Has Ethereum’s $54bn liquid staking industry become too big?

A recent proposal to cut the amount of newly issued Ether was meant to stem the rapid ascent of Ethereum’s $54 billion liquid staking industry.

But critics, some of whom represent those very liquid staking projects, say it would have the opposite effect and pose an existantial risk to solo stakers who give the blockchain its greatest claim to decentralisation — a key feature for software intended to function as a sort of distributed world computer open to everyone.

Staking is to Ethereum what mining is to Bitcoin. It’s the process that simultaneously creates new Ether, confirms and orders transactions, and provides economic security against those who would try to seize control of the blockchain.

For years, researchers have warned that the system has a flaw: Liquid staking protocols, which lock up, or stake, Ether on users’ behalf, could gain control of most of the Ether in circulation and, in turn, undue influence over the blockchain itself.

Last month, a pair of researchers at the Ethereum Foundation warned that the time to act was closing fast. They proposed a simple but profound change: a modest decrease in the amount of newly issued Ether.

The change would lower the return on staking and discourage new entrants, who have overwhelmingly entrusted their Ether to large institutions or protocols rather than stake Ether themselves.

Critics counter that it would have the opposite effect: By reducing the yield on staking, only the largest and most sophisticated operators would find it worth the trouble.

“A proposal like this, if implemented, would essentially end solo staking,” Valdorff, a pseudonymous contributor to Rocket Pool, an Ethereum staking protocol, wrote on an Ethereum research forum. “Making staking profits marginal will ensure that the only validators left are those that are most effective at extracting value.”

Ethereum Foundation researcher Ansgar Dietrichs, one of the proposal’s authors, said the proposal was meant to inspire a much-needed debate. He lamented that he’s seen few counterproposals since its publication on February 21.

“We think there’s an emergency, and we basically wanted to have this as a conversation starter,” he told DL News. “I think we still have a ways to go to make this a productive conversation.”

The rise of liquid staking

Staking offers a modest annual yield. On Thursday, that yield was just under 4%. That is often lower than the return investors can earn elsewhere in DeFi, for example by lending their tokens.

Staking data firm Rated has called solo staking “the backbone of Ethereum,” and estimated it accounted for 6.5% of all staked Ether. Ethereum.org, a community-run website dedicated to the blockchain calls it the “gold standard.”

“It provides full participation rewards, improves the decentralisation of the network, and never requires trusting anyone else with your funds,” the website reads.

But the share of Ether staked by people operating out of their own home is decreasing, according to Nixo Rokish, head of EthStaker, an online resource for solo stakers.

“That is absolutely going down, because most of the new stake is going into liquid staking protocols,” she told DL News.

But staking is expensive — it requires 32 Ether, worth more than $124,000 on Thursday — and technically challenging.

Liquid staking protocols make the process easy, by staking Ether on users’ behalf. Additionally, users can typically deposit any amount of Ether to liquid staking protocols, which batch deposits into the increments of 32 Ether required by the blockchain.

Furthermore, liquid staking protocols address the opportunity cost by issuing IOUs for staked Ether. Those IOUs — known as liquid staking tokens or liquid staking derivatives — can then be used across DeFi in lieu of Ether, a win-win for Ethereum and for users leery of locking away tokens when there are more lucrative ways to use them.

Several years ago, Ethereum researcher Danny Ryan warned that most Ether could eventually end up in a single liquid staking protocol. If that were to happen, the people who govern that protocol would have outsize influence over the blockchain, with the ability to confirm and order transactions as it sees fit.

Staking has surged since last spring, when an upgrade to the blockchain enabled the withdrawal of staked Ether, removing the biggest risk associated with staking. As of Thursday, more than a quarter of all Ether in circulation had been staked, 38% of it through liquid staking protocols including Lido and Rocket Pool, according to pseudonymous data analyst Hildobby.

There are now more than three dozen liquid staking protocols on Ethereum, according to data from DefiLlama. A growing number of stablecoins are accepting liquid staking tokens as collateral. And new Ethereum-based blockchains such as Blast are incorporating staking to offer users passive yields on crypto deposits.

Dietrichs and his co-author, Ethereum Foundation researcher Caspar Schwarz-Schilling, argue that it won’t be long before the vast majority of Ether is deposited in liquid staking protocols.

If that happens, liquid staking tokens such as Lido’s stETH or Rocket Pool’s rETH would become de facto money on Ethereum, supplanting Ether as the asset with the greatest liquidity.

It’s a risky state of affairs, they argue.

“People are calling [staking] the risk-free rate of return or something on Ethereum. That’s not the case. Staking comes with risk, it’s supposed to be an activity for sophisticated parties,” Dietrichs said.

“It’s almost analogous to the financial crisis of 2007 … where we just kept adding intermediary layers until no one understood that there was any risk under the hood,” he said.

Ideally, Ethereum’s distributed team of developers would cap the amount of Ether that could be staked. That would need further research, however.

A more modest solution would involve reducing the creation of new Ether in order to curb the appeal of staking. If implemented today, it would reduce the yield on staked Ether from just under 4% to about 3.5%.

The change could be included in a forthcoming Ethereum upgrade with the codename “Electra,” which is expected to be implemented in nine to 12 months.

“This Electra proposal was really mostly meant to try and keep as many doors open as possible,” Dietrichs said. “Because what we’re concerned [about] is if we do nothing, and we keep having the staking ratio rise quite a bit, it’s going to be really hard to come back down.”

‘Worse than doing nothing’

Still, others thought that would “kill solo staking.”

“I think that the proposed solution is worse than doing nothing as it just pushes staking to centralised operators that hold the most ETH by default,” Lefteris Karapetsas, founder of Rotkiapp and a longtime Ethereum developer, wrote on X, echoing comments from Valdorff and Lido engineer Dmitriy Gusakov.

Rokish said some critics might have another motive.

“If you look at the people who are actually pushing back, those people work for protocols that depend on an infinite number of stake coming in, like DVT protocols, Lido, Rocket Pool,” she said, using the acronym for distributed validator technology.

“All of these people are using solo stakers as an excuse to push back against this.”

Nevertheless, Rokish doesn’t believe the proposal is “robust enough or serious enough to be considered for inclusion.”

“[When] messing with monetary policy, there better be a whole lot of research behind it, and it better not set a precedent of, like, tinkering with things that we don’t fully understand,” she said. “But I do think that the research needs to happen. And it’s kind of urgent at this point.”

Some of the criticism is valid, Dietrichs said. But solo stakers have come to him to voice their support, and he still wants to see Ether issuance curtailed with Electra.

“It’s a small hit [for solo stakers], but [it’s] actually stabilising things for them,” he said of the proposal.

Meanwhile, he welcomes the debate, but hopes critics will produce their own counterproposals.

“In a way, it’s good that it’s a little bit heated, the conversation around this, because it shows that people actually care,” Dietrichs said. “I would be more worried about the state of Ethereum if basically no one had an opinion.”

Aleks Gilbert is a DL News DeFi correspondent based in New York. Email him at aleks@dlnews.com.