Report that LSD protocols may make Ethereum vulnerable to abuse of power after switch to PoS

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 a protocol were to stake the majority of Ether in circulation, it would become vulnerable to censorship demands and other abuses of power blockchain technology have been developed to circumvent them, 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 layer of cartelization and induce significant risks to the Ethereum protocol and associated pooled capital when they breach critical consensus thresholds,” The report said.

Money-making ways

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

But there is a catch: staking their Ether prevents them from using it in other potentially more lucrative ways. Although stakers are compensated in Ether, transaction fees and minable value by miners, they could probably get better returns on their Ether by depositing it in high APY DeFi protocols.

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

Proponents see this as a win-win situation – a way to secure Ethereum by staking its Ether without locking it up and losing out on more lucrative opportunities.

Danny Ryan, researcher at the Ethereum Foundation, disagrees.

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

Tendency to centralization

“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 risks that can ultimately destroy their product.”

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

“Network effects will emerge, where increased usage around a particular liquid staking protocol will increase liquidity and utility as collateral, which will further drive adoption of that solution over its competitors,” he wrote. “As a result, we can expect that only a limited amount of liquid staking protocols can meaningfully coexist.”

Governance Token

Staking derivatives open up the possibility of declaring the vast majority of Ether in circulation, venture capital firm Paradigm, holder of Lido’s LDO governance token, said in a research note last year.

“Without derivatives staking, we could expect 15-30% of ETH to be staked,” Paradigm researchers wrote. “However, /with/staking derivatives, that number could go up to 80-100%, as there is no additional cost for staking compared to not staking.”

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

But monopolizing staking comes with serious risks, according to Ryan.

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

Majority control also makes censorship more likely, Ryan said.

“If pooling under an LSD protocol exceeds 50%, that pooling gains the ability to censor blocks,” he wrote. “In a regulatory censorship attack, we now have a separate entity – governance token holders – that a regulator can make censorship requests to. Depending on the token distribution, this is likely a regulatory target a lot simpler than the Ethereum network as a whole.

Self control

Alternative designs would likely end up with “similar, albeit automated, cartelization,” he added.

The solution? Self-withholding from “capital allocators” and protocols like Lido.

“I recommend that Lido and similar LSD products self-limit for themselves, and I recommend that capital allocators recognize the pooling risks inherent in LSD protocol designs,” Ryan wrote. “Capital allocators should not allocate more than 25% of total Ether staked to LSD protocols due to the inherent and extreme risks associated.”

The message did not fall on deaf ears.

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

Read the original post at the defiant

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