Is Ethereum once again a victim of its own success?

Ever since Ethereum’s shift to a proof-of-stake (PoS) consensus mechanism, an increasing number of users are getting in on the staking action to reap the rewards that come with it. Institutions are also paying attention, given the decrease in network risk and volatility following “The Merge.” This has led to concerns about how much ETH is getting locked into staking contracts, potentially interfering with liquidity on the network.

Developers are already proposing possible solutions to limit the rate of staking, which benefits overall network health but has now limited the opportunities for users to earn a yield from the network. Coupled with an ongoing DeFi winter, there just aren’t as many lucrative returns opportunities in this space as there once were. Truth is, without profitable and reliable alternatives, ETH holders are going to continue to be drawn to staking as the best means of generating return on their assets.

The rise of Ethereum staking

It’s been about a year since Ethereum successfully completed the Merge, in which the blockchain switched from a proof-of-work (PoW) consensus mechanism, like Bitcoin, to a PoS one. This was done to significantly improve the efficiency of the Ethereum network and allowed users to earn a passive income by staking their ETH to secure the network. Ethereum 2.0 was born.

Overall, this has been seen as a positive move for the Ethereum network. A significant number of users have staked their assets already, to the tune of 20% of all circulating Ether. In theory, this sounds great, as the idea is that a diverse array of users are both helping to ensure the security of the blockchain and are being rightly rewarded for doing so. The reality, however, is a bit different.

The rise of large staking providers have made it easier for virtually anyone to get involved, but this is causing the amount of ETH that is staked to continue to quickly rise. At the current trajectory, the amount of ETH locked up could balloon up to as much as 50% by May 2024 and even approach 100% by December next year, according to projections in an Ethereum Improvement Proposal co-authored by Ethereum co-founder Tim Beiko. While actually seeing the entire supply of Ethereum get locked up won’t happen, this situation could still cause a significant liquidity crunch that limits the functionality of the blockchain ecosystem, decentralized apps, and services built on top of it.

This fiasco has led to Ethereum developers approving a new proposal that would control the rate at which new validators could stake ETH. Known as EIP-7514, this change will modify the “churn limit” function to give it a maximum value that will regulate how many validators are able to join or exit the network within a given timeframe. The proposal is already being included in the Cancun-Deneb upgrade that was slated for this October but will likely now be delayed until early next year.

While EIP-7514 will help to buy some time, it doesn’t actually address the underlying problem. Namely, the fact that Ethereum staking, as is, incentivizes locking up funds over keeping them liquid. It’s true that users don’t have to stake Ethereum directly but can turn to other yield-bearing services. However, in the wake of FTX and other recent disasters, the entire DeFi market has seen an almost 80% contraction over the last year. This means there are fewer and less useful places for asset holders to earn yield.

What alternatives need to offer

Users need a safe and lucrative alternative that has advantages to staking, even if the returns aren’t quite at the level provided by staking. These could come in the form of yield-generating accounts that allow for returns on the Ethereum stored inside them, but don’t have days or weeks-long limits on when funds are accessible. Because no staking is actually done, users stay in full control of their own assets.

Better still, accounts such as these could be significantly more user-friendly than the confusing, alienating process of Ethereum staking, holders would simply need to deposit their funds and sit on them. They could remove them at any time, and overall liquidity on the network is not affected. Users also wouldn’t rely on the health of DeFi as a whole, and will generate returns regardless of what the market is doing.

Another essential aspect of these offerings is that they can also be “ring-fenced,” meaning the assets are never intermingled with other user’s funds or company activities and aren’t exposed to broader systemic risk. Assets that are used for growth opportunities are separate from those that are just being held as savings. This is important for keeping users safe, as even if the service itself should collapse, all held funds will be completely intact.

Implementing a service where anyone can grow savings without the need to lock up ETH is the ultimate key to solving the ongoing staking issue that is plaguing Ethereum. Protocol changes are helpful, but what is essential is changing the incentive that users have for earning yield on their assets. By providing growth opportunities that don’t involve actual staking, these accounts can be simpler, safer and healthier for the whole ecosystem than centralized alternatives. The solution is obvious; now it’s time to bring something like this to Ethereum holders worldwide.

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