Liquid Staking Issues & Perils

In our recent article Staking and Liquid Staking: a Primer we covered the fact that staking is rapidly becoming a substantial ecosystem of its own, including via increasing uptake from institutional investors. We explained the differences between simply staking tokens and liquid staking, which enables investors to pledge their tokens but also achieve liquidity by receiving a new token known as a liquid staking token (LST) or liquid staking derivative (LSD), which is typically deployed in decentralized finance (DeFi) to earn yield or other benefits.

Sounds great, so what’s the catch? Well, in addition to the potential catches inherent in any young and relatively untested technology – crypto generally but DeFi in particular is decidedly experimental and prone to major exploits – there are also larger, possibly systemic, risks that people in the space are not only calling out but actively working to mitigate.

First, there are growing concerns that the increasing popularity of liquid staking is building up to a centralization risk for Ethereum. One of the first liquid staking platforms was Lido, created in part to allow those who were staking ETH to get liquidity long before it was possible to withdraw one’s stake. Launched in 2020, the company added staking for ill-fated Terra Luna in March 2021 and Solana in September of that year.

Lido is now the largest liquid staking protocol, having issued $14.5 billion of stETH (staked ETH), and many are raising the centralization risks given that Lido has a 32% share of liquid staked ETH. For example, Ethereum Foundation researcher Danny Ryan wrote a post entitled The Risks of LSD, stating:

Liquid staking derivatives (LSD) such as Lido and similar protocols are a stratum for cartelization and induce significant risks to the Ethereum protocol and to the associated pooled capital when exceeding critical consensus thresholds. Capital allocators should be aware of the risks on their capital and allocate to alternative protocols. LSD protocols should self-limit to avoid centralization and protocol risk that can ultimately destroy their product.

And no less of an authority than Ethereum inventor Vitalik Buterin asked (in the context of a long blog post on whether more things should be enshrined in the Ethereum protocol itself): “might it make sense to enshrine some kind of in-protocol functionality to make liquid staking less centralizing?”

How does Lido respond to these concerns? Protocol relations contributor Marin Tvrdić argues that the economic incentives built into the Ethereum protocol, specifically the risk of slashing (losing one’s staked ETH) for misbehavior, are sufficient protection: “in reality, Lido would need to make 37 entities [the decentralized node operators] do something that’s really bad for the protocol itself. It’s a bit silly to think that Lido DAO has that power; it doesn’t.”

Viktor Bunin, a Protocol Specialist at Coinbase (he joined the company when Coinbase acquired infrastructure provider Bison Trails) has been active in the Crypto Twitter conversation on Lido’s centralizing impact, saying “For all the folks unhappy with Lido, here is a real, workable solution to continue to decentralize it” and quote tweeting a post by the CTO of Obol Network. Asked for further comment, Bunin referred Modern Consensus to a post from when he announced he was joining Obol as an advisor, which stated:

Obol Network enables trust minimized staking on Ethereum using Secret Shared Validators (SSV) technology. SSV is a new infrastructure primitive that enables a validator key to be split between independently operating validator instances… There is also an additional dark horse potential use case in that Obol Network can enable totally permissionless liquid staking, both on the token holder and operator side.