Today, our research team published a study on ethresear.ch, delving into the impact of latency (time) on MEV extraction. More specifically, we demonstrate the costs associated with introducing artificial latency within a PBS (Proposer-Builder Separation) framework. Additionally, we present findings from Adagio, an empirical study that explores the implications of latency optimization aimed at maximizing MEV capture.
In late August 2023, we launched Adagio, a latency-optimized setup on the Ethereum mainnet. The primary objective was to collect actionable data ethically, with minimal disruptions to the network. Until this point, Adagio has not been a client-facing product, but an internal research initiative running on approximately 100 self-funded validators. We initially shared ongoing results of the Adagio pilot in our Q3 Quarterly Insights report in October.
In alignment with our commitment to operational honesty and rational competition, this study discloses the full results of Adagio, alongside an extensive discussion of node operator incentives and potential adverse knock-on effects on the Ethereum network. As pioneers in MEV research, our primary objective is to address and mitigate existing competitive dynamics by offering a detailed analysis backed by proprietary data from our study, which will be explored further in the subsequent sections of this article.
This article offers a top-level summary of our study, contextualizing it within the ongoing Ethereum community dialogue on ethically optimizing MEV performance. We dive into the key findings of the study, highlighting significant observations and results. Central to our discussion is the exploration of the outcomes tied to the implementation of the Adagio setup, which demonstrates an overarching boost in MEV capture.
Ultimately, we recognise that node operators are compelled and incentivised to employ latency optimization as a matter of strategic necessity. As more operators take advantage of this inefficiency, they set a higher standard for returns, making it easier for investors to choose setups that use latency optimization.
This creates a cycle where the use of latency optimization becomes a standard practice, putting pressure on operators who are hesitant to join in. In the end, the competitive advantage of a node operator is determined by their willingness to exploit this systematic inefficiency in the system.
Additionally, we demonstrate that the parameters set by our Adagio setup corresponds to an Annual Percentage Rate (APR) that is 1.58% higher than the vanilla (standard) case, with a range from 1.30% to 3.09%. Insights into these parameters are provided below, with additional clarity available in the original post.
Let’s preface this section with the phrase - Right Place at the Right Time.
Delightfully analogous to the quote above, we’re adding further insights to the overarching discourse on the implication of latency optimization (i.e, a strategy where block proposers intentionally delay the publication of their block for as long as possible to maximize MEV capture) when it has become a burning topic within the Ethereum community, drawing increased attention from various stakeholders concerned about its network implications.
Yet, despite its growing significance, there has been a noticeable lack of empirical research on this subject. As pioneers in MEV research, we've been investigating this concept for over a year, incorporating latency optimization as one of our MEV strategies from the outset. Now, we're proud to contribute to the ongoing discussions and scrutinize the most significant claims with robust, evidence-based research.
In a previous article about Chorus One’s approach to MEV, we emphasized the importance of exploring the dynamics between builders, relays, and validators with the dimension of time.
Our focus on how latency optimization can profoundly influence MEV performance remains unchanged. However, we've identified a crucial gap in empirical data supporting this concept. Compounding this issue, various actors have advocated for methods to increase MEV extraction without rigorous analysis, resulting in inflated values based on biased assumptions. Recognizing the serious consequences this scenario poses in terms of centralization pressure, we now find it imperative to conduct a deep dive into this complex scenario.
Our strategy involves implementing a setup tailored to collect actionable data through self-funded validators in an ethical manner, ensuring minimal disruptions to the network. This initiative is geared toward addressing the existing gap in empirical research and offering a more nuanced understanding of the implications of latency optimization in the MEV domain.
The key objectives of this research is three-fold, including:
In the following section, we will present a comprehensive overview of the three most pivotal and relevant observations from the study, and as promised earlier, we will also delve into the results of Adagio.
Context: First, we delve into PBS inefficiencies and MEV returns.
Here, we explore the inefficiencies in the Proposer-Builder Separation (PBS) framework, showing how timing in auctions can be strategically exploited to generate consistent, excess MEV returns.
Additionally, we demonstrate how all client-facing node operators are incentivized to compete for latency-optimized MEV capture, irrespective of their voting power.
Key Finding: Latency optimization is beneficial for all client-facing node operators, irrespective of their size or voting power.
Using an empirical framework to estimate the potential yearly excess returns for validators who optimize for latency considering factors like the frequency of MEV opportunities, network conditions, and different latency strategies, our results indicate that node operators with different voting powers have varying levels of predictability in their MEV increases.
The above figure demonstrates that higher voting power tends to result in more predictable returns, while lower voting power introduces more variance. The median weekly MEV reward increase is around 5.47% for a node operator with 13% voting power and 5.11% for a node operator with 1% voting power.
The implication here is that big and small node operators cater to different utilities of their clients (delegators) because they operate at different levels of risk and reward. As a result, optimizing for latency is beneficial for both small and large node operators. In simpler terms, regardless of their size, node operators could consider optimizing latency to better serve their clients and enhance their overall performance.
As we look at a longer timeframe, the variability in rewards for any voting power profile is expected to decrease due to statistical principles. This means that rewards are likely to cluster around the 5% mark, regardless of the size of the node operator.
In practical terms, if execution layer rewards make up 30% of the total rewards, adopting a latency-aware strategy can boost the Annual Percentage Rate (APR) from 4.2% to 4.27%. This represents a noteworthy 1.67% increase in overall APR. Therefore, this presents a significant opportunity, encouraging node operators to adopt strategies that consider and optimize for latency.
Context: Second, we discuss the costs of introducing artificial delays, explaining how it increases MEV rewards but at the expense of subsequent proposers.
Key Finding: MEV tends to benefit node operators with higher voting power, giving them more stable returns. When these operators engage in strategic latency tactics, it can increase centralization risks and potentially raise gas cost and faster burnt ETH for the next proposer..
While sophisticated validators benefit from optimized MEV capture with artificial latency, the broader impact results in increased gas costs and a faster burning of ETH for the next proposers. The Ethereum network aims to maximize decentralization by encouraging hobbyists to run validators, but the outlined risks disproportionately affect solo validators. Below, we demonstrate that these downside risks are significant in scale, and disproportionately impact solo validators.
Figure 2 illustrates that introducing artificial latency increases the percentage of ETH burned, potentially reducing final rewards. Even a small increase in burnt ETH can significantly decrease rewards, especially for smaller node operators who are chosen less frequently to propose blocks. The negative impact is most significant for solo validators, making them less competitive on overall APR and subject to greater income variability. Large node operators playing timing games benefit from comparatively higher APR at lower variance to the detriment of other operators.
MEV tends to benefit node operators with higher voting power, giving them more stable returns. When these operators engage in strategic latency tactics, it can increase centralization risks and potentially raise gas fees for the entire Ethereum network. Moreover, larger node operators, due to their size, have access to more data, giving them an edge in testing strategies and optimizing latency.
In this scenario, node operators find it necessary to optimize for latency to stay competitive. As more operators adopt these strategies, it becomes a standard practice, creating a cycle where those hesitant to participate face increasing pressure. This results in an environment where a node operator's success is tied to its willingness to exploit systematic inefficiencies in the process.
Context: In late August 2023, Chorus One launched a latency-optimized setup — internally dubbed Adagio — on Ethereum mainnet.
Its goal was to gather actionable data in a sane manner, minimizing any potential disruptions to the network. Until this point, Adagio has not been a client-facing product, but an internal research initiative running on approximately 100 self-funded validators. We are committed to both operational honesty and rational competition, and therefore disclose our findings via this study.
In simple terms, this section analyzes the outcomes of our Adagio pilot, focusing on how different relay configurations affect the timing of bid selection and eligibility in the MEV-Boost auction.
Our pilot comprises four distinct setups, each representing a variable (i.e. a relay) in our experiment:The Benchmark Setup, The Aggressive Setup, The Normal Setup, and the Moderate Setup.
Key Findings: The results of this pilot indicate that the timing strategies opted by node operators used within relay operations have a significant impact on how competitive they are.
The aggressive setup, in particular, allows non-optimistic relays to perform similarly to optimistic ones. This means that certain relays can only effectively compete if they introduce an artificial delay.
In extreme cases, a relay might not be competitive on its own, but because it captures exclusive order flow, node operators might intentionally introduce an artificial delay when querying it or might choose not to use it at all. Essentially, these timing strategies play a crucial role in determining how relays can effectively participate and compete in the overall system.
These results offer valuable insights into how strategically introducing latency within the relay infrastructure can impact the overall effectiveness and competition in the MEV-Boost auction. The goal is to level the playing field among different relays by customizing their latency parameters.
The above graph displays the eligibility time of winning bids in the Adagio pilot compared to the broader network distribution. As expected, Adagio selects bids that become eligible later with respect to the network distribution. Notably, our setup always selects bids eligible before 1s, reducing the risks of missed slots and increased number of forks for the network.
Finally, it’s worth mentioning that our results indicate that certain setups are more favorable to winning bids. This opens up the possibility for relays adopting latency optimization to impact their submission rate.
Bringing together the data on latency optimization payoff and the results of our Adagio pilot allows us to quantify the expected annual increase of validator-side MEV returns.
The simulation results presented in Fig. 4 show that, on average, there is a 4.75% increase in MEV extracted per block, with a range from 3.92% to 9.27%. This corresponds to an Annual Percentage Rate (APR) that is 1.58% higher than the vanilla (standard) case, with a range from 1.30% to 3.09%.
The increased variability in the range is mainly due to the limited voting power in the pilot, but some of it is also caused by fluctuations in bid eligibility times. The observed median value is 5% lower than the theoretically projected value. To address this difference, the approach will be updated to minimize variance in bid selections and keep eligibility times below the 950ms threshold.
Let’s take a moment to consolidate the key takeaways derived from our study and the Adagio setup.
Since inception, Chorus One has recognised the importance of MEV and spearheaded the exploration of the concept within the industry. From establishing robust MEV policies and strategies, receiving a grant from dYdX for investigating MEV in the context of the dYdX Chain to conducting empirical studies that investigate the practical implications of factors influencing MEV returns, we've consistently taken a pioneering role. Our dedication revolves around enhancing the general understanding of MEV through rational, honest, and practical methods.
For comprehensive details about our MEV policies, work, and achievements, please visit our MEV page.
If you’d like to learn more, have questions, or would like to get in touch with our research team, please reach out to us at research@chorus.one.
If you want to learn more about our staking services, or would like to get started, please reach out at staking@chorus.one
About Chorus One
Chorus One is one of the biggest institutional staking providers globally operating infrastructure for 45+ Proof-of-Stake networks including Ethereum, Cosmos, Solana, Avalanche, and Near amongst others. Since 2018, we have been at the forefront of the PoS industry and now offer easy enterprise-grade staking solutions, industry-leading research, and also invest in some of the most cutting-edge protocols through Chorus Ventures.
For Chorus One, 2023 was the year of OPUS, our novel multi-chain staking solution.
Following months of dedicated development aimed at simplifying staking for investors, we proudly unveiled our flagship product, OPUS, at the wake of this year.
As the year unfolded, our commitment to perfecting OPUS remained steadfast. We fine-tuned various details, actively sought and incorporated customer feedback, and focused on continuous improvement to ensure that staking is as seamless and stress-free as possible. Below, we share the major highlights from OPUS's journey in 2023.
Dive in!
OPUS is the simplest staking solution for investors and institutions.
Resources:
All you need to know about OPUS: https://docsend.com/view/rye2auvy87hcx8vy
Start staking on OPUS: https://opus.chorus.one/portal/login
Learn more: https://chorus.one/staking-api-opus
When it comes to staking ETH, a recurring challenge arises - the requirement to sign multiple transitions for substantial deposits. This complexity has been especially a persistent hurdle in the path of institutional stakers. To combat this, we’ve devised a solution that streamlines institutional staking: the ability to seamlessly stake 8000ETH , or 250 validators in a SINGLE transaction.
Full details: https://chorus.one/articles/stake-8000eth-in-one-go-with-chorus-one
We launched our liquid staking pool on Stakewise V3, enabling individuals to stake any amount of ETH and benefit from Chorus One’s enterprise-grade staking infrastructure and industry-leading MEV yields!
Additionally, staking on Chorus One’s pool enables users to unstake at any time, or utilize their staked ETH capital throughout DeFi.
You can start staking on our vault here.
To learn more, check out the following resources:
4. We launched the first-ever ‘Bridge & Stake’ solution for DYDX
In tandem with our support for dYdX Chain, we also launched the first ‘Bridge and Stake’ solution for DYDX - enabling users to bridge and stake their tokens from Ethereum to Cosmos in one, single, seamless move.
Full details: https://chorus.one/articles/how-to-bridge-your-dydx-tokens-from-ethereum-to-cosmos
Bridge and Stake your DYDX here: https://opus.chorus.one/portal/dydx
Next, we review the substantial product updates implemented in 2023, driven by customer requests and feedback.
The OPUS dashboard makes it incredibly easy for you to access comprehensive details about your staking rewards, including separate reports that highlight your Execution level, Consensus level, and MEV rewards individually.
In fact, Chorus One stands out as the only node operator equipped with an in-house quant team exclusively focusing on MEV and exploring the intricacies of MEV extraction through evidence-based research. We consistently fine-tune our infrastructure, ensuring seamless integration with the Ethereum MEV pipeline.
Resources:
A sneak peek at validator side MEV optimization
MEV Matters: Decoding Chorus One’s winning MEV strategy
Hedging LP positions by staking
Exploring MEV implications and Cross-Domain dynamics on dYdX v4
Visit our MEV page to learn more: https://chorus.one/mev-maximum-extractable-value
As a user, you can get a comprehensive 360-degree perspective of your ETH stake position on the OPUS dashboard. Instantaneously view your total stake, all-time rewards earned, and validator performance within seconds.
OPUS offers customers a seamless, non-custodial experience for staking, earning rewards, rewards reporting, and unstaking. Our most recent product update from November makes the process of unstaking ETH as smooth as possible.
The OPUS dashboard gives you the freedom to personalize your withdrawal address with the wallet you prefer. Unlike conventional staking platforms, where your connected wallet automatically serves as your withdrawal address, OPUS allows you to set your own preferred withdrawal address.
The OPUS dashboard provides step-by-step guidance throughout the staking process, making it easier for you as the user to grasp and navigate the entire staking journey.
By 2024, OPUS customers will receive periodic automated rewards that will be adjusted for fees on-chain. Say goodbye to manual invoicing!
If you’d like to learn more about OPUS, speak with our team, or start staking with us, please reach out at staking@chorus.one. We look forward to hearing from you.
About Chorus One
Chorus One is one of the biggest institutional staking providers globally operating infrastructure for 45+ Proof-of-Stake networks including Ethereum, Cosmos, Solana, Avalanche, and Near amongst others. Since 2018, we have been at the forefront of the PoS industry and now offer easy enterprise-grade staking solutions, industry-leading research, and also invest in some of the most cutting-edge protocols through Chorus Ventures.
As another eventful year comes to a close, we're thrilled to present Reflections - a series that rounds up Chorus One's activities in 2023.
The first edition of Reflections takes a look at some of the major company headlines we released throughout the year. Dive in!
Ensuring the security of our customers' assets and information has always been our foremost priority at Chorus One.
In October, we proudly announced a significant milestone in our ongoing commitment to establishing world-class security measures for our customers: the attainment of the ISO 27001:2022 certification - one of the very few node operators in the industry to do so.
Full details: https://chorus.one/articles/chorus-one-achieves-iso-27001-2022-certification-setting-a-major-security-milestone
Visit Chorus One’s security page: https://security.chorus.one/
We launched Red Horizon, a platform designed to streamline developers’ interaction with the Urbit server.
Learn more: https://chorus.one/articles/announcing-red-horizon
Visit the Red Horizon website: https://redhorizon.com
As an industry leader in MEV research, we shared our approach to MEV this year. In the article, also featured by Flashbots’ in their July newsletter edition, we delve into the MEV extraction process, highlight key players, and offer insights into our MEV strategy.
Check it out here: https://chorus.one/articles/mev-matters-decoding-chorus-ones-winning-mev-strategy
We announced our partnership with Ledger, the global security platform for digital assets and NFTs.
Ledger extended its compatibility with the Cosmos ecosystem in May, and Chorus One is currently supporting this integration by providing our validator services, enabling over a million Ledger Live users to leverage the bolstering Cosmos ecosystem and stake numerous tokens, including Onomy (NOM), Quicksilver (QCK), Persistence (XPRT), Injective (INJ) and more through nodes operated by Chorus One.
Learn more: https://chorus.one/articles/ledger-by-chorus-one-securely-stake-your-tokens-via-the-ledger-live-app
Following our mutually co-hosted breakfast side event at Token2049 Singapore, we were pleased to announce a significant milestone in our collaboration with BitGo, a prominent regulated custody, financial services, and core infrastructure provider.
BitGo partnered with Chorus One to expand staking for a diverse range of networks, including Sui, Sei, Injective, Osmosis, and Agoric. This collaboration underscores our longstanding relationship, spanning over a year, and solidifies our position as a preferred staking provider for institutions seeking security, compliance, and cutting-edge research.
Full details: https://chorus.one/articles/chorus-one-partners-with-bitgo-to-expand-staking-for-leading-networks
We announced our partnership with Fordefi, a leading MPC wallet platform and web3 gateway that enables institutions to seamlessly connect to dApps across networks, while securing their digital assets. This partnership currently facilitates Chorus One’s OPUS customers to stake and unstake multiple tokens using the Fordefi wallet inside the OPUS dashboard.
Learn more: https://chorus.one/articles/fordefi-x-chorus-one-direct-staking-for-opus-customers-via-wallet-integration
We announced that Qredo, a premier self-custody protocol and platform, joined forces with Chorus One to expand staking accessibility for investors. From seamless staking to enhanced security measures, this partnership empowers users with a secure and efficient staking experience.
As part of the partnership, Chorus One's OPUS users can directly stake and unstake multiple tokens through Qredo Wallets. This eliminates the complexities associated with managing multiple wallets and platforms, making staking more accessible to a broader range of investors.
Full details: https://chorus.one/articles/qredo-x-chorus-one-providing-enhanced-staking-accessibility
In the interest of safeguarding investors from potential staking penalties, this year we partnered with Nexus Mutual, the leading decentralized coverage provider, to introduce a range of staking coverage options for our customers.
We were the first node operator to purchase on-chain staking coverage to protect our customers through Nexus Mutual’s innovative tokenised cover.
Full details: https://chorus.one/articles/chorus-one-partners-with-nexus-mutual-to-roll-out-industry-wide-on-chain-staking-coverage-2
We provide a glimpse into the results of our first pilot on the Ethereum mainnet, which combines several modifications that positively impact MEV extraction. This piece was also featured by Flashbots' in their November newsletter!
Read it here: https://chorus.one/articles/a-sneak-peek-at-validator-side-mev-optimization
Our research team published a pioneering research report, fueled by a grant from dYdX, that examines the implications of Maximum Extractable Value (MEV) within the context of dYdX v4 from a validator's perspective.
This comprehensive analysis presents the first-ever exploration of mitigating negative MEV externalities in a fully decentralized, validator-driven order book. Additionally, it delves into the uncharted territory of cross-domain arbitrage involving a fully decentralized in-validator order book and other venues.
This paper, marking a significant milestone in exploring MEV dynamics, identifies factors that influence undesirable MEV extraction, and proposes concrete strategies to level the playing field in derivative trading by counteracting such behavior.
Read the report: https://chorus.one/reports-research/mev-on-the-dydx-v4-chain
Report TL;DR: https://chorus.one/articles/exploring-mev-implications-and-cross-domain-dynamics-on-dydx-v4
In January, we released ‘Eth-staking-smith’, an optimized, open-source Ethereum validator key-gen tool to facilitate key and deposit data generation.
The tool, an industry-first, streamlines the often complex Ethereum validator key management process, especially when dealing with it on a large scale.
Learn more: https://chorus.one/articles/a-deep-dive-into-eth-staking-smith
We published a whitepaper comparing key characteristics of Ethereum and Solana, which explores the block-building marketplace model, akin to the "flashbots-like model," and examines the challenges of adapting it to Solana.
Additionally, recognizing Solana's unique features, we also proposed an alternative to the block-building marketplace: the solana-mev client. This model enables decentralized extraction by validators through a modified Solana validator client, capable of handling MEV opportunities directly in the banking stage of the validator. Complementing the whitepaper, we also shared an open-source prototype implementation of this approach.
Learn More: https://chorus.one/articles/solana-mev-client-an-alternative-way-to-capture-mev-on-solana
OPUS is the simplest staking solution for investors and institutions.
Resources:
A guide to OPUS: https://chorus.one/articles/opus-api-what-is-it-and-why-did-we-build-it
All you need to know about OPUS: https://docsend.com/view/rye2auvy87hcx8vy
Start staking on OPUS: https://opus.chorus.one/portal/login
We’re thrilled to have launched our liquid staking pool on Stakewise v3, enabling individuals to stake any amount of ETH and benefit from Chorus One’s enterprise-grade staking infrastructure and industry-leading MEV yields!
Additionally, staking on Chorus One’s pool enables users to unstake at any time, or utilize their staked ETH capital throughout DeFi.
You can start staking on our vault here.
To learn more, check out the following resources:
In September of this year, we made it possible for OPUS users to stake up to 8000ETH in one, single transaction, eliminating the cumbersome process of signing multiple transitions for substantial deposits.
Learn more: https://chorus.one/articles/stake-8000eth-in-one-go-with-chorus-one
Stake on OPUS: https://opus.chorus.one/portal/login
In tandem with our support for dYdX Chain, we also launched the first ‘Bridge and Stake’ solution for DYDX - enabling users to bridge and stake their tokens from Ethereum to Cosmos in one, single, seamless move.
Full details: https://chorus.one/articles/how-to-bridge-your-dydx-tokens-from-ethereum-to-cosmos
Bridge and Stake your DYDX here: https://opus.chorus.one/portal/dydx
We announced staking support for Gnosis Chain (GNO), Onomy (NOM), Mars (MARS), and Kyve Network (KYVE) in the first quarter of 2023. Learn more and find out how you can stake GNO, MARS, or KYVE with Chorus One:
Gnosis Chain: https://chorus.one/crypto-staking-networks/gnosis
Onomy: https://chorus.one/crypto-staking-networks/onomy
Mars: https://chorus.one/crypto-staking-networks/mars
Kyve: https://chorus.one/crypto-staking-networks/kyve
We announced staking support for Aptos (APT), and Sui (SUI) in the second quarter of 2023. Learn more and find out how you can stake each network with Chorus One:
Aptos: https://chorus.one/crypto-staking-networks/aptos-2
Sui: https://chorus.one/crypto-staking-networks/sui-2
We announced staking support for Archway (ARCH), Sei Network (SEI) in the third quarter of 2023. Learn more and find out how you can stake each network with Chorus One:
Archway: https://chorus.one/crypto-staking-networks/archway
Sei: https://chorus.one/crypto-staking-networks/sei
We announced staking support for dYdX Chain (DYDX), Celestia (TIA), and Chainflip (FLIP) in the fourth quarter of 2023. Learn more and find out how you can stake each network with Chorus One:
dYdX Chain: https://chorus.one/articles/chorus-one-announces-staking-support-for-dydx-v4-as-a-genesis-validator
Celestia: https://chorus.one/articles/how-to-stake-tia-celestia
Next Up: Keep your eyes peeled for Edition #2 of our Reflections series, coming soon!
About Chorus One
Chorus One is one of the biggest institutional staking providers globally operating infrastructure for 45+ Proof-of-Stake networks including Ethereum, Cosmos, Solana, Avalanche, and Near amongst others. Since 2018, we have been at the forefront of the PoS industry and now offer easy enterprise-grade staking solutions, industry-leading research, and also invest in some of the most cutting-edge protocols through Chorus Ventures.
People like to say that those who cannot remember the past are condemned to repeat it. However, sometimes forgetting the past is a deliberate choice: an invitation to build on completely new grounds, a bet that enables a different future.
All bets have consequences. Specifically in crypto, many of t hese consequences are so material t hat t hey become hard to comprehend: hundred-million dollar exploit after exploit, billions vanishing in thin air... In its relatively short history, Ethereum has made many bets when deciding what the optimal protocol looks like. One such gamble was the decision to not enshrine native delegation into their Proof-of-Stake protocol layer.
Before the Merge, the standard PoS implementation was some sort of DPoS (Delegated Proof-of-Stake). The likes of Solana and Cosmos had already cemented some of the ground work, with features like voting and delegation mechanisms becoming the norm. Ethereum departed from this by opting for a purePoS design philosophy.
The thought-process here had to do with simplicity but even above this, the goal was to force individual staking for a more resilient network: resilient to capture and resilient to third-party influence, whether in the form of companies or nation states.
How successful have these ideas been? We could write ad infinitum about the value of decentralization, creating strong social layers and any other such platitudes, but we believe there’s more weight in real arguments. In this analysis we want to expand on the concepts and current state of the liquid staking market and what it actually means for the future of Ethereum. Also, we talk about the role of Lido and other LST protocols such as Stakewise in this market.
If t ere’s some hing that history has shown us is that derivatives can strengthen markets. This is true of traditional commodities where the underlying asset is difficult or impossible to trade, like oil, or even mature financial instruments, like a single stock becoming a complicated index. In fact, the growth in the use of derivatives has led to exponential growth in the total volume of contracts in our economy.
It is common as well that in most markets, the volume of derivatives greatly surpasses the spot, providing significant opportunities across a large design space. It might sound familiar (and we will get to crypto in a moment), but this open-design space has posed major challenges for risk-management practices in the already mature traditional finance, in areas such as regulation and supervision of the mechanisms, and monetary policy.
Liquid tokens are one of the first derivative primitives developed solely for the crypto markets, and have greatly inherited from their predecessors. When designing these products in the context of our industry, one has to account not only for the protocol-specific interactions, but also the terms of regulation (from the internal governance mechanisms and also in the legal sense), fluctuating market dynamics and increasingly sophisticated trading stakeholders.
Let ’s review some of Ethereum’s design choices, and how they fit into t his idea. Ethereum has enforced some pretty intense protocol restrictions on staked assets, famously their 32ETH requirement per validator and lack of native delegation. Game theory has a notoriously difficult reputation in distributed systems design. Mechanisms for incentivizing or disincentivizing any behavior will typically almost always have negative externalities.
Also, on-chain restrictions tend to be quite futile. In our last edition, we discussed some effects that can be observed in assets that resemble “money ”, like the token markets of LSTs, including network effects and power law distributions. But now we want to go deeper and consider, why is Liquid Staking so big in Ethereum and not other chains?
We observe a clear relationship between the existence of a native delegation mechanism and the slower adoption of Liquid Staking protocols. In that sense, other chains have enshrined DPoS, which makes it significantly less likely to result in high-adoption or a similar dynamic, whilst Ethereum has found it self increasingly growing in that direction.
We observe the results of the restrictions imposed at the protocol level. The network *allows* stake to be managed by individual actors, but there is no way to prevent aggregation or pooling. No matter how many incentives you create for the behavior on-chain to be as observable and maximally auditable as possible, the reality is that as it stands, the effect is never auditable.
At the time of writing this analysis, Lido has managed to concentrate 31.76% of the market share for staking in Ethereum under its signature token stETH. This is an out standing figure, not only in absolute terms but also relative to its position in the Liquid Staking market, where it controls an extraordinary ~80%, with close to 167,000 unique depositors on their public smart contracts. It is, by a margin, the largest protocol in crypto by Total Value Locked.
A big issue with TVL is that it is heavily dependent on crypto prices. In the case of Lido, we actually observe that the inflow charts show a constant growing trend from protocol launch to the present day. This is independent from the decreased crypto prices, minimal transaction output on-chain and t e consequent inferior returns on the asset, with an APR that moves in between 3.2 and 3.6% on the average day. This is of course, below the network average for vanilla nodes considering the protocol takes a 10% cut from staking rewards, divided between the DAO and its 38 permissioned Node Operators.
Recently, there’s been heated debate related to the position and surface of Lido inside Ethereum, as it relates to decentralization concerns and a specific number that constantly pops up. What is this 33.3% we keep hearing about ?
There are two important thresholds related to PoS, the first one being t his 33.3 percent number; which in practical terms means that if an attacker could take control of that surface of the network they would be able to prevent it from finalizing... at least during a period of time. This is a progressive issue with more questions than answers: what if a protocol controls 51% of all stake? How about 100%?
Before diving into some arguments, it is interesting to contextualize liquid ETH derivatives as they compare to native ETH. In the derivatives market, the instrument allows the unbundling of various risks affecting the value of an underlying asset. LSTs such as stETH combine pooling and some pseudo-delegation, and although this delegation is probably the main catalyst of high adoption, it is the pooling effect that has a huge effect on decentralization. As slashing risk is socialized, it turns operator selection into a highly opinionated activity.
Another common use of derivatives is leveraged position-taking, in a way the opposite of the previous one that is more focused on hedging risk. This makes an interesting case for the growth of stETH, as in a way its liquidity and yielding capabilities are augmenting native ETH’s utility. There is no reason you cannot, for example, take leveraged positions in a liquid token and enjoy both sources of revenue. At least, this is true of the likes of stETH which have found almost complete DeFi integration. As long as they are two distinct assets, one could see more value accrual going to derivatives, which is consistent with traditional markets.
This growth spurt is an interesting subject of study by itself, but we think it would be also possible to identify growth catalysts, and also apply them across the industry, to discover where some other undervalued protocols might exist if any. For this, you would want to identify when the protocol had growth spurts, find out which events led to that and search for these catalysts in other protocols.
One such example comes when protocols become liquid enough to be accessible to bigger players.
What would happen if we addressed so-called centralization vectors, and revisited the in-protocol delegation. Or more realistically, if we had the chance to reduce the pooling effect and allowed the market to decide the distributions of stake, for example, by having one LST per node operator.
Alternatives like Stakewise have been building in that design space to create a completely new staking experience, one that takes into account the past.
In particular, Stakewise V3 has a modular designt hat mimics network modularity, against more monolithic LST protocols. For instance, it allows stakers the freedom to selectt heir own validator, rather than enforcing socialized pooling. The protocol also helps mitigate some slashing risk, as losses can be easily confined to a single “vault”. Each staker receives a proportional amount of Vault Liquid Tokens (VLT) in return for depositing in a specific vault, which they can then mint into osETH, the traded liquid staking derivative.
Although not without its complexities, it offers an alternative to the opinionated nature of permissioned protocols like Lido, in an industry where only a better product can go face to face with the incumbent.
If you design a system where the people with the most stake enforce the rules and there is an incentive for that stake to consolidate, there’s something to be said about those rules. However, can we really make the claim that t here’s some inherent flaw in the design?
One of the points that get brought up is in the selection of the protocol participants. However, a more decentralized mechanism for choosing node operators can actually have the unintended result of greater centralization of stake. We need only to look at simple DPoS, which counts into its severe shortcomings a generally poor delegate selection with very top heavy stake delegation and capital inefficiency.
Another issue has to do with enforcing limits on Liquid Staking protocols, or asking them to self limit in the name of some reported values. This paternalistic attitude punishes successful products in the crypto ecosystem, while simultaneously asserting the largest group of stake in a PoS system is not representative of the system. Users have shown with their actions that even with LST or even DPoS downsides (all kinds of risk, superlinear penalty scaling) this is still prefered to the alternative of taking on technical complexity.
An underlying problem exists in the beliefs that control a lot of Ethereum’s design decisions, meaning that all value should accrue to just ETH and no other token can be generating value on the base layer. This taxation is something that we should be wary of, as it is very pervasive in the technocracies and other systems we stand separate to. Applications on Ethereum have to be allowed to also generate revenue.
Ultimately, the debate about Lido controlling high levels of stake does seem to be an optics issue, and not an immediate threat to Ethereum. Moreover, it is the symptom of a thriving economy, which we have observed when compared to the traditional derivatives market.
Ethereum’s co-founder, Vitalik Buterin, recently wrote an article out lining some changes that could be applied to protocol and staking pools to improve decentralization. There he outlines the ways in which the delegator role can be made more meaningful, especially in regards to pool selection. This would allow immediate effects in the voting tools within pools, more competition between pools and also some level of enshrined delegation, whilst maintaining the philosophy of high-level minimum viable enshrinement in the network and the value of the decentralized blockspace that is Ethereum’s prime product. At least, this looks like a way forward. Let ’s see if it succeeds in creating an alternative, or if we will continue to replicate the same faulty systems of our recent financial history.
About Chorus One
Chorus One is one of the biggest institutional staking providers globally operating infrastructure for 45+ Proof-of-Stake networks including Ethereum, Cosmos, Solana, Avalanche, and Near amongst others. Since 2018, we have been at the forefront of the PoS industry and now offer easy enterprise-grade staking solutions, industry-leading research, and also invest in some of the most cutting-edge protocols through Chorus Ventures.
