As the industry’s second-largest blockchain, Ethereum, continues on its journey toward a more sustainable and decentralized future, it faces a conundrum: did the switch to a proof of stake (PoS) security model make the network more centralized? JPMorgan analysts believe it did.

Is Ethereum Overly Centralized?

Ethereum’s transition to PoS was celebrated as a key upgrade. However, over a year later, some industry observers fear the Merge and subsequent Shanghai upgrades have pushed Ethereum toward more centralization.

In a research report on Thursday, JPMorgan analysts led by Nikolaos Panigirtzoglou noted that:

“The rise in Ethereum staking since The Merge and Shanghai upgrades has come at a cost as the Ethereum network became more centralized and as the overall staking yield declined.”

Ethereum’s so-called Merge to PoS was successfully completed in September 2022, ushering in staking. The historic Shanghai upgrade executed in April of this year allowed network participants to un-stake and withdraw their tokens, which resulted in skyrocketing staking. 

The Merge replaced the way transactions were verified on the Ethereum network. Instead of miners putting in their computational power to verify a transaction, validators now pledge Ether tokens to verify those transactions. Although that has already reduced the energy consumption of Ethereum by 99.99%, it also means that a considerable portion of the ether securing the network sits with centralized entities.

Lido And Its Centralization Problem

Notably, Lido Finance’s outsized footprint in Ethereum’s staking pools has garnered particular attention in recent months. Lido has been identified as a potential weak point for Ethereum’s ecosystem in terms of decentralization because Lido now supports roughly 32.19% of all ETH staked, as per Moulié’s dashboard.

Liquid staking platforms like Lido, although decentralized, “involve a high degree of centralization,” JPMorgan remarked.

Lido has been increasing node operators to contain the number of staked ETH being controlled by any single operator in a bid to address the centralization concerns, the bank said.

But, centralization by any protocol creates risks for the Ethereum network as a “concentrated number of liquidity providers or node operators could act as a single point of failure or become targets for attacks or collude to create an oligopoly that would promote their own interests at the expense of the interests of the community,” the analysts added.

Another risk from the rise of liquid staking is rehypothecation, the Wall Street bank asserted. This is when liquidity tokens are used as collateral across several DeFi protocols simultaneously. The practice could lead to “a cascade of liquidations if a staked asset drops sharply in value or is hacked or slashed due to malicious attack or a protocol error,” the bank posited.

What Next?

JPMorgan analysts also noted that the rise in staking has decreased the appeal of Ethereum from a “yield perspective,” especially considering the backdrop of soaring yields in legacy financial assets. “The total staking yield has declined from 7.3% before the Shanghai upgrade to around 5.5% currently,” they said.

Just last month, the bank’s strategists observed that Ethereum’s activity after Shanghai has been particularly “disappointing”. At the time, they explained that Ethereum’s daily transactions, daily active addresses, and total value locked (TVL) of decentralized finance (DeFi) protocols on the network have all seen steep declines.

Going ahead, it will be interesting to see how Ethereum overcomes the centralization of validators.