A comprehensive interpretation of the Ethereum 2.0 staking pool and staking derivatives mechanism, characteristics and potential impact

Ethereum’s transition from a Proof-of-Work (PoW) consensus mechanism to a Proof-of-Stake (PoS) consensus mechanism will be the most anticipated milestone since its birth. Instead of the energy-costly PoW blockchain scaling method, PoS allows users to stake their ETH and run block-generating nodes (called validators).

The first step for Ethereum to implement PoS is to launch an independent network that can reach consensus, called the beacon chain. In return for providing security for the system, stakers will receive new ETH tokens from the issuance. In the future, the beacon chain and the current Ethereum will be merged, allowing stakers to also earn transaction fees and miner extractable value (MEV) currently earned by PoW miners.

The Ethereum PoS protocol does not provide stakers with certain features found in other PoS network implementations such as Cosmos, Tezos, and Polkadot. The reason behind this is to incentivize decentralization. However, we believe that the market will always intervene to improve the efficiency and convenience of staking. Therefore, it is important to ensure that the solution gives the greatest private benefits to stakers while also leading to healthy systemic outcomes for Ethereum as a whole.

In this article we will explore the problems currently faced by ETH stakers. We will then demonstrate how staking pools and staking derivatives can help stakers solve these problems while, counterintuitively, increasing the effective security of the network.

How does the ETH staking mechanism work?

To stake independently in Ethereum, a user must deposit 32 ETH into the ETH2 deposit contract and specify two key parameters:

1. Validator public key: Before depositing ETH, the user will generate a key pair for their validator. The private key is used to sign the block, while the public key is used as its unique identification code.

2. Withdrawal voucher for the deposited 32 ETH: Once the withdrawal is initiated, the principal (32 ETH) and staking rewards can only be withdrawn to this address.

Crucially, the public key and the withdrawal certificate do not have to be controlled by the same entity.

The user will then run an ETH2 validator node and sign blocks when it is their turn to produce a block, or be punished for not complying with the protocol.

What problems will ETH stakers encounter?

The efficiency and convenience of the staking protocol can be broken down into the following attributes and their specific implementation in Ethereum:

1. Staking threshold: This determines the minimum amount of stake required to enter the game. The minimum required is 32 ETH, and people can only stake multiples of 32 ETH.

2. Delegation: Can stakers outsource the work of running physical validator nodes, or must they do it themselves? If delegation is not possible, hardware and bandwidth requirements may discourage some people from participating in staking: There is no way in the Ethereum protocol to delegate staking to other validators.

3. Locking: How long does it take before you can withdraw your staked funds? Longer locks tend to 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 function is enabled, it takes 27 hours for the lock to be unlocked.

4. Returns: How much do stakers earn for their time? The higher the return rate, the more people will be willing to stake, and the higher its security. Stakers on the beacon chain can currently receive inflation rewards. After the merger, they will also earn transaction fees and MEV. The inflation reward depends on how much ETH is currently staked. The more ETH staked, the less inflation reward each validator gets, and vice versa. Today, about 4 million ETH is staked, and the current annual return rate is about 7.8%.

These attributes are significant barriers to attracting stakers. All other things being equal, stakers want to be able to stake any amount of ETH, delegate the operation of the infrastructure to others, and immediately withdraw their staked ETH. If possible, they also want to use their staked ETH for other applications, which has become standard procedure in decentralized finance.

In the following we will discuss:

How staking pools solve the delegation and staking minimum thresholds; and how staking derivatives issued by these staking pools solve the long-term lock-up problem and allow stakers to release the liquidity of their staked ETH.

The operation mechanism of the pledge fund pool

On the surface, a staking pool works similarly to a mining pool in PoW, but due to the nature of PoS, it can provide more benefits to its customers:

1. By pooling ETH funds together, stakers can bypass the 32 ETH minimum requirement. This allows stakers with smaller funds to participate in PoS.

2. Rather than letting each user operate a validator node on their own, the fund pool handles the actual operational issues of staking. Some fund pools may also guarantee their customers that they will not be subject to protocol penalties such as large slashes.

3. Similar to the operation of banks, the fund pool can maintain liquid ETH reserves to meet the needs of instant withdrawals. Assuming that not all customers want to withdraw funds at the same time, it may eliminate the need to wait for four months for withdrawals.

4. Finally, the pool can provide tokens that represent the staker’s ETH asset rights and can be used in other applications. This is so important that we will devote a whole chapter to it below.

The pledge fund pool can be centralized or decentralized, and both have their pros and cons that need to be weighed.

Centralized pledge fund pool operation mechanism

Any large exchange could easily implement a staking pool feature. In fact, many already support (or will support) beacon chain staking.

The exchange only needs to:

1. Allow users to choose to stake in exchange for staking rewards.

2. Use the customer’s ETH to run a validator node.

Since the exchange is doing the staking, users do not need to run any infrastructure. It is also very easy for exchanges to provide instant liquidity because they already have a large amount of liquid ETH reserves. Given the value of acquiring customers and liquidity to the exchange business, exchanges can provide this service to users without charging extra.

Decentralized staking fund pool operation mechanism

Now that we have established the difference between individual staking and staking through a pool, as well as the operating mechanism of centralized staking pools, we will explore the architecture of decentralized staking pools using Lido as an example.

From a user's perspective, it's very simple: they deposit ETH into an Ethereum smart contract and receive stETH as a receipt. The balance of stETH tokens adjusts over time to reflect the distribution of staking rewards generated by the contract. That is, 1 stETH will always represent 1 ETH staked.

From Lido’s perspective, whenever 32 ETH is gathered on the Ethereum smart contract, the DAO selects a new validator from the governance-controlled registry. The deposit contract is then called, assigning 32 ETH to the public key of that validator, using the withdrawal credentials of the LidoDAO.

There are two questions to answer here:

1. How to manage withdrawal vouchers? The withdrawal voucher is an ETH2 BLS key, which is split into a 6-of-11 multi-signature using a distributed key generation ceremony. This is not optimal, but it is not risky when withdrawals from the beacon chain are not enabled. By the time stakers can withdraw funds, Lido will have transitioned to using an ETH1 smart contract as a withdrawal voucher instead of a multi-signature. After that, assuming the smart contract has no management function for the funds, 1 stETH can be exchanged for 1 ETH without trust.

2. Who are validators and how do they enter the registry? Validators are businesses that must be approved by governance to engage in staking, such as p2p.org, Chorus One, or stakefish. Each validator has its own maximum stake amount, which is also determined by a vote of the governance body.

stETH token unpacking

We have established that stETH is a proof of stake claim to the staked ETH and any rewards generated in the smart contract, also known as a staking derivative.

Staking derivatives will have a significant impact on the entire Ethereum ecosystem, including Ethereum stakers, regular ETH holders, competition between funding pools, and even Ethereum itself.

Stakers: The main benefit of derivatives to stakers is that they can stake again, allowing them to use the principal for staking in other applications, just like Uniswap's liquidity provider LP tokens can be widely used as collateral in DeFi. This greatly reduces the opportunity cost of staking.

ETH holders who have not pledged ETH: If stETH can be used as collateral to borrow ETH, it can release the demand for borrowing ETH for leveraged pledge. This will push up the loan rate for the supply of 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 for ETH staking in market-leading pools, meaning that ETH staking derivatives may follow a power law or winner-takes-all distribution principle due to the liquidity moat and network effects associated with them. Therefore, in many use cases, stETH may replace ETH, or even completely replace ETH.

Ethereum: A popular argument is that staking derivatives makes PoS less secure because they decouple block production from staking and slashing penalties. This is also known as the principal-agent problem and can lead to a situation where block producers may not be incentivized to follow the protocol because they don’t have anything to stake.

But the argument must be considered against the backdrop of benefits: if staking derivatives reduce the cost of staking, this could 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, which leads to more ETH being staked, which in turn further enhances stETH’s liquidity, and so on.

Without staking derivatives, we can expect 15% to 30% of ETH to be staked, but with staked derivatives, this number could be as high as 80-100% because there is no additional cost to stake an investment compared to not staking.

To illustrate why this results in greater economic security, consider the following attack scenario:

1. If 20% of all ETH is staked, and the attacker needs to obtain 66% of all ETH (the critical threshold to compromise the Ethereum blockchain), they will have to buy 40% of all ETH from the open market.

2. If 60% of ETH is staked, but stETH is liquid, the attacker will have to buy 66% of all stETH, which is 40% of ETH. Note that this requires additional steps, the attacker must first redeem stETH to remove the honest validator, and then re-stake his ETH.

3. If the ETH staking ratio exceeds 60%, the attacker must purchase more than 40% of ETH, and this amount will continue to increase as the staking ratio increases.

4. If 100% of ETH is staked, the attacker will need to obtain 66% of all stETH to reach the same attack threshold.

We can therefore conclude that if staking derivatives can increase the amount of staked ETH to above 60%, it will significantly increase the economic security of Ethereum, rather than reduce it.

Who will be the winner in the staking market?

Decentralization is often thought of as an intangible benefit that comes at a higher cost, and thus users are often unwilling to pay for it (see, for example, the Binance Smart Chain vs Ethereum debate). This line of thinking does not apply to decentralized staking pools, as they have three key advantages over centralized staking pools.

1. Decentralized staking pools have stronger social scalability: For PoS security, an important metric is how much staking is controlled by a single entity. For exchanges, this number may be limited to between 15% and 30%; not only that, the concentration of power in the Ethereum ecosystem may cause social concerns. As long as each validator in the DAO is not a very large entity and the withdrawal certificate cannot be changed/voted, the decentralized staking pool can control any share of the network. We must emphasize how important it is that the decentralized staking pool will have lost all its governance functions by then. Change fees, withdrawal addresses, or validator registries cannot be modified by manual input.

2. Decentralized staking pools have trustless collateral derivatives: Large exchanges like Coinbase or Binance can only issue custodial tokens, and their adoption must be limited because, all else being equal, users absolutely prefer trustless tokens to trusted tokens. This causes centralized staking pools to miss out on the network effects of collateral derivatives. One could point out that the centralized token WBTC will win the tokenized BTC market. However, we believe this is simply because BTC on Ethereum cannot be tokenized in a trustless and capital-efficient way, while this is possible for staked ETH.

3. Decentralized staking pools have fewer restrictions on MEV extraction: Institutional staking pools (such as exchanges) may be subject to social and reputational restrictions that prevent them from extracting some form of MEV. Smaller staking entities and decentralized staking pools that are not subject to these restrictions therefore have the opportunity to provide higher returns to their stakers. It may be possible to transform the decentralization cost premium mentioned above for using decentralized staking pools into a decentralization cost discount. These benefits are so great that the leaders in the joint staking pools are likely to be decentralized/non-custodial staking pools. If the above funds fully achieve minimized governance, it may win the entire market without causing any systemic risk to the Ethereum blockchain.

Summarize

The existence of staking pools and their staking derivatives has similar market realities to MEV extraction and is somewhat inevitable. They will exist and thrive as long as there is a private interest in creating and using them. But if the right solution ultimately wins out and is fully adopted, it can also bring systemic benefits to Ethereum.

Given the huge network effects of stETH and the fact that decentralized pools can be both non-custodial and potentially earn more revenue from MEV, we believe there will be one such decentralized pool that can win the entire market.

Therefore, we should focus on ensuring a non-custodial, strong version of stETH wins the market, rather than centralized staking pools, to ensure good systemic outcomes.