How does Ethereum 2.0 change DeFi?

The SEC’s decision in June to drop charges against Ethereum was a milestone in the platform’s maturation and greater recognition in the financial community.

For those who haven’t been following the case, the SEC argued that Ethereum (ETH) was being sold as unregistered stock, fearing that its sale did not follow certain rules and protocols. However, Ethereum supporters argued that because the network is decentralized, it does not meet the criteria of an investment contract or security.

While the SEC may decide not to take direct legal action, it does open the door to further discussion about centralization. Some technical aspects of Ethereum’s architecture have inspired important conversations around contractual rights among influential entities. While these discussions are primarily internal, addressing these issues can enhance the network’s upgrade goals and support true decentralization.

This is especially true as the network seeks to embody the ideals of “Ethereum 2.0,” a more powerful, accessible, and useful version of its token and infrastructure. Some say it’s already here, while others point out that gaps still need to be filled before its arrival can be definitively declared.

Yes, Ethereum 2.0 has huge potential to transform DeFi and the broader ecosystem, but we can’t just take half a step. Critical progress still needs to be made to realize its full potential.

Validator Centralization

By transitioning to a proof-of-stake (PoS) mechanism in September 2022, Ethereum now allows validators to stake ETH, with large stakes increasing validation opportunities and rewards. This upgrade clearly highlights Ethereum’s key role in DeFi, as it has sparked the creation of countless innovative financial tools on the network for use cases such as lending and trading.

However, emphasizing token ownership rather than the number of validators may concentrate power in a smaller group, contrary to the decentralized spirit of cryptocurrency. In addition, staking requires 32 ETH, which means that validators with large ETH stakes can have a disproportionate influence on network governance and decision-making processes. This creates a feedback loop that favors certain actors and can lead to the concentration of power and wealth in the hands of a few.

In March, Vitalik Buterin even expressed his concerns about “lazy stakers,” people who only participate in staking pools rather than staking individually — clearly demonstrating the relevance of the centralization issue.

At its core, Ethereum represents a shift in the way financial services are designed, accessed, and used. However, reliance on a small number of entities continues to pose risks and calls into question just how decentralized Ethereum 2.0 really is.

Turning to DeFi

Ethereum’s path toward centralization sets the stage for greater complications in the future — namely, regulators and reduced network resilience. Ultimately, Ethereum’s future in DeFi and the blockchain ecosystem as a whole depends on balancing technological advancement while limiting centralization as much as possible. And there are many ways to achieve this.

If implemented correctly, concepts like rainbow staking can further enhance Ethereum’s adaptability while fighting centralization. Essentially, rainbow staking allows users to stake ETH in multiple pools and strategies simultaneously, effectively creating a so-called “rainbow of rewards” where stakers receive these rewards while mitigating anti-competitive risks and building a more resilient ecosystem. The ETH validation process is divided into “heavy” and “light” staking — “heavy” staking focuses on finalized validation services, while “light” staking focuses on censorship resistance of transactions.

For example, a liquidity staking protocol like Lido or Rocket could offer heavy service staking, while existing stakers could choose to run light service operators. Rainbow staking will ultimately lead to a more efficient and competitive network while giving liquidity staking providers more diversity. However, it is not easy to implement and could bring confusion to the entire staking structure.

In addition to rainbow staking, Ethereum can also take advantage of network-wide advances already introduced in its initial 2.0 update, such as sharding. While sharding has come under scrutiny for its security issues, justifying the move to layer 2 and zero-knowledge development, this does not mean that the technology should be abandoned outright.

We’re already seeing an evolution here, thanks to developments like “danksharding” specifically for layer 2. Danksharding involves proposer-builder separation (PBS), which is different from how Ethereum validators operate now — proposing and broadcasting blocks entirely on their own. Instead, PBS shares the love and divides these tasks among multiple validators.

Ultimately, danksharding helps achieve data availability by allowing validators to quickly and efficiently verify blob data while identifying missing data.

Its goal is to allow users to complete layer 2 transactions at the lowest possible cost and scale Ethereum to verify more than 100,000 transactions per second. This will allow dApps such as Uniswap to process transactions at a lower cost and shorten transaction approval time.

However, danksharding’s highly technical infrastructure and implementation ignores smaller rollups and can encourage centralization. So while the technology has fallen out of favor, its benefits in reducing hardware and aiding scalability suggest that the technology itself could be improved to benefit the next generation of Ethereum. Perhaps Ethereum 3.0.

The significant progress made by Ethereum 2.0 in the areas of regulation and decentralization cannot be ignored. Reducing the network’s reliance on a small group of actors for network operations and legal victories is a positive step forward. However, the next phase of Ethereum as a network must include adapting to evolving legal requirements to firmly establish its position as a transformative force in DeFi and mainstream blockchain use.

Despite these obstacles, Ethereum 2.0’s achievements so far have put the ecosystem on the right path. By focusing on the future and reaffirming its commitment to decentralization, Ethereum has strong power to maintain its dominance as an innovator in the blockchain space.

Getting one’s affairs in order is only a small part of solidifying one’s legacy.