There is not much to say in this market, other than the fact that we are crabbing hard. Optimists would have you believe that that this is a period of consolidation for whales. Pessimists, on the other hand, will argue that interest in crypto has dropped considerably and there is no one left but HODLers. While traders wait for breakouts in either position, a sideways market can be seen as bullish when contextualized within the wider macro environment.
Source: CoinGecko
BTC has been ping-ponging between 28k-30k for the past week which is boring and somewhat depressing.
Source: TradingView
However, boring can be good, considering the firestorm that is happening in TradFi. The S&P officially entered the bear market after falling 20% from its record highs at the start of the year. This marks the first time since the crash in March 2020 at the start of the COVID-19 pandemic. It has also posted its seventh straight week of losses, which has not happened since March 2001.
Source: TradingView
Tech stocks have been doing worse as the Nasdaq-100 marked experienced a 28% drop from its yearly high.
Wider market concerns regarding a recession have not changed. However, over the past week, a lot of market-defining news has come to light. The Federal Reserve has become more hawkish, indicating its willingness to keep raising interest rates to reduce inflation. Many retail companies have seen sharp selloffs across as big players like Walmart and Target have warned about tightening profits due to inflation. Meanwhile, bigger tech companies like Netflix and Facebook have started to cut costs by reducing headcount, furthering the amount of FUD in the air.
It is surprising then that despite being treated like a growth stock for months, BTC has not wavered and held the 28k-30k support line. Notably, even Peter Schiff, one of the biggest anti-BTC figures, has begrudgingly admitted that BTC is holding up surprisingly well, despite the wider market nuke. Perhaps a decoupling narrative is starting to take shape?
Lido Quickly Dominating ETH2 Staking
Quick Recap on Eth2 Staking
As Ethereum enters the final stretch towards the Merge, attention naturally turns towards the transition from Proof-of-Work to Proof-of-Stake, and by extension the transition from miners to validators taking on the role of securing the network. A quick recap on the current mechanics:
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The Beacon Chain has been launched, together with the Eth2 deposit contract where validators can declare their support for the Merge by staking ETH.
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A minimum of 32 ETH is required to be a validator, and the staked ETH will be locked in the contract until after the Merge.
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While the PoS system won’t be live until the Merge, validators are already earning rewards on their staked ETH.
At time of writing, 12.7M ETH has been staked in the Eth2 deposit contract, representing >10.5% of total ETH circulating supply.
Enter Staking Pools and Lido
While there are many ways for ETH holders to stake, including solo staking, staking directly with a validator, and staking through a CEX, most of the attention has been on staking pools, such as Lido, RocketPool and Stakewise. These projects have gain prominence primarily due to certain factors / benefits:
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Staking pools allow smaller ETH holders to pool together their ETH to meet the minimum 32 ETH requirement to become a validator.
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Pools still distribute staking rewards (minus a fee) back to stakers.
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Different from staking with centralized exchanges, staking pools also provide stakers with a token which represents their stake, e.g. stETH, rETH, rETH2, which can be redeemed for their ETH + staking rewards once the Merge happens.
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Thanks to effort from the projects, these tokens are now generally accepted in DeFi protocols as equivalent to ETH, effectively giving holders liquidity even though their ETH are staked.
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The projects are decentralized and governed by DAOs, being ideologically more in-line with the wider crypto ethos.
Growing Concerns with Lido’s Dominance
Source: Nansen
Of these staking pools, Lido has been the clear runaway winner, with it now being the dominant Eth2 depositor of them all, representing 32.3% of total staked ETH. While this stake is currently distributed across 22 different node operators, Lido’s dominant position has attracted concerns about the centralization of validators, as well as concentration risk.
Source: Glassnode
These concerns with Lido are not unfounded. Firstly as we mentioned earlier, Lido is a DAO, which is governed by LDO token holders. While the number of token holders has grown over time, it is still hovering around 15.5k addresses (by comparison, UNI and COMP are both held by >200k addresses). Perhaps more worryingly, the top 1% of addresses (~155 addresses) collectively hold >95% of LDO tokens. With Lido’s dominant position, LDO token holders wield outsized influence over the ETH validator landscape, and hence the network security of ETH as a whole. For example, LDO token holders can vote to accept or reject certain node operators into their registry, or adjust allocations of staked ETH towards specific node operators (this affects their voting power in the consensus process).
Secondly, Lido operates via smart contracts just like any DeFi protocol, and the large concentration of ETH now locked into its contract (Lido is now the 2nd largest DeFi protocol on ETH by TVL) makes it a prime target for attackers. An exploit of Lido would be a catastrophic event for Ethereum, impacting a large number of stakers, but also simultaneously weakening the security of Ethereum as a whole.
Finally, while this is not relevant to Ethereum, the native tokens of certain protocols also grant them governance powers over the protocol itself. As Lido amasses a larger stockpile of native protocol tokens, it become a significant actor in a protocol’s governance. Look no further than the recent Terra crisis, and subsequent V2 proposal to hardfork the network as well as airdrop users new LUNA tokens. Prior to LUNA’s hyper-inflation, ~85M LUNA was staked in Lido, representing ~24% of the ~350M circulating supply of LUNA. There is now an ongoing governance proposal on Lido to decide whether to support the LUNA V2 proposal.
This is a correction to my previous interpretation, @VitalikButerin is asking pools to self limit to 15%, community action begins at 22%.
— superphiz.eth 🦇🔊🐼 (@superphiz) May 14, 2022
15% - pools throttle/ stop accepting deposits
22% - the community will take action
33% - is an attack and protocol devs engage https://t.co/jY67BFDOX4
With concerns growing over Lido’s dominant position in Ethereum staking, there have been suggestions from members of the Ethereum community for any staking pool, including Lido, to self-limit their market share to a certain percentage of total staked ETH. Limits between 15%, 22%, to 33% have been floated, with more drastic actions to be taken when protocols breach certain limits. The discussion on this is fairly preliminiary for now, and it'll be interesting to see how this eventually unfolds.
Towards a More Decentralized Lido
To the project’s credit, Lido has addressed these concerns head-on. The project had in July 2021 laid out a roadmap to further decentralize the protocol, and has been publishing regular updates to the implementation of this roadmap. In addition, the project has recently published its Operator Set Strategy, which lays out the core principles of how it intends to develop its operator set. In applying the core principles to the Ethereum network, it also proposes a focus on client diversity which includes, amongst others, no single node operator should have >1% of total ETH staked in Lido. This would mean rapidly scaling up the number of node operators on Lido itself.
Thus far, Lido’s approach have been to review and vet every node operator they onboard as “trusted”. This process is run in batches / cohorts, and is time consuming. In comparison, the second largest staking pool behind Lido, Rocket Pool, has taken a trustless approach, meaning any node operator can be on Rocket Pool, and have already onboarded untrusted node operators with >1,000 operators. This is balanced by Rocket Pool node operators need to at least stake 16 out of the 32ETH in their nodes,
From Lido’s latest decentralization update, there is currently a two-pronged solution to improve and further decentralize the management of Lido’s node operator set:
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Firstly, the gradual adoption of Distributed Validator Technology (DVT), where validators can be organized into committees and propose blocks collectively, reducing the risk of under-performing / mis-behaving individual node operators.
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Secondly, the creation of a Node Operator Score (NOS) that is drawn from different metrics of node performance, and for stake allocation to be based on a node operator’s NOS, thereby giving high-performing operators greater voting power.
This two-pronged solution allows Lido to move away from relying on the project to vet and onboard trusted node operators, and instead transition towards onboarding untrusted node operators more efficiently without introducing too much risk to the Ethereum network. With DVT, untrusted operators can be initially added to committees with majority trusted operators, allowing them to slowly build up their NOS score towards becoming more trusted.
Quick Aside on Liquidity
The other, perhaps slightly under-discussed aspect of this equation is the liquidity of the ‘stake tokens’, e.g. stETH, rETH and rETH2. For these tokens to have utility, especially within DeFi, they need to be fairly liquid. In the first place, other DeFi protocols will want to know that they’re integrating tokens that are already widely circulated. However, these tokens are not created out of thin air - they can only be minted when an equivalent amount of ETH has been staked into the pool. So the more dominant the staking pool is = the more ETH staked = the more liquidity there is for the ‘stake token’.Source: Staking Pool websites
Thin liquidity have given rise to challenges in utilizing these tokens in lieu, or as an equivalent to ETH. They technically should be - such tokens should always be redeemable for equivalent ETH post-Merge (though at the moment its’ locked until the Merge happens, which means these tokens are currently valued slightly less). During the volatile market period earlier this month, the stETH-ETH pair on Curve faced a decline in exchange rates, falling below the prevalent 1:1 exchange rate. Hasu explains why this is here, but Lido has had to deploy additional liquidity to stabilize the exchange rate.
Closing Thoughts
A good validator set is both a public good and a competitive advantage for any protocol; they safeguard the security of the network, and reduces the likelihood of disruptive events such as downtimes, re-orgs, etc. With Lido’s strong success, staking pools as well as staked tokens have begun to take off as a new DeFi primitive. With PoS, or some form of validator-driven consensus mechanism likely to become prevalent, new pools are also forming to take an early share of the pie.
Given the inherent advantages of having scale in a staking pool (as discussed above), expecting protocols to self-limit their market share is neither a reasonable nor practical solution. A more market-economy driven solution which can promote healthy competition between staking pools is required. The current incentives will likely result in a “winner takes most” scenario, so expect similar dominant pools to appear across chains.
‘Stake tokens’ are here to stay, and post-Merge if token holders can stake and unstaked unencumbered, expect them to gain wider prominence. It’s a no-brainer if a token is able to provide “free yield”, while also being just as liquid, and widely accepted / integrated into DeFi protocols and other use cases. Given that stETH is also ERC20 compliant, you may well ask - can it replace WETH in the future? If we ever get to an environment of multiple staker pools with different ‘stake tokens’, just as with stablecoins today, expect Curve 3-pools and 4-pools to appear for these tokens.
Finally, with Lido and other staking pools looking set to play a crucial role the future of crypto moving forward, pay attention too to their governance tokens. Governance can directly influence fees, and it will be interesting to see if a “Curve Wars” phenomenon will also emerged for staked pool governance tokens moving forward.
What else are we paying attention to
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FOMC Meeting Minutes (May 25) and US GDP 1Q 2022 Second Reading (May 26): These two key announcements will provide more details to earlier data points we already had on the Fed's current monetary tightening policies, as well as the US economy's surprising GDP contraction in Q1 2022. From past experience, expect markets to be volatile around these dates.
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Monkeypox may sound like a BAYC meme but it is a real and deadly virus. While we are not medical experts, we have been following the news quite closely. Keep a close lookout on this and see how it develops. Hopefully, it does not turn into Covid 2.0.
This article was produced in collaboration with Benjamin Hor. You can follow him on Twitter here.
Zhong is CoinGecko's Head of Research. Prior to CoinGecko, he led the Innovation Department at the Securities Commission Malaysia and was a key driver in the formation of policies regarding cryptocurrencies, the classification of cryptocurrency as securities, and the implementation of crypto-related regulations. Follow the author on Twitter @zhongychan
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