Does Lido Control Too Much Liquid Staking?

Things move fast in crypto land, even during “crypto winter.” Just over a year ago, Ethereum still operated using Proof-of-Work, meaning that exactly 0.000 ETH were “staked.” Once Proof-of-Stake roared to life, it turns out people liked earning rewards and now, incredibly, over 20% of all ETH are committed to the network via staking.

This article is part of CoinDesk's "Staking Week" presented by Foundry.

The one clear downside of staking, of course, is that your Ethereum is unavailable. This led to the world of liquid staking, where you receive what’s effectively a “shadow token,” such as stETH (staked Ethereum), in exchange for the ETH that you’re committing to the network, and then you can use (or invest) the new token, all while earning rewards on your underlying asset. “Originally you were not able to withdraw your Ethereum, and it was stuck there. Liquid staking had a perfect product-market fit,” says Marin Tvrdić, the protocol relations contributor for Lido, the largest liquid staking protocol.

But is this too good to be true? Can getting freebie tokens create too much leverage? And are there hidden risks in the system? “If someone tells you there's no risk, they’re lying,” says Tvrdić over a recent Zoom call. “There’s always risk. Even if you hold native Ethereum, there's risk.” Tvrdić shares this and other staking real-talk, including why Lido is more decentralized than people realize, what he envisions as the future of staking, and why we might get to a world that is “over-staked.”

Interview has been condensed and lightly edited for clarity.

What’s the mission of Lido?

Marin Tvrdić: Lido's primary mission is to decentralize Ethereum. And how the protocol operates is to distribute staking across multiple node operators, and as evenly as possible, as safely as possible. It's never concentrated on one node operator. It's spread across.

How would you describe the magic that’s required to pull this off?

Not the DAO, nor the protocol itself, holds custody of users’ ETH, or staked ETH. At no point is it a custodial solution. At every single point in time, from the moment ETH enters the protocol and gets deposited on a validator, it's self-custodial.

Without getting too deep in the weeds here, how does it work? Is it a system of smart contracts that automatically allocates all of the ETH across different node operators?

Exactly as you said. It's a set of smart contracts that route Ethereum from the end-user, through node operators, to specific validators. And it operates in a permissionless manner, and no one, no human person, has any interactions, at any point, with the protocol. So, it's fully, fully, fully smart contract-managed. And best of all, contracts are open-sourced, so anyone at anytime can come and audit everything by themselves.

There has been a massive uptick in both staking and liquid staking. Do you have any sense of who’s doing this, exactly? Institutional investors, or just regular people with a bit of Ethereum lying around? And do you know where they are geographically?

Geographically, it's global, right? And specifically, the Lido protocol is something that I'm proud to say is a protocol for everyone. You get institutional-grade security, but even retail users can deposit their one or two ETH, because they don't have that huge financial barrier to actually enter and stake. That’s opening up the gates for adoption.

If you observe the Lido protocol itself, and interactions it has on the blockchain, which is publicly visible, there are crypto-native institutions that interact with it. There is exposure to the more traditional institutions, because stETH, in this form, is the only asset on the market that’s institutional-ready. Because it's liquid. No other competing product has the same liquidity, thus the institutional side gravitates towards Lido liquid staking.

What do you mean, exactly, by institutional infrastructure? Can you give a concrete example?

If I’m an institution, why would I choose the Lido protocol? It's rather simple. It's the most liquid. It handled over $1 billion of withdrawals. No other liquid staking protocol on the market handled that amount of withdrawals. That's really, really important.

When you're an institution, you want to be sure that you can access your Ethereum at any point of time, right? So, it really is a robust and battle-tested protocol, because it currently has $14 billion worth of Ethereum in the underlying protocol. It signals battle-tested and readiness. And also, nine audits were done for the Lido V2 upgrade. No other protocol is pushing so hard with security audits.

Critics worry that if too much Ethereum is staked with Lido, that could harm the network. How do you respond to this?

The concern is that if Lido goes over 33% of total ETH staked, that could harm the network. I’d say that’s more of a marketing campaign to slow Lido’s growth, to allow competitors to catch up.

When you go into Ethereum mechanics, it’s true that with 33% of the network, you can affect the network finality. Blocks would not be closed, theoretically.

But 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.

Even if it did have that power, what people don’t understand is that the node operators are concerned about slashing. [“Slashing” is a penalty for validators, in Staking, if they in some way misbehave — the Staked Ethereum is “slashed” or removed.] If they’re affecting finality [and hurting the network], they get slashed. When they get slashed, they lose Ethereum from their validators, which means end-users are losing their Ethereum, which means node operators are losing their source of income. So why would one actually try to do that? It doesn’t economically make any sense.

Got it. You’ve already touched on this a bit, but how do you respond to those who worry that Lido is too centralized?

So, imagine a reality where there's no Lido. It would be completely ruled by centralized exchanges. What Lido does currently, as a protocol, is bring balance to the ecosystem. It diversified a number of entities, and that's how it de-risks the attack vectors on the Ethereum itself.

There was a reality when centralized exchanges dominated. They controlled Ethereum, and that's where Lido actually blossomed. Because it helped decentralize the network, and everyone loved it.

See also: How Staking Rates Can Drive the Crypto Economy Forward | Opinion

And what no one talks about is the Lido protocol is currently the only one that's sustainable. Now. Today. Covering all the expenses, and being able to maintain the security level required for institutions, for retail, for essentially Ethereum itself, while others are operating on VC money. The more the staking grows, the lower the rewards will be. That's how the mechanics of Ethereum work. So if we increase dramatically the number of Ethereum staked, rewards will go down. And that means none of these protocols would be sustainable.

Isn’t there a paradox here? To your point, as staking grows the rewards will come down. If we get to a world where everyone is staking, does that mean the rewards are eliminated, which would mean no one wants to stake?

So it can never be 100% staked, because, in that case, no one would have Ethereum to pay the gas, right? There's going to be a sweet spot. The market will find its fit. At some point, I think we will be over-staked, in terms of staked Ethereum, and it will give less rewards, and then people will start actually withdrawing Ethereum from staking, because it doesn't make sense. And then we will find balance and continuity.

What's your guess of when we get to over-staked?

That’s super-hard. Honestly. Because Ethereum itself, as a network, is also a living thing. I expect tweaks to the actual network to make it more sustainable for everyone.

Let’s talk about leverage. One of the advantages of Lido, or any liquid staking, is that when you commit your Ethereum to the network, you then get a liquid token in return, and then you can go and do other things with it.

In theory people could deposit their liquid Ethereum (stETH) into another protocol as collateral, and then get another liquid token in return, and then go and deposit that token into a third protocol, and so on. Or “yield farming” as some call it. Doesn’t this kind of over-leverage introduce risk, and isn’t it bad for the system?

Hmm. So, I wouldn't call it yield farming, because it's not actually a currency, and you're not consuming structured financial products. And it’s the user who actually puts his asset to additional risk by over-leveraging.

And it's on a protocol level to stop it. For example, on a lending market, to put caps, to avoid cascade liquidations. The market, at this point, is mature enough to have large protocols that actually take care of that kind of security, and prevent users from doing something they don't understand, or getting too greedy and endangering everyone. So there are some limitations imposed.

Putting over-leverage aside, how about the broader risks here? There have been many, many examples in crypto where a system looks “risk-free” but then somehow implodes or melts down, costing users millions. How do you think about the inherent risk of Lido?

In terms of smart contract risk, it's ever-present. If someone tells you there's no risk, they’re lying. There's always risk. Even if you hold native Ethereum, there's risk. When there's a network upgrade, there's risk that something goes wrong.

But that's the base risk. And it's very, very, very low risk. And then as you scale, on a protocol level, each smart contract on top is additional risk. Everyone is agreeing on that.

So, then it's up to the user to actually do a bit of research, and decide which protocol actually has the most dedicated attention to the smart contracts and security. Lido has spent almost $2,000,000 on nine audits. I’m not saying it’s the perfect solution, but it’s a solution that contributors are working on, and are working to make it even better. We don't try to compete with weird marketing campaigns. We’re trying to build trust around the Lido protocol, and that goes well with the mission of decentralizing Ethereum.

What does the world look like when staking becomes even more mainstream? And what do you see as the future of staking?

I see it as more simplified, honestly. Currently, even with the Lido protocol, if you just arrived it’s a bit of a steep learning curve. In the future I see it as being seamless. I see it as like the Web2 experience, that we all know from our traditional apps, being brought to the blockchain.

There will be customer-specific applications that will enable interaction in a seamless way. You can already see it through various wallets, on the centralized exchanges, that create super-apps that adopt liquid staking as well. The same will happen on the institutional side.

So, improved custodian offerings, wallets with specific smart contract features, so they can, for example, pick what kind of risk they want exposure to. There are so many things actually happening in the market now, during crypto winter, that I think will change the landscape itself in the future.