Ethereum 2.0-Stake Fund Pool and Stake Derivatives Mechanism, Features and Potential Impact

Ethereum’s transformation from a proof-of-work PoW consensus mechanism to a proof-of-stake PoS consensus mechanism will be the most watched milestone since its birth. Abandoning the high energy cost of the PoW blockchain expansion method, PoS allows users to pledge their ETH and run block generation nodes (called validators).

The first step for Ethereum to achieve PoS is to start an independent network that can reach consensus, called the beacon chain. In return for providing security to the system, the pledger will receive new ETH tokens from the additional issuance. In the future, the beacon chain and the current Ethereum will merge, so that the pledger can also earn the current transaction fees and miner extractable value (MEV) earned by PoW miners.

The Ethereum PoS protocol does not provide pledgers with certain functions in the implementation of other PoS networks such as Cosmos, Tezos and Polkadot. The reason behind this is to encourage decentralization. But we believe that the market will always intervene to improve the efficiency and convenience of pledges. Therefore, it is important to ensure that the solution gives the pledger the greatest private benefit, while also bringing healthy system results to the entire Ethereum.

In this article, we will discuss the current problems encountered by ETH pledgers. Then we will demonstrate how the pledged fund pool and pledged derivatives can help the pledger solve these problems. At the same time, contrary to intuition, it can also enhance the effective security of the network.

How does the ETH pledge mechanism work?

To independently pledge in Ethereum, users must deposit 32 ETH into the ETH2 deposit contract and specify two key parameters:

  1. Verifier public key: Before depositing ETH, users will generate a key pair for their verifier. The private key is used to sign the block, and the public key is used as its unique identification code.
  2. Deposited 32 ETH withdrawal voucher: Once the withdrawal is initiated, the principal (32 ETH) and pledge reward can only be withdrawn to this address.

Crucially, the public key and the withdrawal certificate need not be controlled by the same entity.

Then the user will run an ETH2 validator node and sign the block when it is their turn to produce the block, or be punished for not complying with the agreement.

What problems will ETH pledgers encounter?

The efficiency and convenience of the pledge agreement can be divided into the following attributes, as well as its specific implementation plan in Ethereum:

  • Pledge threshold: This determines the minimum amount of pledge required to enter the game. At least 32 ETH is required, and people can only pledge multiples of 32 ETH.
  • Delegation: Can the pledger outsource the work of running the physical validator node, or must he do it himself? If authorization is not possible, hardware and bandwidth requirements may prevent some people from participating in staking. There is no way to delegate pledges to other validators in the Ethereum protocol.
  • Lock-up: How long will it take to withdraw the pledged funds? Longer lock-ups tend to increase the security of the agreement, but due to lower flexibility and higher opportunity costs, it is less attractive to pledgers. Currently, the pledger cannot retrieve ETH from the beacon chain at all. After the withdrawal function is enabled, it takes 27 hours to lock and unlock .
  • Return: What is the time income of the pledger? The higher the rate of return, the more people will be willing to pledge, and the higher its security. Pledgers on the beacon chain can currently receive inflation rewards. After the merger, they will also earn transaction fees and MEV . Inflation reward depends on the current number of ETH investment pledge . The more ETH pledged, the lower the inflation reward for each validator, and vice versa. Today, about 4 million ETH is pledged, and the current annual return is about 7.8%.

These attributes are great obstacles to attracting pledgers. Under all other conditions being equal, the pledger hopes to be able to pledge any amount of ETH, delegate the operation of the infrastructure to others, and immediately withdraw the pledged ETH. If possible, they also hope to use their pledged ETH for other applications, which has become a standard procedure for decentralized finance.

In the following we will discuss:

  • How the pledged fund pool solves the minimum threshold for delegation and pledge; and
  • How do the pledged derivatives issued by these pledged capital pools solve the problem of long-term lock-up and allow pledgers to release the liquidity of their pledged ETH?

The operating mechanism of the pledged fund pool

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

  1. By pooling ETH funds together, pledgers can bypass the 32 ETH minimum requirement. This allows pledgers with smaller amounts of funds to participate in PoS.
  2. The fund pool does not allow each user to operate the validator node by themselves, but the fund pool handles the actual operation of the pledge. Some fund pools may also assure customers that they will not be punished by agreements such as large slashes.
  3. Similar to the operating methods of banks, the fund pool can maintain liquid ETH reserves to meet the demand for instant withdrawals. Assuming that not all customers want to withdraw money at the same time, the four-month withdrawal period may be eliminated.
  4. Finally, the fund pool can provide tokens that represent the equity of the pledger’s ETH assets and can be used in other applications. This is very important, so we will devote a full chapter to this content below.

The pledged fund pool can be centralized or decentralized, and the pros and cons of the two need to be weighed.

Centralized pledge fund pool operation mechanism

Any large exchange can easily implement the pledge fund pool function. In fact, many already support (or support ) beacon chain pledge.

The exchange only needs:

  1. Allow users to choose to pledge in exchange for pledge rewards.
  2. Use the customer’s ETH to run the validator node.

Since the exchange is 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 customer acquisition and liquidity to the exchange’s business, the exchange can provide users with this service without additional charges.

Decentralized pledge fund pool operation mechanism

Now that we have determined the difference between single pledge and pledge through the fund pool, as well as the operation mechanism of the centralized pledge fund pool, we will take Lido as an example to discuss the structure of the decentralized pledge fund pool.

From the user’s point of view, it is very simple: they deposit ETH into an Ethereum smart contract and receive stETH as a receipt. The balance of stETH tokens will be adjusted over time to reflect the distribution of pledge rewards generated by the contract. This means that 1 stETH will always represent 1 ETH pledged.

From Lido’s perspective, whenever 32 ETH is gathered on an Ethereum smart contract, the DAO will select a new validator from the registry controlled by governance. Then call the deposit contract, allocate 32 ETH to the validator’s public key, and use LidoDAO’s withdrawal certificate.

There are two questions to answer here:

  • How to manage withdrawal vouchers? ATM is a ETH2 BLS key certificate, using the distributed key generation ceremony may be split into 6-of-11 multisignature . This is not the optimal choice, but there is no risk when the withdrawal function from the beacon chain is not activated. When the pledger can withdraw money, Lido will have transitioned to an ETH1 smart contract as the withdrawal certificate instead of multi-signature. After that, assuming that the smart contract has no management function for funds, 1 stETH can be exchanged for 1 ETH without trust.
  • Who are the validators and how do they enter the registration form? Verify people must govern approval of professionals who engage in mortgage business , for example, Chorus One or stakefish. Each validator has its own maximum pledge amount, which is also determined by voting by the governing body.

stETH token unpacking

We have determined that stETH is a proof of claim for the pledged ETH and any rewards generated in the smart contract, which is also known as pledged derivatives.

Pledged derivatives will have a significant impact on the entire Ethereum ecosystem, including competition among Ethereum pledgers, regular ETH holders, capital pools, and even Ethereum itself.

Pledger: The main benefit of derivatives to the pledger is that it can be re-pledged, so that it can be pledged in other applications, just like Uniswap’s liquidity provider LP tokens can be widely used in DeFi Same as collateral. This greatly reduces the opportunity cost of pledges.

ETH holders who have not pledged ETH: If stETH can be used as collateral for borrowed ETH, it can release the demand for borrowed ETH for leveraged pledge. This will push up the loan interest rate for the supply of ETH and ultimately benefit all ETH holders.

Competition between fund pools: The existence of stETH makes the fund pool have a strong network effect. This network effect brings strong economic stimulus to ETH pledge in the market-leading capital pool, which means that due to the liquidity moat and network effect associated with it, ETH pledge derivatives may follow the power law or the winner-takes-all distribution principle . Therefore, in many use cases, stETH may replace ETH, or even completely replace ETH.

Ethereum: A popular saying is that collateralizing derivatives will reduce the security of PoS because they decouple block production from staking and slash penalties. This is also known as the principal-agent problem and can lead to the following situations: since block producers do not have any pledges, they may not be incentivized to follow the protocol.

But this argument must be considered in terms of revenue: if the pledge of derivatives reduces the cost of pledge, it may lead to more (or even all) of ETH being pledged. Please note that this is a perfect example of a virtuous circle: the more liquid stETH becomes, the lower the opportunity cost of pledge will result in more ETH being pledged, which in turn will further enhance the liquidity of stETH. analogy.

If derivatives are not pledged, we can expect that 15% to 30% of ETH will be pledged. But after using pledged derivatives, this figure may be as high as 80-100%, because compared with no pledge, pledged investment has no additional cost.

To illustrate why this brings higher economic security, consider the following attack scenarios:

  • If 20% of all ETH is pledged, and an attacker needs to obtain 66% of all ETH (undermining the key threshold of the Ethereum blockchain), they will have to buy 40% of all ETH from the open market.
  • If 60% of the ETH is pledged, but the stETH is liquid, the attacker will have to purchase 66% of all stETH, which is 40% of ETH. Please note that this requires additional steps. The attacker must first redeem stETH to delete the honest validator, and then re-stake their ETH.
  • If the ETH pledge ratio exceeds 60%, the share of ETH that the attacker must purchase will exceed 40%, and it will continue to increase as the pledge ratio increases.
  • If 100% of the ETH is pledged, the attacker will need to obtain 66% of all stETH to reach the same attack threshold.

We can therefore conclude that if the pledged derivatives can increase the amount of ETH pledged to more than 60%, it will significantly improve the economic security of Ethereum, rather than reduce its security.

Who will be the winner in the pledge market?

Decentralization is generally regarded as an intangible benefit and requires a higher price, so users are usually unwilling to pay for it (for example, see Binance Smart Chain vs. Ethereum debate). This kind of thinking does not apply to decentralized pledged capital pools, because they have three key advantages compared with centralized pledged capital pools.

  • The decentralized staking fund pool has stronger social scalability: For PoS security, an important indicator 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 concern. As long as each validator in the DAO is not a very huge entity, and the withdrawal voucher cannot be changed/voted, the decentralized pledge fund pool can control any share of the network. We must emphasize how important it is that the decentralized pool of pledge funds has lost all its governance functions by then. Changes to fees, withdrawal addresses, or verifier registration form cannot be modified by manual input.
  • The pledged derivatives of the decentralized pledged fund pool are trustless: large exchanges like Coinbase or Binance can only issue custodial tokens, and their adoption must be restricted, because under the same conditions, users absolutely Prefer trustless tokens rather than trustworthy tokens. This will cause the centralized pledge fund pool to miss the network effect of pledge derivatives. Someone may point out that the centralized token WBTC can win the tokenized BTC market. However, we believe that this is only because BTC on Ethereum cannot be tokenized in a trustless and capital-efficient way, which is feasible for pledged ETH.
  • Decentralized pledge fund pools have fewer restrictions on MEV withdrawal: Institutional pledge fund pools (such as exchanges) may be restricted by society and reputation, preventing them from withdrawing some form of MEV. Smaller pledge entities and decentralized pledge capital pools that are not subject to these restrictions therefore have the opportunity to provide higher returns to their pledgers. The decentralized cost premium of using the decentralized pledge pool mentioned above may be transformed into a decentralized cost discount. These benefits are so huge that the leader in the joint pledge fund pool is likely to be a decentralized/non-custodial pledge fund pool. If the above funds fully achieve minimal governance, it may win the entire market without causing any systemic risks to the Ethereum blockchain.

to sum up

The existence of the pledged fund pool and its pledged derivatives has similar market realities to MEV withdrawal, and it is inevitable to a certain extent. As long as there is a private interest in creating and using them, they will exist and flourish. But if the right solution eventually wins out and is fully adopted, it can also bring systemic benefits to Ethereum.

In view of the huge network effect of stETH and the fact that the decentralized fund pool may be neither custodial nor may earn more income from MEV, we believe that there will be such a decentralized fund pool that can win the entire market.

Therefore, we should focus on ensuring that a non-regulatory and powerful version of stETH wins the market instead of a centralized pool of pledge funds to ensure good systemic results.

Acknowledgement: Thanks to Arjun Balaji, Vasiliy Shapovalov, Konstantin Lomashuk for their valuable comments and reviewing this article.

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