This article focuses on overlooked factors that are crucial for the decentralization of Ethereum's pledge layer. This includes the impact and returns of Ethereum ETFs, the challenges of decentralization, the scale of institutional capital flow, and Lido

This article focuses on overlooked factors that are crucial for the decentralization of Ethereum's pledge layer. This includes the impact and returns of Ethereum ETFs, the challenges of decentralization, the scale of institutional capital flow, and Lido.

I. Ethereum ETF will follow the approval of Bitcoin ETF

People are turning their attention to spot Ethereum ETFs, and the confidence in the approval of spot Bitcoin ETFs stems from the SEC's apparent inconsistency in approving futures based products but refusing to approve spot based products. Blackrock's application for an Ethereum spot ETF on November 9th further intensified this concern.

Considering the existence of the CME Ethereum futures market and multiple futures based Ethereum ETFs, the approval logic seems quite transferable. Even the regulatory methods for Ethereum in the United States are non securities based. The possibility of Gensler or future regulatory agencies changing their previous handling is unlikely for many reasons.

Indeed, the SEC's recent legislation on Coinbase listed securities excludes ether.

II. Ethereum ETFs with rewards are a natural extension of unsecured Ethereum ETFs

Before the approval of the spot Ethereum ETF, issuers will be scrambling to find an implementation plan that allows them to earn Ethereum pledge voting rewards. ETH with rewards is better than ETH without rewards and may attract new investors who have been on the sidelines so far.

The issuer will compete to become the first market participant to launch pledge voting rewards. At first, the issuer seemed to run its validators irrationally, considering knowledge barriers, business model challenges of node operations, and increased regulatory risks.

In order to enter the market first, the issuer must propose a solution that complies with the existing regulatory framework and can be approved as soon as possible. Therefore, the least laborious approach is for the ETF issuer to reach contractual agreements with third-party centralized pledge voting providers, including loan agreements, which charge a small fee.

This is already the solution adopted by Ethereum ETFAETH for pledge of 21Share. 21shares will host their ETH on CoinbaseCustomer and may lend the underlying ETH to CoinbaseCloud, Blockdameon, and Segment.

AETH has attracted a net asset value of $240.77 million, equivalent to 121400ETH, all of which have been pledged to centralized providers. These inflows are completely unrelated to the rate of return, as regardless of the rate of return, a fixed percentage is programmatically mortgaged.

III. Institutional pledge voting will shift towards liquidity alternatives, bringing new challenges to Ethereum's decentralization

Smart institutions may seek pledge voting with providers outside of ETF packaging, who have a more favorable cost structure and greater utility. Decentralized protocols such as Lido have been opened as assets to existing institutional clients in various custody, QC, and regulated environments. As decentralized protocols, they provide a consistent experience and institutional level security, but are open to all market participants who wish to pledge any number of ETHs.

On the other hand, some new projects are positioning themselves specifically for institutional needs. Especially companies like LiquidCollect are building a 'liquidity pledge solution specifically designed for institutional compliance needs'. Institutions can mint lsETH, which is pledged by one of three centralized providers (Coinbase, Segment, and Stacked) who also manage the project. The idea here has two aspects:

• Liquidity pledge is a better product than ordinary pledge voting; You have retained the monetary attributes of your ETH and most of the rewards.
• Institutions must pledge with KYC/AML compliant providers, otherwise they may face civil and criminal liability.

The first viewpoint is quite obvious.

Liquidity tokens (LSTs) can be used as collateral throughout DeFi, serving as the underlying asset in the liquidity pool and avoiding withdrawal queue time.

In addition, institutional products such as ETFs benefit from liquidity to manage fund redemptions in less than a day. For illiquid funds, they are usually managed by maintaining a portion of the unsecured ETH in custody. There is a risk that a large-scale influx of withdrawals may lead to a substantial bank run, while the remaining ETHs are de pledged, and the reward rate may be dragged down during normal operations.

Having liquid tokens will make it possible to manage redemptions more smoothly and also increase the proportion of funds that can be pledged at any given time. In order for this to become a realistic possibility, it is evident that the mobile token must be mobile. If the token does not have sufficient liquidity available, simply providing tokens is not enough. Currently, the only liquid token used by institutions with any substantial in chain and out of chain liquidity is Lido's stETH.

The second viewpoint is not very clear. Regulated institutions typically need to fulfill a series of obligations to reduce the risk or likelihood of money laundering or promoting crime. For this reason, KYC/AML has an obligation to maintain an auditable track of financial flows between institutions and their clients. In addition, there may be higher requirements for 'qualified custodians'. That is to say, qualified custodians and institutions as a whole should be able to fulfill their KYC/AML obligations, whether they are LST tokens or pledge providers, without compromising asset selection.

Even if the pledge voting provider explicitly establishes a contractual relationship with the owner or custodian of the funds, I do not believe that regulatory agencies will create a new KYC/AML compliance obligation for Ethereum's pledge voting. This is because I believe regulatory agencies will understand over time that Ethereum pledging voting is a special computational activity, and its characteristics do not match the traditional or financial sense of "cash flow". Holders and custodians of LST should be able to execute KYC/AML on any assets within their scope and fulfill their compliance obligations to reduce the risk of money laundering or criminal financing.

The concentration of pledges within centralized entities poses various urgent challenges for the development of Ethereum blockchain. Overall, the possibility of various disruptions to blockchain has become increasingly possible at different levels of pledge shares:

• Block restructuring attack
• Final confirmation delay
• Fork selection
• stress

The first two types of attacks can interfere with the normal operation of blockchain, and Ethereum has built-in incentive mechanisms to prevent attackers from attempting to do so, such as gradually diluting the attacker's reward and pledge balance. However, when the market share among individual node operators reaches 33% or higher, even if disrupting network operations becomes expensive, the participant may still begin to delay final confirmation. At a higher level of market share, such as 50%, attackers can effectively fork the blockchain and choose the fork they 'recognize'. At 67% or higher, blockchain actually becomes a delegated database completely controlled by a single party.

These attacks are not just theoretical, they are at the core of Ethereum's value as a settlement layer.

Ethereum's pledge proof mechanism enables centralized players to accumulate a large and potentially controllable total Ether pledge share through market forces. For example, centralized entities are already in a favorable position to quickly convert multi line business (including custody relationships) into pledge relationships and consolidate their position in the pledge field. It is already the largest validator on the internet, with a market share of 16%, and operates multiple acquisition channels, such as cbETH and CoinbaseEarn for retail clients, as well as CoinbaseCloud and CoinbasePrime for institutional clients.

Behind this influx of new capital, there is a potential dangerous challenge to the neutrality of Ethereum, or as described by the Ethereum Foundation as a "Layer0" attack on the "social layer". Even if full of goodwill, adding a pledge voting provider that only assumes "KYC/AML compliant" permission, even if this compliance is illusory and without legal or technical support, will only accelerate the adoption of pledge voting by centralized players who are firmly regulated and occupy market share.

Increasing the market share of centralized entities poses a risk to Ethereum's collateral layer. They fundamentally have a different set of obligations than decentralized agreements. Decentralized protocols exist as incentive layers for smart contracts, coordinating the purpose of activities among many participants.

For example, RocketPool's rETH has nearly 20000 holders, 9000 RPL holders, and over 22000 pledged deposit addresses, representing a unique node operator. Or a smart contract layer like Lido coordinates 39 globally distributed node operators, nearly 300000 stETH holders, and approximately 41000 LDO holders.

However, the company first has a fiduciary responsibility towards its shareholders and is obligated to be accountable to local legal authorities and regulatory agencies. Although Ethereum's decentralization may be somewhat related to the company's business (such as exchanges), it does not exceed these two obligations.

There is also a risk of other aspects of excessive regularization, namely a soft "Layer0" attack, even with goodwill intentions. If Ethereum is to become the world's settlement layer, it must have nuclear level censorship resistance and credible neutrality. If large enough, these centralized entities will hinder the core goals of Ethereum.

IV. The scale of institutional mobility may be considerable

Some people may overlook the arrival or impact of spot Ethereum ETFs due to a lack of institutional interest. However, there are some useful precedents in the commodity sector that can tell us the level of interest that exchange traded products (ETPs) bring to new asset classes. As financial instruments, ETFs and ETPs are very effective in providing standardized and democratic access for institutional and retail investors. When these tools enter distribution channels for institutional allocation, pension funds, or social security contributions, funds will flow heavily into the underlying asset classes.

The same benefits of spot BTCETF apply to spot Ethereum ETFs. For example, approximately 80% of US wealth is controlled by financial advisors and institutions, who can participate and are generally recognized by regulatory agencies and the government. We can expect this increased legitimacy and recognition to drive demand for Ethereum beyond ETF packaging. We have seen signs of institutional interest. Intermediaries such as Bitwise have heard that the potential allocation has increased from 1% to 5%. Brian Armstrong stated that in their Q3 financial report, Coinbase has doubled the number of institutional users to over 100.

It is difficult to guess the exact amount of net inflows from institutions. However, the GLDETF of gold attracted a net inflow of $3.1 billion in the first year alone. Buying any amount of gold before an ETF is much more difficult than buying BTC/ETH. You need to personally transport and store it, verify and verify its purity, and pay high transaction costs to traders. The gold ETF has improved its asset base characteristics and democratized its value proposition through massive fund allocation, targeting millions of individual investors.

Bitcoin and Ethereum are digital preferred assets that can transmit billions of dollars in just a few minutes. The entry barriers to physical gold do not exist here. Although ETFs may not necessarily improve the fundamental value proposition of Bitcoin or Ethereum - they may threaten them - they provide a similar level of democratization and access to both types of assets.

In fact, the vast majority of people around the world may never have any actual cryptocurrency, but they may have some financial exposure through pension allocation, private savings, or investments to some extent. The regulated financial channels in the developed world already have high permeability and capillarity. ETFs can help decipher asset classes, allowing individual investors who may have been on the sidelines to easily intervene within familiar frameworks such as banks or brokers.

V. What does all this mean for Ethereum's collateral layer?

Large scale, income insensitive inflows from institutions may drive the overall number of ETHs pledged higher than the probability target suggested by economic principles or based on encrypted endogenous variables. The vast majority of these inflows may accumulate disproportionately among centralized providers inside and outside ETF packaging. A larger concentration of pledges within a centralized entity will reduce Ethereum's censorship resistance and credible neutrality, without credible and successful adversarial capabilities.

VI. Lido as an effective balance

The focus of today's public dialogue largely revolves around Lido - whether they control too much collateral or not, and in the worst-case scenario, the attack pathways that this may introduce. The following is a quick overview of i) how much control Lido governance actually has over node operators, if any, and ii) how DAO handles governance risks, and iii) how DAO considers expanding the node operator (NO) portfolio and going to the center to test the set of validators.

• Governance risksHasu's GOOSE submission+dual governance proposal
• Expand NO portfolio: Pledge router+DVT module
• Go to the center and collect the laboratory equipmentJonCharbsPoG+Grandjean paper.

Please also refer to this excellent article by Mike Neuder of the Ethereum Foundation on the practical risks of Lido's dominance.

The criticism of Lido is largely based on a static perspective on the collateral market. It did not take into account how the pledge market developed and its actual reality. In order to fully evaluate the pledge market, it is necessary to consider future growth and market forces:

• Future growthInstitutional adoption may promote centralization of centralized entities
• market forces(Liquidity) Pledges have the characteristic of winning all.

Future growth

The only effective balance is to increase the market share of decentralized liquidity pledge agreements at the cost of centralized market share. Although multiple decentralization protocols are likely to obtain sufficient shares to form effective support, Lido is currently the only feasible option to maintain the robustness and decentralization of Ethereum's pledge layer:

• It is objectively successful in attracting new Ethereum holders, as Lido smart contracts have guided over 30% of all pledged ETHs, while stETH has almost 300000 holders
• It is objectively successful in limiting the growth of individual node operators, as they all use Lido as a successful channel to attract new Ethernet pledges, but cannot increase their individual market share within Lido, surpassing other node operators
• Its governance is currently objectively minimized, and with the advancement of measures such as dual governance, this degree will further decrease.

Fork selectionJon Charbonneau

Especially, LST governance can manage the additional subjective incentives required by decentralized operators (e.g. different modules may receive different rates) . A free market economy will not lead to independent pledgers or uniform distribution of pledges in the long term. The Ethereum core protocol is largely based on the idea that it should be objective and not express opinions where possible. However, in order to achieve a combination of decentralized operators, subjective management and incentives will be required.

Although minimizing governance is usually desirable, LST may always require some minimal form of governance. Some programs are required to match the requirements of collateral with the requirements of running validators. LST governance will always require the objective function of managing the portfolio of operators (such as the objectives of pledge distribution, weights of different modules, geographical objectives, etc.). This fine-tuning may not occur frequently, but this high-level goal setting is crucial for monitoring and maintaining the decentralization of the operator portfolio