Comprehensive Interpretation of Ethereum 2.0 Staking Fund Pools and Staking Derivative Mechanisms, Features, and Potential Impacts
In-depth exploration of the issues faced by Ethereum 2.0 stakers, and how staking pools and staking derivatives can address these problems.This article was published on research.paradigm.xyz, written by Georgios Konstantopoulos and Hasu, who are Paradigm research partners and independent researchers, respectively, and compiled by Perry Wang.
The transition of Ethereum from a Proof of Work (PoW) consensus mechanism to a Proof of Stake (PoS) consensus mechanism will be the most notable milestone since its inception. By abandoning the energy-intensive PoW blockchain scaling approach, PoS allows users to stake their ETH and run block-producing nodes (known as validators).
The first step for Ethereum to implement PoS is to launch an independent network capable of reaching consensus, called the Beacon Chain. In return for providing security to the system, stakers will receive new ETH tokens generated through inflation. In the future, the Beacon Chain and the current Ethereum will merge, allowing stakers to also earn transaction fees and miner extractable value (MEV) currently received by PoW miners.
The Ethereum PoS protocol does not offer certain features found in other PoS networks like Cosmos, Tezos, and Polkadot for stakers, primarily due to the incentive for decentralization. However, we believe that the market will always intervene to enhance the efficiency and convenience of staking. Therefore, it is crucial to ensure that solutions provide stakers with maximum private benefits while also contributing to healthy systemic outcomes for Ethereum as a whole.
In this article, we will explore the current issues faced by ETH stakers. We will then demonstrate how staking pools and staking derivatives can help stakers address these issues while, counterintuitively, enhancing the effective security of the network.
How does the ETH staking mechanism work?
To stake independently on Ethereum, users must deposit 32 ETH into the ETH2 deposit contract and specify two key parameters:
Validator public key: Before depositing ETH, users generate a key pair for their validator. The private key is used to sign blocks, while the public key serves as its unique identifier.
Withdrawal credential for the deposited 32 ETH: Once withdrawals are enabled, the principal (32 ETH) and staking rewards can only be withdrawn to that address.
Crucially, the public key and withdrawal credential do not need to be controlled by the same entity.
Users will then run an ETH2 validator node and sign blocks when it is their turn to produce blocks or be penalized for non-compliance with the protocol.
What problems do ETH stakers encounter?
The efficiency and convenience of staking protocols can be broken down into the following attributes, along with their specific implementations in Ethereum:
Staking threshold: This determines the minimum amount of staking required to enter. A minimum of 32 ETH is needed, and people can only stake in multiples of 32 ETH.
Delegation: Can stakers outsource the work of running a physical validator node, or must they do it themselves? If delegation is not possible, hardware and bandwidth requirements may hinder some from participating in staking. The Ethereum protocol does not provide a way to delegate staking to other validators.
Lock-up period: How long until staked funds can be withdrawn? Longer lock-up periods often increase the security of the protocol, but they are less attractive to stakers due to lower flexibility and higher opportunity costs. Currently, stakers cannot withdraw ETH from the Beacon Chain at all. After the withdrawal feature is enabled, unlocking the lock-up requires 27 hours.
Returns: How are stakers' time returns? The higher the return rate, the more willing people are to stake, and the higher the security. Stakers on the Beacon Chain currently receive inflation rewards. After the merge, they will also earn transaction fees and MEV. The inflation rewards depend on how much ETH is currently staked. The more ETH staked, the lower the inflation reward per validator, and vice versa. Currently, about 4 million ETH is staked, with an annual return rate of approximately 7.8%.
These attributes pose significant barriers to attracting stakers. Under all other conditions being equal, stakers would prefer to stake any amount of ETH, delegate the operation of infrastructure to others, and withdraw their staked ETH immediately. If possible, they would also like to use their staked ETH for other applications, which has become standard practice in decentralized finance.
In the following sections, we will discuss:
How staking pools address delegation and minimum staking thresholds; and
How the staking derivatives issued by these staking pools solve the long lock-up issue and allow stakers to release the liquidity of their staked ETH.
How do staking pools operate?
On the surface, staking pools operate similarly to mining pools in PoW, but due to the nature of PoS, they can offer more benefits to their clients:
By pooling ETH funds together, stakers can bypass the 32 ETH minimum requirement. This allows smaller stakers to participate in PoS.
The pool does not require each user to operate their own validator node; instead, the pool handles the actual operational issues of staking. Some pools may also guarantee clients that they will not be subject to protocol penalties such as significant slashing.
Similar to banking operations, the pool can maintain a liquidity reserve of ETH to meet immediate withdrawal demands. Assuming not all clients wish to withdraw simultaneously, this may eliminate the need to wait for a four-month withdrawal period.
Finally, the pool can provide tokens representing the stakers' ETH asset rights, which can be used in other applications. This is crucial, and we will dedicate a full chapter to discuss this in detail.
Staking pools can be centralized or decentralized, each with its own pros and cons to weigh.
Centralized staking pool operation mechanism
Any large exchange can easily implement staking pool functionality. In fact, many already support (or will support) Beacon Chain staking.
Exchanges only need to:
Allow users to choose to stake in exchange for staking rewards.
Use customers' ETH to run validator nodes.
Since the exchange is conducting the staking, users do not need to run any infrastructure. It is also very easy for exchanges to provide instant liquidity, as they already have a large reserve of liquid ETH. Given the value of acquiring customers and liquidity for exchange businesses, exchanges can offer this service to users without additional fees.
Decentralized staking pool operation mechanism
Now that we have established the difference between individual staking and staking through a pool, as well as the operation mechanism of centralized staking pools, we will use Lido as an example to explore the architecture of decentralized staking pools.
From the user's perspective, it is very simple: they deposit ETH into an Ethereum smart contract and receive stETH as a receipt. The balance of the stETH token adjusts over time to reflect the allocation of staking rewards generated by the contract. This means that 1 stETH will always represent 1 ETH staked.
From Lido's perspective, whenever 32 ETH is pooled in the Ethereum smart contract, the DAO selects a new validator from a governance-controlled registry. It then calls the deposit contract, allocating 32 ETH to that validator's public key and using LidoDAO's withdrawal credential.
There are two questions to address:
How are withdrawal credentials managed? The withdrawal credential is an ETH2 BLS key, which is split into a 6-of-11 multisignature using a distributed key generation ceremony. This is not the optimal choice, but there is no risk while the withdrawal functionality from the Beacon Chain is not yet enabled. By the time stakers can withdraw, Lido will have transitioned to using an ETH1 smart contract as the withdrawal credential instead of a multisignature. After that, assuming the smart contract has no management capabilities over the funds, 1 stETH can be trustlessly redeemed for 1 ETH.
Who are the validators, and how do they enter the registry? Validators are specialized staking enterprises that must be approved by the governance body, such as p2p.org, Chorus One, or stakefish. Each validator has its own maximum staking amount, which is also determined by a governance vote.
Unpacking the stETH token
We have established that stETH is a proof of claim to the staked ETH and any rewards generated in the smart contract, which is also referred to as a staking derivative.
Staking derivatives will have a significant impact on the entire Ethereum ecosystem, including Ethereum stakers, regular ETH holders, competition between pools, and even Ethereum itself.
Stakers: The primary benefit of derivatives for stakers is the ability to re-stake, allowing them to stake this principal in other applications, just as Uniswap's liquidity provider LP tokens can be widely used as collateral in DeFi. This greatly reduces the opportunity cost of staking.
Unstaked ETH holders: If stETH can be used as collateral to borrow ETH, it can release the demand for borrowing ETH for leveraged staking. This will drive up the loan interest rates for supplying ETH, ultimately benefiting all ETH holders.
Competition between pools: The existence of stETH gives its pools a strong network effect. This network effect creates a strong economic incentive to stake ETH in market-leading pools, meaning that due to the associated liquidity moat and network effects, ETH staking derivatives may follow a power law or winner-takes-all distribution principle. Therefore, in many use cases, stETH may replace ETH, or even potentially completely substitute ETH.
Ethereum: A popular argument is that staking derivatives reduce the security of PoS because they decouple block production from staking and slashing penalties. This is also known as the principal-agent problem, which may lead to the situation where block producers have no stake and thus may not be incentivized to follow the protocol.
However, this argument must be considered in terms of returns: if staking derivatives lower the cost of staking, it may lead to more (or even all) ETH being staked. Note that this is a perfect example of a virtuous cycle: the more liquid stETH becomes, the lower the opportunity cost of staking, leading to more ETH being staked, which in turn further enhances the liquidity of stETH, and so on.
Without staking derivatives, we can expect that 15% to 30% of ETH will be staked. However, with the use of staking derivatives, this number could rise to 80-100%, as staking investments incur no additional costs compared to not staking.
To illustrate why this would bring greater economic security, consider the following attack scenarios:
If 20% of all ETH is staked, and an attacker needs to acquire 66% of all ETH (the critical threshold for compromising the Ethereum blockchain), they would have to purchase 40% of all ETH from the open market.
If 60% of ETH is staked, but stETH is liquid, the attacker would need to acquire 66% of all stETH, which is 40% of ETH. Note that this would also require additional steps, as the attacker must first redeem stETH to remove honest validators and then re-stake their ETH.
If the staking ratio of ETH exceeds 60%, the share of ETH the attacker must purchase will exceed 40% and will continue to increase as the staking ratio rises.
If 100% of ETH is staked, the attacker would need to acquire 66% of all stETH to reach the same attack threshold.
We can thus conclude that if staking derivatives can increase the amount of staked ETH to over 60%, it will significantly enhance the economic security of Ethereum rather than diminish it.
Who will be the winners in the staking market?
Decentralization is often viewed as an intangible benefit that comes at a higher cost, leading users to be generally unwilling to pay for it (e.g., see the debate between Binance Smart Chain and Ethereum). This reasoning does not apply to decentralized staking pools, as they have three key advantages over centralized staking pools.
Decentralized staking pools have stronger social scalability: An important metric for PoS security is how much staking is controlled by a single entity. For exchanges, this number may be limited to between 15% and 30%; furthermore, the concentration of power within the Ethereum ecosystem may raise social concerns. As long as each validator in the DAO is not a very large entity and the withdrawal credentials cannot be changed / voted on, decentralized staking pools can control any share of the network. It is crucial to emphasize how important it is that decentralized staking pools lose all governance functions at that point. Changes to fees, withdrawal addresses, or validator registries cannot be modified by manual input.
The staking derivatives of decentralized staking pools are trustless: Large exchanges like Coinbase or Binance can only issue custodial tokens, which must be limited in their adoption because, under all other conditions being equal, users absolutely prefer trustless tokens over trust-based tokens. This leads centralized staking pools to miss out on the network effects of staking derivatives. Some may argue that the centralized token WBTC has won the tokenized BTC market. However, we believe this is only because BTC on Ethereum cannot be tokenized in a trustless and capital-efficient manner, while this is feasible for staked ETH.
Decentralized staking pools have fewer restrictions on MEV extraction: Institutional staking pools (such as exchanges) may be constrained by social and reputational factors that prevent them from extracting certain forms of MEV. Smaller staking entities and decentralized staking pools that are not subject to these constraints thus have the opportunity to provide higher returns for their stakers. This may transform the decentralized cost premium of using decentralized staking pools into a decentralized cost discount. These benefits are so significant that the leaders in joint staking pools are likely to be decentralized / non-custodial staking pools. If the aforementioned funds minimize governance effectively, they may win the entire market without posing any systemic risk to the Ethereum blockchain.
Conclusion
The existence of staking pools and their staking derivatives has a market reality similar to MEV extraction, and to some extent, it is inevitable. As long as there are private interests in creating and using them, they will exist and thrive. However, if the right solutions ultimately prevail and are widely adopted, they can also bring systemic benefits to Ethereum.
Given the significant network effects of stETH and the fact that decentralized pools may be both non-custodial and earn more income from MEV, we believe there will be a decentralized pool that can win the entire market.
Therefore, we should focus on ensuring that a non-regulatory, robust version of stETH wins the market rather than a centralized staking pool, to ensure good systemic outcomes.
Acknowledgments: Thanks to Arjun Balaji, Vasiliy Shapovalov, and Konstantin Lomashuk for their valuable feedback and review of this article.
