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The Ethereum Protocol: The Risks of Liquidity Staking

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When liquid collateralized derivatives exceed critical consensus thresholds, there are significant risks to the Ethereum protocol and associated capital pooled.

Original title: " The Ethereum Protocol: The Risks of Liquidity Staking "

Original author: Danny Ryan, Core Researcher of Ethereum Foundation

Original compilation: Nanfeng, Unitimes

Liquid Staking Derivatives (LSD), such as Lido or other similar agreements, are a level of cartelization, when they exceed the key consensus threshold, the Ethereum protocol and pooled The underlying capital entails significant risk. Capital allocators should be aware of the risks to their capital and allocate to alternative protocols. At the same time, LSD protocols should limit themselves to avoid centralization and protocol risks that could eventually destroy their product.

Note that while current LSD protocols such as Lido have a lot of room for improvement, this article does not address flaws in the design of these current implementations. Instead, the purpose of this paper is to show that there are inherent problems with the LSD protocol when it exceeds the consensus threshold.

Creating levels of cartelization

In extreme cases, if an LSD agreement Exceeded a key consensus threshold, such as 1/3, 1/2, or 2/3 (that is, the pooled ETH pledge in the LSD protocol exceeds 1/3, 1/3 of the total ETH pledge in the Ethereum beacon chain 2 or 2/3), and through coordinated MEV (miner extractable value), block time manipulation, and/or (transaction) censorship - i.e. cartelization of block space, then staked with other unpooled ETH Compared with gold, pledged derivatives can achieve excess profits. In this case, due to the huge returns of the cartel, the capital participating in ETH staking through other places will be frustrated, thus self-reinforcing the control of this cartel on ETH staking.

The LSD protocol can minimize governance, upgradeability, and other risks over time, but "who" can be the node operator in the LSD protocol The problem of being part of the Node Operator (Node Operator, hereinafter referred to as NO) set still exists. This lever is the main cause of cartelization.

Determining "who" becomes the node operator (NO) of the LSD protocol involves two issues—that is, "who" is added to the set of node operators, " Who" was removed from the set. In the long run, this can be designed in two ways - either through governance (token voting or other similar mechanisms), or through automated mechanisms around reputation and profitability.

Option 1: Governance of node operators

On the first design method In other words, the NO (node operator) is determined through governance, and the governance Token (such as the LDO of the Lido protocol Token ) has become a major risk of Ethereum. if the Token can decide "who" can become a node operator in this theoretically majority LSD protocol, then the Token Holders of the NO can (by voting) force the NO to perform activities such as transaction review, multi-block MEV extraction, etc., otherwise they will remove the NO from the set of node operators.

In fact, the enforcement of such economic monopoly activities will only strengthen the Token Control of NOs. if the Token Exercising its monopoly to gain excess profits through disruptive mechanisms, then, in extreme cases, NOs will not be as profitable as operating independently. Therefore, it is possible to determine the governance of NOs Token Could become a self-reinforcing cartelization and abuse of the Ethereum protocol.

There is another obvious risk to this governance of determining NOs, and that is regulatory scrutiny and control. If pooled ETH deposits in an LSD protocol exceed 50% of the total deposits in the Ethereum protocol, then these pooled ETH deposits gain the ability to censor blocks (worse, if these pooled ETH deposits accounted for 2/3 of the total deposit, then they can "finalize" these blocks). In a regulatory censorship attack, we now have one distinct entity - the governance Token Holders of - regulators can submit requests to them to review blocks. This is likely to be a simpler regulatory goal than the Ethereum network as a whole, depending on the Token of the distribution. In fact, DAO Token The distribution of is usually so bad that only a few entities determine the majority of votes.

Therefore, in any form of agreement to the majority LSD Token In governance control, we all rely on the goodwill of the protocol's DAO or any governance structure. Relying on the good faith, anonymity or Token Geographical distribution is not safe to stop attacks and we must see this as insufficient in the long run.

Option 2: Select node operators based on profitability

The second design In terms of the way NOs are selected based on their profitability and reputation as “who” can be added to the LSD protocol’s set of node operators, we would actually end up with a similar, albeit automatic, cartelization outcome. First of all, it takes a certain amount of time and capital to enter the concentration of node operators (that is, invest some ETH, similar to the design of Rocket Pool, and then slowly demonstrate its own profitability and allocate more ETH deposits). While the time and capital required to enter this set of node operators may make entry more difficult for new entrants, this is not a true cartelization vector for this approach to design. Instead, the cartelization vector of this design is that NOs are automatically removed from the set of node operators if their performance does not meet certain profitability criteria.

Centralized kicking out of node operators based on profitability is probably the only trustless (non-governance) way to ensure NOs are beneficial to the LSD protocol pool Way. But defining profitability is problematic - either you define some absolute number (like a good baseline ETH minting reward), or you need to define some relative number (like within 10% of average/normal profitability).

But considering the unpredictability of MEV/transaction rewards in certain time windows, and the importance of MEV rewards to long-term profits, these numbers need to be dynamic , and compared to other node operators/validators over time. That is, due to the high volatility of the system's economic activity over a period of time, the system cannot be designed to have some absolute metric - such as having to earn X profit from transaction fees.

This profitability comparison metric may work well when all node operators use "honest" technology, but if any number of NOs Using destructive techniques (such as multi-block MEV extraction or adjusting blocks to obtain more MEV), thus distorting the profit target, honest NOs will eventually be kicked out from the node operator pool (if they do not join and use of these disruptive technologies).

Thus, this means that no matter which of the above approaches - be it governance of NOs or selection/eviction based on profitability - this over-consensus Threshold capital pools will become a level of cartelization. It is either a direct cartel formed through governance, or a disruptive, profitable cartel formed through smart contract design.

Pledged ETH as the backing of governance

Digression: Some people think that LSD ETH Holders can have a say in the governance of their underlying LSD protocol, making for a potentially poorly distributed, plutocratic governance Token security backing.

It is important to note here that ETH holders are not, by definition, Ethereum users, and in the long run, we expect Ethereum users to be more than There are far more ETH holders. This is a key and important fact illustrating Ethereum governance - ETH holders or stakers are not granted on-chain governance. Ethereum is a protocol that users choose to run.

In the long run, ETH holders are only a subset of users, so ETH holders participating in staking are even a subset of that subset. In the extreme case, that is, all ETH participates in the pledge through a certain LSD agreement, and the governance voting weight of the pledged ETH cannot protect the Ethereum platform for users.

The insidious nature of governance

Even though there is a time delay in LSD governance, making pooled Funds can exit the system before governance changes occur, and the LSD protocol will also suffer from "boiled frog" governance attacks. Small, slow changes are less likely to take staked capital out of the system, but the system can still change dramatically over time.

Also, as mentioned earlier, LSD holders are not the same as Ethereum users. LSD holders may accept governance votes required for some kind of censorship, but this is still an attack on the Ethereum protocol that users and developers will mitigate through means at their disposal - social intervention.

It should be noted that "in the face of malicious governance, pledged ETH can always be withdrawn" is actually technically incorrect today, The future is also uncertain to be true. The validator's activation key is the only key in the current Ethereum PoS design that allows withdrawal from staking. While there have been a number of proposals proposing the ability to add BLS and smart contract exit credentials to initiate exits, none of these have yet agreed on purpose or design.

Risk to Capital vs. Risk to the System

Most of the discussion above has focused on Being in an LSD pool (like Lido) poses a risk to the Ethereum protocol, not to those who hold capital in the pool system. So, this seems to be affected by the "tragedy of the commons" - everyone makes a rational decision to use this LAS protocol for staking, which is a good decision for users, but a growing problem for the protocol. The worse the decision. But, in fact, the risk to the Ethereum protocol and the risk to the capital allocated to that LSD protocol are tied together when the consensus threshold is exceeded.

Cartelization, abusive MEV extraction, (transaction) censorship, etc. Attack these threats in the same way—that is, burn them through social intervention. So funneling money into this layer of cartelization not only puts the Ethereum protocol at risk, but in turn puts this pooled capital at risk.

These may seem like "tail risks" that are hard to take seriously, or may never happen, but if we learn anything in the Crypto space Stuff - if it can be exploited or has some unlikely "critical edge case" then it will be exploited or broken sooner than you think. In this open dynamic environment, vulnerable systems crash again and again, and vulnerable systems are hacked for fun and profit.

Ethereum protocol and users can recover from an LSD centralization and governance attack, but it won't be pretty. I recommend that Lido and similar LSD offerings self-limit for their own benefit, and that capital allocators be aware of the capital pooling risks inherent in the LSD protocol design. Due to the inherent and extreme risks associated, capital allocators should not allocate more than 25% of the total ETH collateral to the LSD protocol.

**This article only represents the views of the original author and does not constitute any investment opinion or suggestion.