$LDO’s Governance Influence Over Ethereum

Source: Lido Finance

In Ethereum 2.0, the block-producing will be responsible by $ETH stakers who validate new transactions and maintain the network security. Anyone who could control a sufficient amount of staked $ETH in theory could influence the network. Who may gain control of a sufficient amount of staked $ETH? Lido Finance. It has already amassed more than 31% of staked $ETH in the beacon chain. Lido Finance is governed by $LDO token holders, is this mean $LDO holders could exert certain governance power over Ethereum 2.0?

TL;DR

  • Lido is the most successful liquid staking protocol for Ethereum, this brings power to $LDO token.
  • To solve the problem that $LDO token may exert some influence over Ethereum, it is now proposed to give stETH certain veto power over Lido’s governance.
  • stETH is already the most successful $ETH liquid staking derivative, and now it may even get some governance power over the Lido protocol and the Ethereum network. This will further make stETH more attractive as the best $ETH liquid staking derivative and bring more customers to Lido Finance.

In this article we will discuss:

  1. Explain how Ethereum works in the simplest way
  2. Explain how Lido works in the simplest way & its influence over Ethereum node operators
  3. Who governs Ethereum?
  4. The Lido’s new dual-governance model and a power flywheel

How Does Ethereum 2.0 Work?

In the simplest way explained, Ethereum is a Proof-of-Stake blockchain, $ETH holders can stake their $ETH into a staking contract and take responsibility to validate new transactions in the Ethereum 2.0 network. If they behave well, they get new $ETH for rewards. However, if they behave badly and do not complete the validation job, their staked $ETH will be slashed.

To be a validator is not a small commitment:

  1. One can only apply to become a validator by staking 32 $ETH first. 32 $ETH is not a small amount of money.
  2. Validators are expected to maintain sufficient hardware and connectivity to participate in block proposing and transaction validation.
  3. The deposited tokens are locked into the staking contract and cannot be used for other purposes. What is worse is the current setting does not allow withdrawals once the $ETH is deposited into the staking contact until Ethereum 2.0 officially goes online. Therefore, liquid staking protocols emerge to provide a solution to release liquidity for the locked staked $ETH.

Similar to the PoW network, Ethereum 2.0 still has the 51% attack problem. If anyone controls 51% of staked $ETH, they could control the whole network. Of course, 51% of all staked $ETH is huge in terms of value. As of 1st Aug, the total number of staked $ETH in the Ethereum 2.0 (the Beacon Chain) is around 13.8 million, 51% of it worth $10.3 billion.

Two concepts to emphasize in this section:

  1. Being a validator is a big commitment and requires specific knowledge and equipment;
  2. Anyone who controls 51% of the staked $ETH control the network.

How Does Lido Finance Work?

Lido Finance provides Ethereum liquid staking service.

As mentioned above, being a validator of Ethereum 2.0 requires large minimum capital, technical complexity around the validation process, and extended lockup periods. Ordinary $ETH holders lack the professionalism as a validator and do not want their assets to lose liquidity after being staked. Therefore, Lido Finance, a liquid staking service protocol, emerged to solve these problems.

Lido Finance allows users to deposit their $ETH into Lido’s protocol, which then delegates the staked $ETH to professional validators (aka node operators). At the same time, after staking $ETH into Lido Finance, users will receive a derivative asset — stETH issued by Lido Finance, representing the ownership of the staked $ETH.

Source: Twitter@Leo_Glisic

Once the node operators receive the staked $ETH entrusted by Lido Finance, it will be used for Ethereum 2.0 transaction validating. Node operators receive $ETH rewards (staking rewards) for transaction validating. After deducting the fees to node operators and Lido’s staking pool service fee, the rest of these rewards accumulate into users’ staked $ETH.

Lido DAO’s Power Over Node Operators

Node operators are the actual party that is responsible for Ethereum 2.0 transaction validation. Lido Finance acts as an agent that directs users $ETH to different node operators, and these node operators are added and removed through the governance of Lido DAO.

Below you can find the current whitelisted node operators by Lido DAO.

Source: Node Operator Join Log

These whitelisted validators are market leaders in the industry, such as P2P staking, Stake.Fish, and Chorus.one. While Lido DAO has no direct control over them, Lido governance can have indirect influence over which node operators can be whitelisted. The governance process for deciding on a node operator to be included is as follows:

  1. Lido Node Operator Subgovernance Group (LNOSG), representatives of the Lido team and whitelisted node operators’ teams, propose changes to be made to the node operator set, e.g. adding new members.
  2. The change of the node operator set needs to be voted by the Lido governance token — $LDO holders.
  3. Lido DAO can also vote for the inclusion or exclusion of any set of node operators, not only those proposed by LNOSD.

Therefore, Lido DAO (represented by $LDO holders) could vote to exclude any node operator or include any new node operator.

If Lido governance gradually votes for a certain set of validators, it could potentially lead to a centralization of validating power for the Ethereum network.

As the single largest single Ethereum 2.0 liquidity staking provider, there is more than 31% of the total staked $ETH currently channeled through Lido. It is not impossible for Lido to further expand its market share, achieving more than 51% of the total staked amount of Ethereum 2.0 channeled through it. While these staked $ETH are distributed among a set of validators, Lido can gradually impact the composition of the set of validators and thus exert influence on the Ethereum network.

Who Governs Ethereum?

A common misconception is by holding $ETH, one can have governance power over Ethereum network. However, $ETH is not a governance token.

It is worth mentioning that Lido can influence node operators, but not the Ethereum governance process. In essence, $ETH or staked $ETH both have no governance power regarding the Ethereum network. This is different from many other proof-of-stake blockchains which have “a one-token = one vote” system. The native token holder directly governs the network through on-chain governance.

For example, Cosmos Hub has an on-chain voting mechanism, $ATOM holders decide governance proposals by voting.

Source: Cosmos Hub Governance

Ethereum governance is completely off-chain and is decided by Ethereum Core Developers. Ethereum Core Developers decide protocol changes, rather than the token holders. These developers discuss and coordinate any changes on Ethereum through online forums or off-line conferences, and decide whether to introduce new proposals into Ethereum’s protocol via a network upgrade. Then, it is the responsibility of the validating nodes to decide whether or not to execute that upgrade. There is no formal on-chain voting mechanism.

So far, we have learned that $LDO holders can influence Ethereum 2.0 by influencing node operators. You may wonder how come the Ethereum community could allow this kind of thing to happen.

A Dual-Governance Model

Lido faced the pressure to solve this problem, the community has proposed a $LDO+stETH dual governance model, which is currently under discussion.

Under the new governance model, $LDO holders can still propose and vote in the same way as before, however, it will give the $ETH staking derivative — stETH a veto power over certain areas of the Lido governance. This means stETH can veto a proposal they deem harmful to the Ethereum network, providing a counterbalancing power to the $LDO governance.

stETH veto power is proposed to only apply to certain areas in the Lido governance, including:

  • Managing the Ethereum node operators set and its parameters.
  • Upgrading the Ethereum liquid staking protocol code.
  • Changing the total fee percentage of the Ethereum liquid staking protocol outside of an agreed boundary. (e.g. $LDO vote can set the protocol fee between 5% to 20%, anything beyond this need to go through the dual governance)
  • Minting and burning $LDO.

Issues not related to Ethereum, but only to the Lido protocol itself, such as how the protocol vault is used, will remain governed solely by the $LDO holder.

A Power Flywheel

As you may realize things will get quite interesting if this proposal finally gets approved. $ETH token itself does not have any governance power. $LDO token can exert a certain influence on Ethereum via deciding the composition of node validator sets. And the staked version of $ETH — stETH can enjoy a certain level of governance power through the dual-governance model (e.g. the veto power regarding node operators’ selection and minting and burning of $LDO), resulting in stETH will essentially have more governance influence to the Ethereum than $ETH in some sense.

Final Thoughts

While this article discussed the impact of $LDO over Ethereum, the upcoming Proof-of-Stake Ethereum 2.0 is still no doubt the most decentralized blockchain except Bitcoin. Ethereum insists on governance by core developers, avoiding the possibility that exists in other PoS blockchains where a small number of large whales could control most of the native tokens, and exert a direct impact on governance. For Ethereum, no matter how much $ETH is staked in one liquid staking protocol, its impact on Ethereum is still indirect. The balance of power among the $ETH stakers, the holder of $LDO, and different node operators are complex and interrelated. If dual governance is introduced, the veto power of stETH will further complicate this game relationship and further reduce Lido’s influence on Ethereum.

The original post can be found here at TokenInsight.

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