Liquidity Police

The Eth2 ecosystem is growing at a rapid pace. There is already over 2 million ETH staked on the Beacon Chain and new deposits are showing no signs of stopping any time soon.

The upward trajectory of Ether price and complexity of self-staking has led to a parabolic rise in pooled staking solutions. The idea is very straight forward, instead of the required 32 ETH minimum, stakers are able to stake in denominations of 0.5 ETH or less. In addition, pool operators eliminate the need of running complex software, they do the heavy lifting on behalf of the stakers. All that needs to be done is deposit and that’s it.

Staking pools have gone a step further and resolved an additional pain point for users, liquidity. Staked ETH is currently locked until later phases of the network and while staking performance is great, the average person has a liquidity preference when it comes to a risky, ever dynamic industry such as blockchain. If markets move quickly, Hodlers want to move with them.

The solution is simple, stakers are issued an ERC-20 token against their stake. Stake 1 ETH, and get 1 ETH derivative (dETH) against it. The advantages are clear;

• Ease of use — simple for the average user to operate and keep track of.
• Liquid — users are able to sell and transfer their dETH.
• Leverage — Gained by staking the dETH in other yield-bearing vehicles.

As innovative as this approach is, there are many limitations to dETH. Under no circumstances should they be perceived as real ETH and in some cases, such assets might be significantly devalued against ETH. The reason is simple; pool operators hold the user’s validator key, as such, they have the final say when a pool is liquified and funds need to flow from the Beacon Chain back to the hands of pool participants.

Pooled staking requires the user to effectively send their ETH to a third party that stakes it on their behalf. Third parties or pool operators are not able to steal Ether, as they do not hold the withdrawal keys, however, they do hold the validator key which is in charge of signing the exit transaction from the Beacon Chain. The withdrawal key defines where your funds should be sent to, the validator key executes the sending.

Let’s imagine a scenario where a large amount of a specific pool’s ETH is being called upon by its users. In such a case, operators are required to approve the liquidation. Pool protocols today are not built to support forced liquidation (as would happen in protocols such as MakerDao for example). The human involvement in the interim creates an added layer of risk for the end-user. An attempt to mass liquidate a pool might lead to a % of operators refusing to support the liquidation.

There are few ways in which current pools are mitigating such a scenario:

• Socializing losses — in case of the inability to liquidate, the network in effect has lost the ETH until the operators agree to liquidate. Losses will be ‘socialized’ i.e. burdened by the entire network so the impact on individual stakers will be softened.
• Community insurance — a portion of fees paid on entry to a pool or from staking rewards are aggregated in a dedicated insurance fund.
• Partial collateral — operators are required to post collateral that will be used in case of slashing or other operator related issues. In most cases the collateral is posted in ETH, there are some instances where additional ERC-20 tokens are required to supplement the ETH collateral. The collateral in question will never cover the entire staked ETH amount in the network. It is in effect partial collateral.
• Contractual assurance — probably the ‘weakest’ way to enforce behavior on operators. The pool requires the operators to sign a contract and may seek legal remedy in case of breach.

The above methods provide some level of reassurance to stakers but will always be inferior to protocol-based governance and decentralization. Protocols like MakerDao or Aave will lose a significant amount of their value and appeal if they are centralized. The same applies to staking pools, the current centralized architecture has many downsides. The quality of the derivative ETH provided by such pools is questionable at best. A crypto asset can only be as strong as the code it’s based on, adoption is key but it cannot sustain a faulty crypto asset over time.

The liquidation concern is a bit far away. Operators will not be able to liquidate their respected pools until later phases of Eth2. However, derivative ETH is already very much present and utilized in centralized exchanges and DeFi protocols. There are huge advantages to derivative ETH when issued by a centralized exchange, the rules there are simple, you can sell it back to ETH if the market is willing to buy it from your hands. When it comes to integration with DeFi protocols and the creation of leverage, the game is entirely different. It only makes sense that participants in decentralized finance will be decentralized themselves (stable coins are an outlier).

Predictions

• We will see 10–15 major derivative ETH tokens issued by staking services.
• Hundreds of millions of those ETH will be used in DeFi protocols for leverage.
• There will be at least one major event where derivative ETH will be proven to be worth much less than the underlying asset.
• Holders of one of the major dETH tokens will experience a liquidity shock of large magnitude and will not be able to liquify their positions without sustaining significant losses.

There is a real need for truly decentralized ETH derivatives based on consensus mechanisms that support forced liquidation. It’s only fair to provide stakers with every possible reassurance to make sure they can receive their ETH back if they request it, they shouldn’t be reduced to asking nicely or beg, they shouldn’t have to trust any middleman or custodian. After all, it’s their ETH!