, said in a research note last year.

“Without staking derivatives, we might expect 15-30% of ETH to be staked,” Paradigm researchers wrote. “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.”

The researchers said this “virtuous cycle” could “strictly increase Ethereum’s economic security instead of decreasing it.”

But the monopolization of staking comes with serious risks, according to Ryan.

If an LSD protocol in which token holders choose validators — e.g. Lido — were to stake a majority of the Ether in circulation, “then the token holders can force cartel activities of censorship, multi-block [miner-extracted value], etc, or else the [validator] is removed from the set,” Ryan wrote.

Majority control also makes censorship more likely, Ryan said.

“If pooled stake under one LSD protocol exceeds 50%, this pooled staked gains the ability to censor blocks,” he wrote. “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.”

Self-restraint

A;ternative designs would likely end with “a similar, albeit automated cartelization,” he added.

The solution? Self-restraint on the part of “capital allocators” and protocols like Lido.

“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,” Ryan wrote. “Capital allocators should not allocate to LSD protocols exceeding 25% of total staked Ether due to the inherent and extreme risks associated.”

The message did not not fall on deaf ears.

On Friday, Lido opened a discussion on its governance forum on limiting its share of stake on the Beacon Chain, whose merger with Ethereum will complete the network’s transition to proof-of-stake. 

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