The Merge was widely applauded both for its execution (changing a key element of the blockchain while it’s running was no small thing), and the promises it brought to Ethereum’s future: reducing energy consumption, setting up a base for future scalability and accessibility improvements…

However, along with hopes and dreams, the new consensus has brought new problems, mostly of the regulatory kind.

These pros and cons are spiking heated debates all over the crypto space, which now tries to figure out how to fight off the new dangers.

 

Centralization concerns

While PoW consensus is based on computations (work) that nodes (miners) are required to complete to be able to add blocks, PoS blockchains rely on nodes that stake their native cryptocurrency as guarantee of good behaviour (called validators).

An aspiring Ethereum validator must lock a minimum of 32 ETH to be able to actively participate in the network and earn its fees. However, not everyone has $43’000 to put aside, which led to the emergence of staking services that pool users’ funds and allow them to stake any amount of ETH in return for a yield. These services are now at the heart of the centralization concern.

According to Nansen, a crypto analytics company, out of 13.8 million of staked ETH, over 60% is now controlled by only four entities: Lido (30.2%), Coinbase (14.5%), Kraken (8.3%) and Binance (6.6%). What’s more, while Lido is a DeFi service, others are traditional centralized companies.

This is dangerous for Ethereum, especially taking into account that once a user locks their ethers in such service, they relinquish all control over it (unlike miners who can always unilaterally stop providing their hashrate to a mining pool). Moreover, during the next 6-12 months the staked ethers cannot be un-staked, which makes the situation even worse.

So, what exactly does the centralization entail?

The entities that control most part of the network can collude and try to rewrite the blockchain or halt it on purpose. However, the economic incentives of such actions won’t be enough to lose the staked funds, and, most importantly, the core businesses that key stakers have.

The real risk of centralization is censorship.

Regulatory risk is an emerging trend in the crypto space, but so far it concerned mainly crypto services, i.e. companies dealing with crypto and DApps built on a blockchain, not the blockchain itself. Now, with centralized staking services gaining influence on the blockchain operations, the regulators could use them as an entry point to try and “break” the blockchain’s censorship-resistance.

The biggest such risk comes from the United States, where the Treasury has already shown its determination by banning Tornado Cash-related smart contracts. It is not impossible that centralized US-incorporated staking services would be required to not process specific Ethereum transactions, thus striping the blockchain off its main quality – censorship-resistance.

 

Ethereum and the SEC

Another regulatory risk can come from the financial and tax authorities. Here too, American regulators are most eager: Gary Gensler, the Chair of the SEC, has already mentioned that he considers only Bitcoin as a commodity. Now, with Ethereum basically run by its “shareholders”, i.e. people who own and stake ethers, the probability that the SEC tries to label ETH a security is as high as ever. This could, in turn, create a plethora of regulatory and tax hurdles that the crypto space may not be ready for yet.

The process may have already started. This Monday, the SEC all but claimed the authority over Ethereum transactions: in a filing made against Ian Balina, accused of undisclosed promotion of tokens recognized as unregistered securities, the SEC stated that Ethereum nodes “are clustered more densely in the United States than in any other country. As a result, those transactions took place in the United States”.

This phrase provoked a massive outrage across the crypto community, which judged it not only unfounded, but also unnecessary in an apparently easy case the SEC had against Mr Balina. Was the SEC trying to set precedent?

For now, the regulatory exposure that centralized staking services have created is not enough to compromise Ethereum. Lido (30% of staked ETH) is decentralized, meaning that any change to its protocol must be voted in by its DAO, and over 25% of Ethereum stakers are estimated to be individuals. However, the Merge did raise many questions; it is now up to the Ethereum community to try and answer them.

Written by D.Center