Lido’s market dominance and Ethereum decentralization post-Merge

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After a successful third testnet merge, Sept. 19 was recently proposed as the tentative target date for the Ethereum Merge. Ethereum is set to fully transition from proof-of-work (PoW), the original consensus mechanism used by the Bitcoin network, to the more energy-efficient proof-of-stake (PoS) used by younger networks like Solana and Cardano.

“The Merge won’t solve Ethereum’s scaling concerns on its own. It is just the beginning of a road map to achieve future scaling upgrades,” Jacob Blish, head of business development at Lido, shared with Cointelegraph.

The staked Ether (ETH) on the Beacon Chain, the PoS network that mirrors Ethereum’s transactions, is expected to remain locked up for at least six months after the Merge is completed. After the Merge, staked ETH liquid tokens will start benefiting from transaction fees and maximal extractable value, meaning yields will go up.

There has been a lot of hype around the Merge. It is the single biggest event in crypto for a very long time, Rocket Pool founder Darren Langley told Cointelegraph, adding, “The lockup period is testing liquid staking protocols now but this is mainly due to macro conditions and the ongoing Centralized Finance (CeFi) drama. Once it blows over, liquid staking will explode.”

Currently, ETH staking yields are earning close to a 4% annual percentage rate (APR), with just over 10% of the ETH supply being staked, according to StakingRewards.

Lido’s liquid staking service

The launch of the Beacon Chain created a need in the ecosystem for a decentralized liquid staking solution that would compete against centralized exchanges (CEX) and could be used within decentralized finance (DeFi) for lending, borrowing and more. 

The staking service offered by Lido has gained popularity as the first protocol to implement a liquid staking derivative on Ethereum through the minting of the stETH token. Contrary to popular belief, stETH is not meant to be pegged to ETH. As Blish shared:

“Staked ETH issued by Lido is backed 1 to 1 ETH but the exchange rate isn’t pegged. It can fluctuate and trade at a premium or a discount as the secondary market forces dictate the price. This doesn’t affect the underlying backing of stETH.”

Lido’s first mover advantage to launch a liquid staking product has helped the protocol move ahead with more DeFi integrations for stETH as well as other multichain-staked products for Solana, Polygon, Polkadot and Kusama. The team recently announced that stETH will expand to layer-2 solutions to further their DeFi integrations.

Various staking protocol balances as of May 2022. Source: Twitter

The protocol attracted liquidity to the Curve pool with incentives in the form of additional rewards of the Lido token (LDO) and a referral program to further its growth strategy and consolidate itself as a temporary winner within the liquid staking space. 

When compared to other protocols in the DeFi ecosystem as a whole, Lido stands out as the only product that has been able to compete and even surpass its centralized counterparts, like the Binance ETH (BETH) token, in terms of total value locked.

Alternatives to liquid staking derivatives

New products tend to start out having strong market leaders, but soon competition develops and innovation ensures fresh entries that have the potential to take up market share. The network effect achieved by Lido in a short period has made it challenging for its competitors to catch up and seize a substantial share of the market. 

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Other liquid staking projects have small differences in fees, product decentralization and the token characteristics they offer, but the value proposition remains the same: to empower users to maximize their capital efficiency and compound their yield while securing the network.

“The Ethereum ecosystem is built on trustless decentralization. That much voting power in the hands of one organization is certainly counter to that ethos,” Jordan Tonani, head of institutions at Index Cooperative, told Cointelegraph, adding, “Having a healthy competition between multiple liquid staking protocols is a better outcome, and shortly after the Merge, a new crop of liquid staking protocols will be propped up to promote decentralization.”

Rocket Pool represents over 1.5% of all Ethereum staked, with 1,300 individual node operators across 84 geographic locations. Because of this, it could impact Lido’s market dominance and grow its relevance in the liquid staking space with new scaling solutions.

Stakehound, Stkr and Stakewise are some of the other projects trying to make a dent in Lido’s market share but still lag behind in terms of liquidity depth and utility as collateral in DeFi.

It is worth highlighting that Rocket Pool’s permissionless approach seems to appear more decentralized at first sight, contrary to Lido’s permissioned one, which was a trade off in order to ensure the reliability of node operators at the early stages of the protocol. The Lido team has been working on permissionless onboarding based on performance reputation to shift from their current model. 

Monopoly or oligopoly, it has to be decentralized

Considering the data, Lido currently has a monopoly on the immature liquid staking derivative market.

Lido, as a decentralized autonomous organization (DAO), opened the debate on its governance forum around stETH being limited to a fixed percentage of the whole ETH staked. Blish explained:

“We are aligned with Ethereum’s decentralization ethos at the core. Governing the protocol through a DAO ensures Lido will not pursue any actions that can enter into conflict with our community and values.”

Also, a dual token governance proposal was recently passed that allows holders of stETH to veto governance proposals by LDO token holders that can harm stakers on the Ethereum network. 

Similar to the liquid staking dilemma proposed above, Bitcoin (BTC) mining appears to show centralizing forces. The space has matured into a market where the three biggest mining pools have over 50% of the network’s hash rate. And, the top six mining pools account for more than 80% in the last three months, according to data from BTC.com.

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It is hard to predict the changes we will experience after the Merge and what implications it might have on liquid staking products. Even though liquid staking derivatives trend toward centralization, an optimistic middle-term evolution might come from other alternative products gaining ground and dividing the market into an oligopoly.

“Realistically, there will be many players in the ecosystem, but maintaining a strong level of decentralization is critical to Ethereum’s success — particularly its credible neutrality,” said Langley, “The key to decentralization is lowering barriers-to-entry, including lowering the collateral requirement and the technical challenges.”

Some volatility is expected in the following month as the hype around the Merge continues to build around liquid staking products. Demand for these products has never been stronger. Further developments will prove if the space will be run by one, a few, or many liquid staking derivative products.

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