J.P Morgan analysts say Ethereum’s increasing staking use is making the network more centralized. This is coming as the use of Ethereum for staking continues to grow following the Merge upgrade executed in September 2022.
The Merge brought a proof-of-stake consensus mechanism to Ethereum, which enabled staking on the network. Staking is a feature of proof-of-stake networks that allows users to earn rewards by staking their tokens.
By staking tokens, they stakers help to secure the network by becoming validators, and are in turn rewarded with more tokens. On Ethereum, the Shanghai upgrade in April this year allowed validators to withdraw the staked ether locked in the network and reinvest, leading to a surge in staking.
According to JP Morgan analysts, this rise in staking has resulted in a more centralized Ethereum network and lower staking yields.
“The rise in Ethereum staking since the Merge and Shanghai upgrades has come at a cost as the Ethereum network became more centralized and as the overall staking yield declined,” JPMorgan analysts led by Nikolaos Panigirtzoglou wrote in a note on Thursday.
The analysts further stated that the network is controlled mainly by liquid staking providers. Citing Lido as an example of a top liquid staking provider, they argued that such platforms “involve a high degree of centralization,” even though they are decentralized on their own.
“The top 5 liquid staking providers control more than 50% of staking on the Ethereum network, and Lido specifically accounts for almost one-third,” the analysts said.
Ethereum at Risk
One of the challenges that cryptocurrencies are meant to solve is the problem of centralization. This is a situation in which only a few entities control a network. As a proof of work blockchain, Ethereum enjoyed more decentralization since miners are scattered everywhere and have to compete to mine blocks and earn rewards.
Proof-of-stake networks are not so. Instead, stakers and validators are chosen mainly based on how much ether they hold. This means that a few big stakers like Lido are chosen, which makes Ethereum more centralized and at more risk of every issue that comes with centralization.
“Needless to say that centralization by any entity or protocol creates risks to the Ethereum network as a concentrated number of liquidity providers or node operators could act as a single point of failure or become targets for attacks or collude to create an oligopoly that would promote their own interests at the expense of the interests of the community, e.g. by censoring certain transactions or by front running on end users’ transactions,” the analysts added.
The analysts also raised concerns on the possibility of rehypothecation, a situation in which stakers liquidity tokens as collateral across multiple DeFi protocols simultaneously.
According to the analysts, this practice can result in a cascade of liquidations if a staked asset drops sharply in value or is hacked or slashed due to a malicious attack or a protocol error
Declining Staking Yield
Staking is supposed to bring yields that serve as incentive for stakers to continue securing the network. The current growth of staking on Ethereum has however led to declining yield.
“The total staking yield has declined from 7.3% before the Shanghai upgrade to around 5.5% currently,” they said.
This could lead to less incentive for stakers, which can further expose the network to the risk of even more centralization as fewer validators are motivated to stake.