Jay's Takeaways: The Risks of LSDs

What are the risks?

Original tweet (posted on Sep 2, 2023)

Lido finance is taking over ETH staking with nearly 33% of staking market share

Danny Ryan put together a great write up on "The Risks of LSDs" -- this is an important read for anyone who uses Ethereum and/or holds liquid staking derivatives (LSDs). Here’s my summary:

What is the risk?

• Liquid staking derivative (LSD) protocols pick the node operators (NO)

• The risk: any one particular LSD exceeding critical consensus thresholds (⅓, ½, ⅔)

Why is this a risk?

• The LSD can pick a majority NO – this NO can now skew consensus. Why would they?

  • They can achieve crazy profits due to MEV extraction, block timing, censorship

How are NOs picked?

• Governance token approach

  • If we use the gov token to vote on which NO to add/remove, you have a situation where rational actors will buy up all the LSD token to allocate their NO of choice

  • This will occur until potential profits in altering consensus is equal to the cost of accruing the necessary # of vote / gov tokens

• Economic selection approach 

  • Filter NOs based on metrics. Entering as an NO would require time, capital, and “good” behavior (e.g. threshold of issuance awards)

  • One of the major challenges is defining the metric -- how can you define one that optimizes for the number of good, honest actors?

  • This can lead to perverse incentives where the "cartel" tries to game the system, working together to remove the set of honest NOs from the system

• LSD holders governance approach

  • This is the notion that LSD holders should have voting power and can then act as a safety backstop for poor behavior

  • Counter argument – in the long run, the # of ETH users will be magnitudes over the # of ETH holders (wallets holding ETH beyond the necessary amount for txns) -- and the # of LSD holders < # of ETH holders

  • Thus, LSD holders are a poor representation – what LSD holders want != what users of the ETH protocol want

Closing thoughts

• Small changes add up over time, and in the long run, this could morph ETH into a value extractive, centralized protocol without anyone taking notice

• Tragedy of the commons -- staking with LSDs is a good decision for the individual (more yield) but a bad decision for the protocol

• However, if the protocol ends up in a bad spot, LSD holders also suffer (ETH price goes down) 

• "The pooling of capital [..] puts not only the Ethereum protocol at risk, but, in turn, the pooled capital"

• Although this is seen as a tail risk, if it can be exploited for profit, sooner or later it will be