Banks as validators on Ethereum 2.0?
What is Ethereum 2.0?
On June 16, 2021, some news was published on Coindesk (https://www.coindesk.com/banks-edge-closer-to-ethereum-2-0-staking) stating that banks or other large companies could participate in Ethereum 2.0 staking. The impact of such a possibility within regulatory world is very significant, so we will try to explain the implications that bank participation would have
Ethereum 2.0 is the new Ethereum protocol, improved in order to remedy the problems arising in scalability (currently, Ethereum processes around 15 transactions per second or tps), security (initial DAO hack scandal, and other hacks within DeFi) and Gas price calibration.
To this end, a series of steps are proposed, starting with a modification of the consensus mechanism applied, moving from the current Proof of Work (PoW) to the so-called Proof of Stake (PoS) to subsequently increase the processing capacity of the network through the introduction of Shards chains.
To sum up, Ethereum’s current capacity would be improved with the introduction of Shards Chains, as it allows partitioning the blockchain into up to 64 parallel PoS chains, and increasing scalability to 64x, which is equivalent to 960 tps. Additionally, the protocol modification proposed by Matter Labs, called zkPorter promises to optimize up to 20,000 tps[1], which practically allows Ethereum to compete with classic payment processors such as Visa or Mastercard.
Understanding consensus mechanisms: PoW vs PoS:
Returning to the original discussion, the great debate in terms of consensus mechanisms has revolved, at least from the perspective of cryptocurrencies, around these two systems. Although there are more systems (Delegated Proof of Stake, Proof of Authority, Proof of Capacity, among others), the two most relevant are the ones mentioned above. The main characteristics and theoretical basis of both are explained below:
- PoW System: also called mining, it guarantees consensus by posing a brute-force cryptographic problem for all validating nodes in the network, whose solution is reached through continuous mathematical iteration. In other words, the participants try to find a numerical sequence that satisfies the parameters of the problem posed, so that the energy consumption of the participating node to solve it before the rest (risk) is set against the potential reward in the form of the token or underlying asset of the network in case of success (reward).
Once the mining node incorporates a pool of unconfirmed transactions into a block, validates compliance with the logical rules governing the protocol, and finds the numerical sequence by means of a cryptographic function that satisfies the problem, it includes the block in the chain and propagates it throughout the network, so that all participating nodes maintain a copy of the ledger.
As the network protocol establishes the time for a block generation, the difficulty of solving the cryptographic problem adapts, so that the greater the added computational power, the greater the difficulty, and vice versa.
- PoS System: it guarantees consensus by escrowing the tokens or underlying assets of the network, so that if transactions are validated correctly, more tokens are obtained (reward), and if transactions are validated incorrectly, the deposited tokens are lost (risk).
In this case, once the validating node incorporates a pool of unconfirmed transactions into a block and validates compliance with the logical rules governing the protocol, it includes the block in the chain and propagates it throughout the network, so that all participating nodes maintain a copy of the system.
The focus of the discussion is in terms of ESG (Environmental, Social and Governance), one of the pillars of the banking world, based on a system of sustainable finance. Under PoW, energy is compromised, while under PoS, the equity or stake of the validator is compromised. However, the intense consumption of electrical energy required by a network with a high level of difficulty raises doubts about its sustainability.
In this sense, the amendments proposed to the MiCA European cryptoasset regulation proposal [2] already advocate a study of the differences between PoW and PoS, as well as the possible prohibition or limitation of the offer of unsustainable cryptoassets (by collateral or, precisely, by consensus mechanism) by cryptoasset service providers or CASPs[3]. Proponents of PoW point out that, under this system, there is a real investment of resources, which guarantees the security of the network against different attacks, and makes it practically impossible to reverse the blocks that are part of the chain (theoretically, a computational power greater than 50% of the network’s capacity could generate a fork of the blockchain approved in the block considered and create a different sequence whose propagation among the nodes would be superior to the original blockchain).
Ethereum 2.0 staking: trade-off between capital and profitability.
In the case of Ethereum 2.0, a minimum staking level of 32 Ethereum is required to participate in the network as a validating node, which de facto eliminates the possibility for any node to participate in validation. However, the incentive system of the consensus mechanism is maintained, since the validator who deposits his token is incentivized to validate correctly for a double reason: the token can be revalued or, at least, no reasons for loss of value are given, and the validator can generate tokens starting from the initial stake. Also, the new mainnet, called Beacon Chain, stores and manages the register of validator nodes, and coordinates the application of the PoS consensus mechanism.
To go along with the news, the participation of banks — credit institutions and, therefore, regulated entities — in the Ethereum 2.0. ecosystem involves their inclusion as validator nodes. To do so, banks will have to contribute Ethereum. And such contribution can be made in several ways:
- Ownership: the lender acquires Ethereum and records it in its books as an intangible asset. The volatility in the price of the asset impacts the profitability of the entity, which is exposed to market risk and operational risk for such asset. Likewise, its treatment in capital is a deduction of the highest quality component of capital (called CET1 or Core Equity Tier 1), so the entity assumes a trade-off between the profitability generated, which is quantified as income, and the cost of capital, which is increased by such deduction.
- Reverse Repo: through this instrument, the credit institution receives Ethereum on a temporary basis and delivers cash. The loan received from Ethereum does not imply the recording of the asset in the entity’s balance sheet, since it does not meet such definition: good or right controlled by the company with the capacity to generate future economic returns. As there is a timestamp, due to the reversion of the asset holding, it cannot include such asset in the balance sheet, and it does not participate in the risks and benefits of the token. In other words, it is not exposed to its volatility.
But it is worth considering whether the operation could allow the inclusion of a collateralization mark (the loan made by the entity is covered with such collateral) or, at least, the registration of a real right to reflect that the Ethereum owned by the borrower is covering an obligation of the borrower. The smart contract that is constituted for the staking of the Ethereum does not establish as a requirement that such asset is unencumbered, understanding as encumbrance that such asset is attached to the fulfillment of the obligation to repay the loan. In such a case, the following scenario could arise:
The Ethereum collateralizing the reverse repo, which is deposited as staking of the validating node by transaction of the borrower on behalf of the lender, is lost due to errors in the validation of transactions by the node. In such a case, Ethereum’s power of disposition does not appear to be limited to the object of securing the performance of the obligation, as in the case of repo or pledge, but is extended. And, therefore, the collateral is executed prior to the lender’s default on the obligation and does not therefore fulfill the character of collateral.
Conclusions:
In conclusion, only entities that own Ethereum as an asset, and therefore only the owners, can act as validating nodes. This limits, at least currently, the participation of credit institutions in PoS staking, a model that, according to the calculations of Thomas Eichenberger, Head of Business Units at Sygnum Bank, can yield between 6% and 8% per annum.
