30.10.2023
September 2022. Ethereum's transition to proof-of-stake, widely known as The Merge, was finally completed. The upgrade dramatically reduced energy consumption by an impressive 99%. It also strengthened the network's security, making it much more resistant to attacks and unauthorized access. Additionally, this improvement laid the foundation for greater scalability, making it easier to upgrade the network in the future.
The eagerly anticipated upgrade of the second-largest cryptocurrency by market capitalization has become a reality at last.
A few days after the Ethereum Merge, JPMorgan expressed concern about the network's decentralization. The financial institution argued that a few entities control most staked ETH. Shortly after the Merge, Coinbase and Lido quickly came to control more than 40% of the ethereum network's blocks. At that time, Coinbase held 15% of the total stake, while Lido controlled 31%. If a single entity controls a two-thirds majority stake (66%), it can significantly hinder other validators from participating in the blockchain consensus process.
While this query may eventually fade into the annals of the crypto world, it is evident that JPMorgan, one of the world's largest financial institutions, remains vigilant regarding the potential risk of ethereum's increasing centralization.
According to JPMorgan's report, ethereum's transition to Proof of Stake through the Merge and Shanghai upgrades has led to centralization. The report states that the growing prevalence of liquid staking and the dominance of centralized cloud service providers are driving centralization within the ethereum blockchain. If this claim holds true, it raises concerns about the potential concentration of power among a small number of network participants, rendering ethereum vulnerable to censorship and attacks.
The question then arises: Is ethereum genuinely undergoing centralization right before our eyes, is it at risk of becoming more centralized, or are these concerns excessive?
The Liquid staking concentration.
One of the pivotal transformations brought about by “The Merge” is the transition from miners, who were crucial in the Proof-of-Work process, to stakers who now serve as validators within the Proof-of-Stake consensus mechanism. Staking entails the act of locking a specified quantity of cryptocurrency to verify and support blockchain operations, all while earning rewards through the duration of the lock-up period.
As reported by the blockchain analytics platform Nansen, a notable statistic emerged before “The Merge”, revealing that a staggering 64% of the staked Ether (ETH) was under the control of just five entities.
Source: Nansen
Nansen's report shows that only about 11% of all ETH in circulation is staked, with 65% being liquid and 35% being illiquid. This means that most ETH holders are not participating in staking, which is important for the security of the ethereum network. There are a total of 426,000 validators and 80,000 depositors on the ethereum network. However, a small group of entities control a significant portion of staked ETH.
The top four entities, including Lido, Coinbase, Kraken, and Binance, have diverse origins and characteristics. Notably, Lido stands out as the sole decentralized autonomous organization (DAO) among them, indicating a higher degree of decentralization due to its governance protocol. However, Lido faces a challenge related to its native governance cryptocurrency, LDO, which is primarily concentrated in the hands of a limited number of participants. For instance, approximately 46% of the governance power is held by the top 9 addresses (excluding the treasury), and it's common for a select few addresses to wield significant influence over proposals.
One year later, what has changed? To understand this, let's examine the developments that followed the “Shanghai” upgrade.
The Shangai upgrade.
The Shanghai/Shapella upgrade enabled withdrawals of 18 million staked ETH tokens, worth $35 billion at the time. Despite concerns about a post-upgrade sell-off, the ETH price rallied to yearly highs. The upgrade not only didn't diminish the presence of stakers but, in fact, led to their gradual increase over time.
Source: Glassnode
The number of active validators after the Shangai upgrade increased by almost 60%.
One year later, several aspects have evolved, while others have remained unchanged. As of the current moment, we've observed an increase in the number of validators and a remarkable 100% growth in the percentage of ETH locked across various platforms.
Source: Nansen
The distribution of staked ETH has remained largely unchanged since the Shanghai upgrade, with Lido remaining the leading staking platform. Coinbase's participation has decreased slightly, but it is still a significant player in the market.
Source: Nansen
Over 23% of the circulating ETH supply is currently staked, but the majority of the stakers are in a loss at an average staked price of USD $2,026.
More staked ETH does not necessarily mean a more or less decentralized network, as it depends on the distribution of staked ETH. Nevertheless, staking services have grown significantly since The Merge, making staking more accessible and easier for many users. That’s one of the reasons for how quickly the total number of validators has grown. By design, the Ethereum blockchain becomes more secure with more validators, but there are some practical implications. At the current growth rate, the total number of validators could exceed the advisable number of stakers within a few years, putting the entire blockchain at risk of becoming nonfunctional.
To address the challenge of rapid validator growth, the ethereum community proposed EIP-7514, a flexible mechanism to adjust the number of accepted validators. The proposal is controversial because it was included at the last minute for the next Cancun/Deneb upgrade. EIP-7514 is seen as a necessary but temporary fix, an issue the community must discuss in depth.
A (mostly) successful shift in consensus protocol.
Ethereum's shift to Proof of Stake, marked by the execution of "The Merge" and "Shanghai," upgrades has undoubtedly brought significant changes to the network. These changes have both positive and negative implications for the decentralization of the platform.
On the positive side, the process of transition to Proof of Stake has proved ethereum has one of the most involved and participative communities. The involvement of the community is essential to the long-term sustainability of the network, as evidenced by the fact that the proposal is not only being questioned but also actively discussed.
Concerns about centralization are justified, particularly given the concentration of staked ETH among a few entities. A concentration that has endured even as the total number of validators has grown. The prevalence of liquid staking providers has created a scenario where a small group can significantly influence decision-making on the network. This concentration of power can become a vulnerability, discouraging new actors from participating. How? Contrary to expectations, liquid staking platforms allow stakers to delegate their ETH without the required 32 ETH to become a validator, making them passive participants in Ethereum's decision-making. The ethereum community must remain steadfast in its commitment to addressing security and decentralization concerns.