Balancing Act: Ethereum's Staking Surge Causes Growing Pains

In 2022, Ethereum shifted from proof-of-work (PoW), a crypto mining consensus mechanism, to proof-of-stake (PoS) staking consensus mechanism. The shift had the positive effect of lowering Ethereum's energy use by over 99%.

Yet The Merge has led to serious reconsiderations of Ethereum's purpose.

Not a Subtle Shift

The changes that Ethereum is experiencing are important for the entire crypto ecosystem. ETH is the second-most popular cryptocurrency after bitcoin (BTC). Also, the Ethereum blockchain makes up more than half of the decentralized finance (DeFi) market.

Ethereum has a broad mission, which can be summarized as creating more ways to engage in transactions on a global scale. The network aims to create a fairer financial system and an open internet. In addition, Ethereum does not set a limit on the amount of ETH that can be minted. In contrast, there is a limited supply of Bitcoin, 21 million coins.

Since Ethereum now relies on PoS, the future of the platform is linked to the number and type of users that stake their ETH. Ethereum offers four methods for staking: Solo home staking, staking as a service, pooled staking and centralized exchanges. Users who engage in solo home staking and staking as a service must stake a minimum of 32 ETH (around $50,000). A solo home staker should also have a dedicated computer connected to the internet ~24/7.

There are over 800,000 validators staking more than 25m ETH. Source: Dune Analytics

Pooled staking and centralized exchanges are available for users who do not have or feel comfortable staking 32 ETH. Yet these options are complex and come with risks. Users must educate themselves on how to avoid or mitigate these risks. They must also develop strategies to earn rewards.

The question is how novice users and users with less funds that join the Ethereum community can become validators. As Ethereum welcomes new types of users, including gamers, artists and others new to crypto, the network must define its purpose and make more equitable decisions.

Staking has Changed Ethereum

As of October 2023, more tokens are being staked than ever before. This information comes from the Q4 2023 report "The State of Staking," a quarterly analysis of key trends in the staking industry. The report is published by Staked, a staking platform subsidiary of cryptocurrency exchange Kraken. Ethereum is the major player in PoS networks because it has a 79% share of this sector.

"The State of Staking" report states that staking yields are at historic lows. In 2023, Ethereum's Consensus layer (CL), also known as Ethereum 2.0 or Eth2, experienced a yield drop to a low of 3.2%. Ethereum's Execution layer (EL), also known as Ethereum 1.0 or Eth1, saw a yield drop to a low of 1.3%. For clarification, smart contracts and network rules are stored on Eth1. Enforcement of devices contributing to the network to act in accordance with regulation occurs on Eth2.

The question of what happens when more users are staking but those users are seeing less in returns is now being answered in real time. The problem is that users with resources to spare can afford to play the long game. New users and those with less resources cannot. They are also discouraged to do so because they are seeing a low ROI for staked assets.

Liquid staking is the top ETH staking category. Source: Dune Analytics

Ethereum is also challenged by the rate of staking on the network. "The State of Staking" report indicated that as of October 2023, Ethereum crossed the 20% stake rate. This means that 20% of ETH tokens, which are valued at roughly $41.5 billion, are currently staked. If the trend to stake increasingly more ETH tokens continues, up to 50% of all ETH could be staked by May 2024, 75% by September 2024 and potentially 100% by December 2024. This information comes from an Ethereum Improvement Proposal ( EIP-7514 ) written by Tim Beiko, who coordinates Ethereum core developers, and a developer called Lion Dapp, who goes by @dapplion on Twitter/X.

The two authors state the cost of staking more ETH is putting more strain on Eth2. The layer is highly likely to experience more congestion and security concerns soon. If, in theory, all ETH tokens get locked up in staking, no user would be able to make transactions on the network.

A Pause in Validator Signups

On September 14, 2023, Ethereum developers met over Zoom and voted in favor of a significant change to the Execution layer of the network. The developers agreed to limit the number of new validators, which are allowed to join Ethereum every six minutes.

The cap goes back to the fact that validators must stake a minimum of 32 ETH to engage in the top two types of staking, solo home staking and staking as a service. In other words, slowing down the rate at which validators can join Ethereum means, theoretically, that there are fewer validators staking ETH. Also, less ETH gets locked up in staking.

Flows since Ethereum's last major upgrade, Shanghai fork. Source: Dune Analytics

As of October 2023, Ethereum's developers are using this break in validator sign-ups to come up with a lasting solution. This may take the form of lowering validator rewards even further. There will be a problem if this action pushes new users and users with less funds further away from staking.

The situation raises concerns about equity and accessibility. Ethereum developers must ask what changes they can make to encourage staking by users in disadvantaged categories. Such actions invite users that are not companies, developers and investors to the platform. If Ethereum does not make it easy for such users to stake, how will these users get involved with staking?

Solving the riddle should involve Ethereum's developers asking new users and users with low amounts of funds what changes would assist them. Ethereum's developers should also ask what educational resources and tools beyond web forums and calculators would benefit users in these categories, now and going forward.