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Is Ethereum Still Decentralized? It’s Complicated
Since bursting onto the scene in 2015, Ethereum has firmly established itself as a premium blockchain for developers in the crypto and Web3 industries. Created to expand upon the Bitcoin blockchain’s utility, Ethereum fully embraced the early Facebook ethos of “move fast and break things” with mixed results. While it has ushered in an unprecedented level of development in the space, it also enabled bad actors the ability to seamlessly create rug pulls and grifts.
Ethereum has constantly evolved over its lifespan, even going so far as to abandon the consensus mechanism that it was built on. Last September, after years of delay, Ethereum shifted away from the energy-intensive proof-of-work (PoW) mechanism to a proof-of-stake (PoS) model. This was a radical shift, and one that was a technical nightmare to pull off, but one that Ethereum’s founder, Vitalik Buterin, had been pushing for years.
While it dramatically improved the scalability, and energy usage, it impacted its level of decentralization. In this article, we will explore exactly why this was the result of Ethereum shifting to Proof of Stake.
The Blockchain Trilemma
Buterin identified what is widely known as the blockchain trilemma. In it, he identifies the three competing forces that blockchains run into. He identified that every blockchain will inevitably have to make a sacrifice of either its scalability, decentralization, or security in favor of the other two.
Bitcoin is a notoriously slow blockchain, and its mainnet reaches a capacity of 7 transactions per second (tps). This is by design to maximize its decentralization and security. This focus on decentralization and security means that the Bitcoin L1 blockchain is very difficult to scale. It cannot be done on the mainnet without the use of a hard fork to adjust the mechanics outlined in the Genesis Block.
Buterin understood that in order for Ethereum to reach its full potential and become a dominant blockchain that could process tps on a scale required to run a “new internet,” it would need to prioritize scalability.
The Merge
Ethereum, prior to The Merge, operated on the same PoW model that Bitcoin did. It was a slightly faster blockchain with an average of 27 tps. Still far from where it needed to be if it was going to process the volume of transactions needed for the thousands of projects built on top of its L1. Ethereum claimed that once the full rollout of The Merge happens, it will be able to process over 100,000 tps.
Before The Merge, anyone with enough technical savvy was able to download a copy of the Ethereum blockchain for a chance to mine the next block and verify the transactions (and receive rewards). Post-Merge and shifting to PoS, only those who had successfully staked 32 ETH were able to become validators.
Where before anyone was able to become a node and validator for the Ethereum blockchain, the PoS introduced limitations to this. While users are able to pool their ETH to become a validator, the entry point is too restrictive for most people.
Those with deep pockets benefited and became the largest owners of validators on the network. This has created a concentration and centralization of the validators.
Who are the Validators?
This centralization of validators was concentrated into the hands of those that had previously accumulated the most amount of ETH in the build-up to The Merge. Institutional holders created the largest staking pools, with 59.6% of ETH staked coming from exchanges, including Binance, Lido Finance, Coinbase, and Kraken.
Retail investors are not completely locked out of the process in a PoS model. They can still stake their ETH through these staking pools for a portion of the reward. However, they have no say in the verification of transactions or the governance of the blockchain.
It is true that the centralization of the validators dramatically improves the efficiency of the blockchain, but in doing so, the blockchain opens itself up to potential regulatory capture. Let’s explore exactly how.
OFAC Regulations
The main problem for concentrating the validators into the hands of institutional entities is that those institutions are required by law to comply with certain regulations. Most notably, in the U.S., there are Office of Foreign Assets Control regulations that enforce regulations over international regions and individuals.
Exchanges like Binance, Coinbase, and Kraken are all required to collect and provide KYC and AML data sets from their consumers and provide them to government regulators in order to hold a license in the U.S. These controls have only increased in the last year since the collapse of FTX.
Decentralization is an important pillar of the principles of early blockchain technology for this exact reason. How can a blockchain claim to be immutable (unchangeable) and censorship resistant if the very validators who have control over validating and approving transactions are required to abide by government regulations?
Further Centralization
In June 2023, a core developer from the Ethereum Foundation named Michael Neuder made a proposal to further increase the staking threshold from 32 ETH to 2048 ETH. He argued that validators had become too decentralized, and it was causing a slowdown in the processing of transactions.
If approved, this would further concentrate the validators while removing the smaller staking pools operated by individuals that were able to raise the initial 32 ETH. This would once again improve the scalability of the blockchain but ultimately diminish the decentralization component of it.
At this time it’s just a proposal but it’s an important development to keep track of in the near future.
Final Thoughts: It’s No Bitcoin
Ethereum has seen a lot of change over the years. There have been hard forks of ethereum when it didn’t meet social consensus. The developments outlined in this article that have taken place after The Merge set a dangerous precedent for Ethereum of constantly shifting the goalposts of who is allowed to validate.
It opens up the blockchain to further regulatory capture and may even spur on a civil war within the current pool of validators. In this writer’s view one thing is for sure – Ethereum is no longer a decentralized blockchain.
