Applying TradFi principles to liquid staking would ‘contort the marketplace’

Liquid staking in crypto is a novel concept that is difficult to compare to anything in traditional finance. But one way to get the gist is to think of it like a bank. 

The customer deposits funds into the bank, which then takes the collective deposits of all customers to manage risk and accrue revenues, paying back customers a small percentage in interest.

When someone purchases staked ether (stETH) on a platform like Lido, they’re not staking their deposit themselves. Like a bank, the platform manages the assets on the depositor’s behalf, passing a small portion of profits back to the depositor.

Unfortunately, this analogy quickly breaks down, Steakhouse Financial DAO Consulting contributor ADCV explains on the Bell Curve podcast (Spotify/Apple).

“These [platforms] are not actually custodial, so they don’t fulfill many of the conditions that would actually make them banks. They’re just smart contracts that coordinate incentives between players in a decentralized and permissionless way.”

“Ethereum itself is unlike anything that’s ever been done before,” ADCV says. “It doesn’t really match closely to analogs from the past or from [traditional finance]. Neither does staking and also therefore, neither does liquid staking.”

Staking concierge?

One recent improvement to Lido that makes it look even less like a bank is its staking router mechanism, which allows the platform to serve as a sort of hub for a marketplace of staking allocation, previously described to Blockworks. As of now, the system utilizes a “very simple governance” to approve modules, podcast host Mike Ippolito explains.

“It approves a target limit. Let’s say it’s 1%. Once that 1% essentially gets filled, the overflow goes towards the whitelisted validators that originally were with Lido until you move that up to 2% or something like that.”

This is fine for smaller scale operations, but as of now, Ippolito says that no mechanism exists to allow large-scale institutional stakers to connect with a particular set of validators that have know-your-customer “KYC” requirements — ensuring everything is on the up and up.

Ippolito suggests that a liquid staking as a service model could emerge where the platform acts as concierge, connecting delegators with their preferred validators.

ADCV admits the notion is “interesting,” but ultimately flawed. “Allowing people to customize the exposure to the delegation,” he says, “risks creating centralizing forces inside the staking router itself.”

The goal of Lido, he explains, is to make staking “as easy as possible to as many people as possible” in a “neutral middleware type of structure.”

“You don’t KYC [Simple Mail Transfer Protocol] servers, when you send emails,” he says. “It’s very difficult to justify, if you think from first principles, why you would KYC a trustless, permissionless protocol such as Lido, because then you may as well KYC Ethereum.”

ADCV argues the responsibility to perform KYC — complying with FATF, preventing crimes and money laundering as well as supervising centralized custodians and financial services — lies with institutions, not protocols. “There’s no reason why an institution couldn’t KYC its customers and use Ethereum, for example,” he says.

It’s just not the same

It goes back to the fact that Ethereum and staking mechanisms are not analogous to traditional finance, ADCV says. “It’s just not the same. Applying things that apply to money, you’re going to have a very difficult time, or you’re going to contort the marketplace into a shape that makes it less useful or less credible.”

“An Ethereum ecosystem that’s super centralized is less valuable for everyone,” he says. “That market incentive is there to centralize, and that’s one of the things that Lido is so conscious of fighting.”

The “more interesting approach,” ADCV says, would be to engage regulators and “encourage them to run validators themselves.” 

“This is so new and so unlike anything else that you need to have a stake in it yourself in order to safeguard the neutrality of the system and to allow your citizens to participate in it equally.”

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