Today's Recommendation | Future Evolution and Challenges of the Ethereum Pledge Market

This article focuses on the overlooked but important factors faced by the decentralization of Ethereum's pledge layer.In this article, I will explore the following topics:Ethereum ETF will follow the approval of Bitcoin ETFEther ETFs with rewards are a natural extension of unsecured Ether ETFsInstitutional pledges will shift towards liquidity alternatives, bringing new challenges to Ethereum's decentralizationThe scale of institutional mobility may be considerableWhat does it mean?Lido as an effective balanceBefore we begin, we would like to thank SteakhouseFinancial's adcv for their feedback and insights

This article focuses on the overlooked but important factors faced by the decentralization of Ethereum's pledge layer.

In this article, I will explore the following topics:

• Ethereum ETF will follow the approval of Bitcoin ETF
• Ether ETFs with rewards are a natural extension of unsecured Ether ETFs
• Institutional pledges will shift towards liquidity alternatives, bringing new challenges to Ethereum's decentralization
• The scale of institutional mobility may be considerable
• What does it mean?
• Lido as an effective balance

Before we begin, we would like to thank SteakhouseFinancial's adcv for their feedback and insights.

The confirmation of spot Bitcoin ETFs seems almost certain.

Naturally, people turn their attention to potential Ethereum ETF stocks. The confidence in the approval of spot Bitcoin ETFs stems from a clear inconsistency in the SEC's approval of futures based products but refusal to approve spot based products. Blackrock's application for an Ethereum spot ETF on November 9th further intensified this concern.

Considering the existence of Zhishang's Taifang futures market and multiple futures based Ethereum ETFs, the approval logic seems quite portable. Even the regulatory methods and handling of Ethereum in the United States are based on a non secure foundation. Due to various reasons, Gensler or future regulatory agencies are unlikely to abandon their previous processing methods (see thread with image).

In fact, the US Securities and Exchange Commission's recent legislation on Coinbase listed securities excludes Ethereum.

Read the entire thread

Before the approval of the spot Ethereum ETF, issuers will compete to find an implementation plan that enables them to receive Ethereum pledge rewards. Rewarded ETHs are definitely better than unrewarded ETHs, and may attract new investors who have been on the sidelines so far.

Gwat

The issuer will compete for the first to enter the market and provide collateral rewards. Initially, considering knowledge barriers, business model challenges of node operations, and increased regulatory risks, it seemed unreasonable for issuers to run their own validators.

In order to enter the market first, issuers must propose solutions that are suitable for the existing regulatory framework and can be approved as soon as possible. Therefore, the path with the least resistance is for ETF issuers to sign contract agreements, including loan agreements, with third-party centralized pledge providers who charge a small fee.

This is already the solution for 21Share pledging Ethernet ETFAETH. 21shares hosts their ETH through CoinbaseCustomer and may lend the underlying ETH to CoinbaseCloud, Blockdameon, and Segment.

Typical Fund Structure Explanation

AETH has attracted $240.77 million in AUM, 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.

Institutional pledges will shift towards liquidity alternatives, bringing new challenges to Ethereum's decentralization

Smart institutions may consider pledging with providers outside of ETF packaging, who have a more favorable cost structure and greater utility. Decentralized protocols like Lido can already serve as assets for existing institutional clients in various custody, quality control, and regulatory environments. As decentralized protocols, they provide a unified experience and institutional level security, but are open to all market participants with any number of ETHs.

On the other hand, the new trend of the project is specifically targeting institutional needs. Especially, companies like LiquidCollect are building a liquidity pledge solution that takes into account institutional compliance needs when designing. Institutions can cast lsETH, which is mortgaged by one of three centralized providers (Coinbase, Segment, and Stacked) who are also responsible for managing the project. The idea here has two aspects:

• Liquidity pledge is a better product than ordinary pledge; You retain the currency attributes of ETH and most of the rewards.
• Institutions must pledge with providers that meet KYC/AML requirements, otherwise they may bear civil and criminal liability.

The first point is very obvious.

Liquid Pledged Tokens (LSTs) can be used as collateral for the entire DeFi, as a base asset in the liquidity pool, and to avoid withdrawal queue times.

In addition, institutional products such as ETFs benefit from liquidity in order to manage fund redemptions within one day. For non liquid funds, they are usually managed through the custody of a portion of ETH. This faces a greater risk of withdrawal surges, which will basically lead to bank runs, while the remaining ETHs will be pledged and will drag down the reward rate during normal operations.

Obtaining liquid tokens will make it possible to manage redemptions more smoothly and increase the proportion of funds that can be pledged at any given time. In order for this possibility to become a reality, liquid tokens must clearly have liquidity. If the token does not have sufficient liquidity available, providing only tokens is not enough. Currently, the only liquid token with meaningful on chain and off chain liquidity available for institutional use is Lido's stETH.

The second point is not very clear. Regulated institutions typically face many obligations to minimize the risk or likelihood of money laundering or facilitating criminal activities. To this end, there is a KYC/AML obligation to maintain auditable tracking of financial flows between institutions and their clients. In addition, there may be higher requirements for so-called 'qualified custodians'. That is to say, qualified custodians and institutions should generally be able to fulfill their KYC/AML obligations without affecting the choice of asset, LST token, or pledge providers.

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

The concentration of equity in centralized entities has brought many urgent challenges to the development of Ethereum blockchain. In summary, blockchain may suffer a series of disruptions, and the likelihood of such disruptions is increasing in different levels of stack market share:

• Prevent Restructuring Attacks
• Final deterministic delay
• Fork selection
• Thorough coercion

The first two types of attacks disrupt the normal functionality of blockchain, and Ethereum has built-in incentives to prevent attackers from attempting these attacks, such as gradually diluting rewards and mortgaging balances for 'attackers'. However, when the market share of a single node operator reaches 33% or higher, the participant may begin to delay the final result, even if the cost of disrupting network operations becomes high. In high market share scenarios, such as 50%, attackers can effectively fork the blockchain and choose the fork they "indulge" in. In 67% or higher cases, blockchain is actually a fully controlled delegated database.

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

The proof of equity mechanism on Ethereum allows centralized participants to accumulate a large amount of market share and potentially control the total pledge of Ethereum solely through market forces. That is to say, centralized entities are already in a favorable position to occupy the institutional market.

For example, Coinbase, which has multiple business lines (including custody relationships), can quickly convert these businesses into pledge relationships and consolidate its position in the pledge field. It is already the largest single validator on the network, with a market share of 16%, and operates multiple acquisition channels, such as cbETH and CoinbaseEarn for retail customers, as well as CoinbaseCloud and CoinbasePrime for institutional customers.

The new influx of capital poses a potential dangerous challenge to the neutrality of Ethereum, or is described by the Ethereum Foundation as a layer 0 attack on the "social layer" through excessive regulation. Adding an artificial structure where only so-called "KYC/AML compliant" pledge providers are "allowed", even if this compliance is illusory and has no legal or technical factual basis, will only accelerate the adoption of pledges by centralized participants, hoping to expand new market share through regulatory consolidation and capture.

Expanding market share through centralized entities poses a risk to Ethereum's collateral layer. Compared to decentralized agreements, they fundamentally have different obligations. Decentralized protocols exist as incentive layers for smart contracts to coordinate activities among many participants.

For example, RocketPool's rETH has nearly 20000 holders, 9000 RPL holders, and over 2200 pledged deposit addresses representing unique node operators. Or Lido, a smart contract layer that coordinates over 39 global 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 are other areas where excessive regulation can be used, which is a soft layer 0 attack that, even with good intentions, can compromise the neutrality of Ethereum. 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 suppress the core goals of Ethereum.

The scale of institutional mobility may be considerable

Due to a lack of institutional interest, some people may underestimate the arrival or impact of spot Ethereum ETFs. However, there are some useful precedents in the commodity sector that can illustrate the level of interest that exchange traded products (ETPs) have brought to new asset classes. As a financial tool, ETFs and ETPs are very effective in standardizing and democratizing the access of institutions and retail investors. When such tools enter the distribution channels of institutional allocation, pension funds, or social security contributions, the inflow of funds will significantly accelerate into the basic asset category.

The same advantages of spot BTCETF also apply to spot ETHETF. For example, about 80% of American wealth controlled by financial advisors and institutions can participate and gain the universal legitimacy stamp of regulatory agencies and the government. We can expect that the increase in legitimacy and recognition will drive further demand for Ethereum beyond ETF packaging. We have seen signs of increasing institutional interest. Intermediaries such as Bitwise have heard that the potential allocation ratio will increase from 1% to 5%. Brian Armstrong stated that Coinbase doubled the number of institutions it added to its third quarter earnings report, reaching over 100.

It is difficult to guess the exact amount of capital inflows from institutions. However, gold's GLDETF had a net flow of $3.1 billion in its first year alone. Buying any amount of gold before an ETF is much more difficult than buying BTC/ETH. You need to physically transport and store it, verify and identify its purity, and incur high transaction costs for distributors. The gold ETF represents an improvement in the fundamental attributes of the asset and democratizes its value proposition to millions of individual investors through massive fund allocation.

Bitcoin and Ethereum are digital priority assets that can transmit billions of dollars in just a few minutes. The entry barrier for physical gold may not necessarily exist here. Although ETFs may not necessarily improve the fundamental value proposition of Bitcoin or Ethereum - they may hinder them - they provide a similar degree of democratization and access to these two asset classes.

The reality is that the vast majority of people on Earth may never own any physical cryptocurrency themselves, but rather satisfy a certain degree of financial risk through pension distribution or private savings or investments. The regulated financial channels in developed countries already have high permeability and capillary effect. ETFs can help individuals uncover the mysteries of asset classes, otherwise they may be on the sidelines and can easily introduce new risk exposures within a framework that individual investors are already familiar with, such as banks or brokerage firms.

So what does this mean for Ethereum's collateral layer?

A large influx of funds from institutions that are not sensitive to returns may result in the total amount of collateral ETH being higher than the level implied by economic principles, or higher than the probability target based on cryptocurrency endogenous variables. Most of these traffic may flow disproportionately to centralized providers inside and outside the ETF wrapper. Without credible and successful checks and balances, equity will be more concentrated in centralized entities, which will reduce Ethereum's censorship resistance and credibility neutrality.

Lido as an effective balance

Most of today's public discussion revolves around Lido - whether they control too many shares, and the attack vectors that may be introduced in the worst-case scenario. This is an important and valuable conversation. At the risk of repetitive and lengthy debates, here are some quick resources that outline i) how much control Lido governance actually has over node operators (if any), ii) how DAO responds to governance risks, and iii) how DAO considers expanding governance risks. Node operator (NO) set and decentralized entire validator set.

• Governance risk: Hasu's GOOSE submission+dual governance proposal
• Extended NO set: stack router+DVT module
• Decentralized validator set: JonCharbsPoG+Grandjean paper

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

Most of the criticism of Lido is based on a static view of the stack market. It did not take into account the growth mode of the pledge market and its actual situation. In order to fully evaluate the pledge market, it is necessary to consider future growth and market forces:

• Future growth: Institutional adoption may drive the concentration of centralized entities
• Market Power: (Liquidity) Pledge has a strong winner take all dynamic

Most of the content of this article provides an overview of future growth as it is an important aspect that has not yet been fully discussed. In our digital public domain, the driving force of winner take all has been extensively debated, but often lacks a background for future growth. Rational market incentives, including those to maintain a decentralized Ethereum network, may not prevent institutions from taking the path of least resistance and introducing new capital into Ethereum.

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 objectively successfully attracted new Ethereum from its holders, as Lido smart contracts have transferred over 30% of all pledged ETHs, while stETH has nearly 300000 holders
• It has objectively successfully limited the growth of individual node operators, as they each use Lido as a successful acquisition channel for new Ethereum shares, but cannot increase their personal market share within Lido more than other node operators
• At present, its governance is objectively minimized and further minimized through measures such as dual governance

Fork selection (Jon Charbonneau)

In particular, LST governance can manage the additional subjective incentives required by decentralized operators (for example, different modules may charge different rates).In the long run, a free market economy will not lead to a long tail or uniform distribution of rights for individual equity holders.The Ethereum core protocol is largely based on the idea that wherever possible, it should be objective and unbiased. However, subjective management and incentives are needed to achieve a decentralized set of operators.

Although minimizing governance is usually desirable, LST may always require some form of minimal governance. Some processes are needed to match the pledge requirements and the requirements for running validators. LST governance is always needed to manage the objective functions of the set of node operators (such as equity allocation objectives, different module weights, geographical objectives, etc.). This fine-tuning may be rare, but this high-level goal setting is crucial for decentralized monitoring and maintenance of the operator set