Did the Merge Negatively Impact Ethereum’s Incentive Alignment?
Proof of Stake (PoS) based blockchains have long received criticism from Proof of Work (PoW) advocates in the cryptocurrency realm for what is perceived as a misaligned incentive structure. PoS systems are seen as tending towards centralisation because they reward validators based on the amount of cryptocurrency they hold and are willing to “stake” as collateral. Consequently, entities with larger holdings have a greater chance of being chosen to validate transactions and create new blocks, thereby earning more rewards. This feedback loop naturally provides an advantage to wealthier participants, leading to an accumulation of both wealth and validation power in the hands of a few.
Central to the discussion of Ethereum’s post-Merge centralisation is the role of relayers and the dominance of liquid staking services like Lido, Kiln and Figment and some major cryptocurrency exchanges such as Coinbase and Binance. Relayers, crucial for bridging transactions between block builders and proposers, have become pivotal in maintaining the network’s efficiency. Yet, the reliance on a small number of these entities for a majority of Ethereum’s transactions is in danger of introducing systemic risks and potential points of failure. This concentration of power is antithetical to the foundational principle of blockchain technology, which advocates for a distributed and decentralised approach to validating transactions and securing the network.
Today liquid staking pools at Lido, Coinbase, and Binance collectively control a significant portion of Ethereum’s staked ETH. This concentration not only poses questions about the equitable distribution of staking rewards but also raises regulatory and security issues. The potential for these entities to influence network decisions or become targets for regulatory scrutiny could undermine Ethereum’s resilience and autonomy. Moreover, the dependence on a few central nodes for transaction validation and block production challenges the network’s ability to resist censorship and maintain its open, permissionless nature.
The economic incentives tied to the PoS mechanism exacerbate these centralisation pressures. Validators with substantial staked ETH have greater influence over the network, potentially marginalising smaller participants and leading to an oligopolistic control structure. This scenario could deter the network’s ability to foster a diverse and competitive validator ecosystem, essential for ensuring Ethereum’s long-term decentralisation and security. The changes to the economic model following the Merge, particularly regarding the compensation and sustainability of relayers, illustrates the complexities of maintaining a balanced, decentralised network.
What’s the Worst That Could Happen?
A creeping centralisation of Ethereum, following its transition to a PoS consensus mechanism, poses significant risks to the network, if they are not adequately mitigated.
Firstly, centralisation could lead to a concentration of power in the hands of a few large validators or entities, making the network more susceptible to attacks, including the potential for collusion among validators to censor or reverse transactions. This concentration could also make Ethereum more vulnerable to a 51% attack, where a single entity gains control of the majority of staking power and thereby compromises the network’s integrity.
Secondly, a more centralised Ethereum could become an easier target for regulatory scrutiny and intervention. Regulatory bodies may exert pressure on centralised entities controlling a significant portion of the network, potentially leading to enforced compliance measures that conflict with the decentralised and permissionless nature of blockchain technology. This could include for example, censorship of specific transactions or freezing of assets associated with certain addresses.
Decentralisation is key to the resilience and robustness of blockchain networks. A centralised Ethereum would be more prone to failures or attacks on key infrastructure points, reducing the network’s overall resilience. This could lead to downtime, loss of funds, or compromised data integrity, undermining user confidence in the platform.
Ethereum’s appeal lies in its decentralised nature, offering a platform that is not controlled by any single authority. If the community perceives Ethereum as becoming too centralised, it could lose trust and support, which in turn could lead to reduced development activity, fewer Decentralised Applications (DApps) being built on the platform, and users migrating to alternative blockchains.
Centralisation could also stifle innovation within the Ethereum ecosystem. A small number of entities with disproportionate control could prioritise their interests, potentially limiting opportunities for smaller players and reducing the diversity of applications and solutions developed on the platform. This could slow the pace of innovation and growth within the ecosystem.
There is also the risk of economic centralisation, if staking rewards are concentrated among a few large validators. This could discourage new participants from joining the network, as the barriers to becoming a meaningful contributor become increasingly insurmountable.
What Can the Ethereum Community Do to Prevent Centralisation?
We don’t think this will happen as there are several strategies that can be pursued by the Ethereum community to ensure the chain maintains its long term success.
By lowering entry barriers for validators and promoting a wide range of participants, Ethereum can distribute its validation process more evenly. This could involve reducing the amount of ETH required to stake or support staking pools that enable smaller holders to participate.
Adjusting the Ethereum protocol to disincentivise centralisation, such as penalising overly large staking pools or adjusting rewards to favour smaller validators, could also help maintain a more balanced network.
Supporting and developing decentralised staking solutions that offer an alternative to large, centralised staking pools can help distribute validation power. Projects like Rocket Pool represent steps in this direction by enabling more individuals to become validators.
Educating the community about the risks of centralisation and how to participate in staking responsibly can empower more users to contribute to network security. This also includes awareness of the importance of choosing diverse staking services.
Developing and utilising governance mechanisms that prevent any single entity from having too much influence over the network. This might include more democratic voting processes or algorithmic governance models that ensure a wide distribution of decision-making power.
Encouraging validators to use a variety of Ethereum client software and to operate in different geographic locations can reduce the risk of network-wide failures or attacks that target specific clients or regions.
Conducting regular audits of the network’s decentralisation metrics and being prepared to take corrective action if certain thresholds of centralisation are approached. This could include community-led initiatives to redistribute staking power.
Engaging in dialogue with regulators to ensure that compliance and regulatory frameworks do not inadvertently favour centralisation by imposing requirements that only large operators can meet.
By taking these steps, the Ethereum community can work towards a more decentralised and robust network, preserving the ethos of blockchain technology while ensuring its long-term viability and security.
As Ether surged past the $3k level this week, and with the prospect of an ETH spot ETF being approved looking increasingly likely, Ethereum is coming under increasing scrutiny, and has now the perfect opportunity to reinforce its decentralisation credentials.
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