Ethereum's Technical Evolution and Institutional Interest in ETH Staking

Ever since Ethereum became a practical blockchain technology platform and developed into an incumbent player next to Bitcoin, it has encountered several infrastructure challenges concerning scalability, throughput, efficiency and security. Problems with scalability hinder the speed at which transactions can occur, while challenges with throughput affect the number of transactions that can be handled per second. Efficiency relates to the excessive energy consumption and expenses involved in mining; whereby complex computational problems were solved to safeguard new coins using the now-defunct Proof of Work (PoW) consensus mechanism.

As to security, since the functionality of the Ethereum blockchain is based on executing smart contracts, security challenges mainly involve smart contracts as opposed to the Ethereum network. Compounding security challenges on Ethereum are various Layer-2 decentralized applications (dapps) and scaling solutions that are built on top of Ethereum, many of which are not finance-related.

To mitigate and subsequently overcome the above challenges, starting in August 2021, the Ethereum network underwent several infrastructural improvements, starting with EIP-1559, which improved the network’s fee system. The next improvement took place in September 2022, known as the Merge, which was a major shift in the network’s consensus mechanism. The Merge was followed by the Shapella upgrade in April 2023. The Shapella upgrade enabled validators on the network to unstake their network-locked ether.

These improvements have led to a growing interest in decentralized financial (DeFi) protocols by financial institutions and the yield they offer to investors. Hence the development of Ethereum staking as a financial product.

Also known as the London Hard Fork, the Ethereum Improvement Proposal (EIP)-1559 was a milestone in the evolution of the Ethereum blockchain into its current state. It involved changes in codes to improve the blockchain’s transaction fee system. The cornerstone of this improvement was relinquishing the gas fee system known as ‘first-price auction’. The first-price auction scheme, or legacy system, required network participants to bid competitively to have their transactions processed, with the highest bidders almost always getting prioritized over others.

EIP-1559 introduced a new fee system with three key features: the base fee, variable block size, and the tip.

Base fee: Prior to EIP-1559, a validator would have to submit a bid as a transaction fee, which would then be taken up by miners who could see all the transactions and their associated bids. Miners would then receive transaction fees in their entirety. EIP-1559 introduced a base fee that is the minimum gas price that a validator must pay to be included in a block. The key benefit of the base fee is that, as a result of its predictability, it makes gas fees more predictable and high fees less frequent.

Variable block size: EIP-1559 also changed block size and gas number dynamics. Post upgrade, Ethereum blocks now have 1 to 30 million gas units worth of transactions, which were previously capped at 15 million. Moreover, post-upgrade, the base fee is directly related to the implementation of variable block sizes.

Miner tip: Also referred to as a ‘priority fee’, the miner tip functions as an incentive mechanism for miners to prioritize transactions. Miner tips are used in times of high transaction demand on the blockchain network, which means when a block is filled with its maximum of 30 million units worth of transactions. In other words, the miner tip mechanism is a temporary reincarnation of the ‘first-price auction’ system.

EIP-1559 made the fees predictable and reduced volatility. Users and dapps that seek prioritization of their transactions on the network can pay minors a tip (priority fee) for faster inclusion and processing of their transactions. EIP-1559, which took place in August 2021, has since led to improvements in the user experience, a better fee structure, and automation.

In September 2022, another milestone was reached in the upgrade of the Ethereum blockchain network. It was an overhaul of the blockchain network’s consensus mechanism. Ethereum underwent a successful upgrade to transition from a proof-of-work (PoW) consensus mechanism to one of proof-of-stake, which came to be known as the Merge. It involved merging the Ethereum mainnet, its execution layer, with the Beacon Chain, its proof of stake consensus layer. As a result of the Merge, the network relinquished the mining model (PoW).

Proof of stake, the new consensus mechanism, involves the active participation of stakers (validators) in validating transactions. Today, Ethereum can be staked on centralized cryptocurrency exchange platforms such as Coinbase, Kraken and Bitstamp, as well as decentralized exchanges (DEX) like Lido, dYdX, Uniswap and 1inch.

A fundamental difference between PoW and PoS is the huge savings in energy consumption that PoS offers—over 99% in energy savings to mint a new block, comparable to Finland’s energy grid. On the security side, PoS offers a sigh of relief as it makes it extremely difficult for bad actors to control hashing power for fraudulent transactions, a practice known as the 51% attack under the PoW consensus mechanism.

Post Merge, the tokenomics of Ethereum continued to evolve as smart contract platforms saw growing use cases and viable business adoption in NFT and DeFi, enlarging the Ethereum ecosystem.

The Shapella upgrade (a portmanteau of Shanghai and Capella) was the most recent upgrade to the Ethereum network that took place in April 2023. It marked the completion of Ethereum’s transition to PoS. The upgrade removed uncertainty around whether and when ETH stakers would be able to withdraw their assets and rewards. The significance of Shapella lies in its ability to impact supply and demand for ETH and its price, as it enabled validators to withdraw staking rewards and made it possible for the potential release of billions of dollars of dormant staked ETH into the blockchain’s supply chain.

Before the Shapella upgrade, stakers could only deposit their ETH into the Beacon Chain and earn rewards, but they could not withdraw their funds. Therefore, the upgrade offers an exit for stakers, which comes in two formats: full withdrawals and partial withdrawals.

Full withdrawals pertain to when validators completely exit the Ethereum network, which entails taking out the necessary 32 ETH to act as a validator. On the other hand, partial withdrawals solely involve withdrawing the rewards accumulated during a specific validator's staking journey.

Ethereum’s journey to further improvement continues. The next upgrade that is expected to take place later this year is EIP 4844, which, upon completion, is expected to reduce fees, increase transaction throughput, and make it more cost-effective to integrate layer-2 solution protocols with Ethereum.

The enhancements to the Ethereum blockchain have led to decreased volatility, risk and a more secure network. They have brought about the evolution of a tech platform that offers investors yield with liquid staking tokens and restaking protocols, which are gaining significance in the emerging financial ecosystem of Web3. The staking rewards promised by the above technological developments are enticing banking and custodial institutions to invest in and develop staking and data solutions for a growing ETH staking market. This growing market offers new opportunities for asset managers and advisors to develop customizable staking solutions for their clients.

CoinDesk Indices (CDI) is the leading provider of digital asset indices by AUM since 2014. CDI offers single-asset reference indices, broad market and sector indices, and systematic strategies. Part of this solution suite includes the Ether Trend Indicator (ETI) and the Composite Ether Staking Rate (CESR).

ETI is a daily signal which conveys the presence, direction, and strength of the current price trend of ether. ETI seeks to help the market navigate the ‘crypto seasons’ by providing outcome-driven investment products that aim to unlock new sources of return, help manage risk, and improve overall efficiency to reduce potential costs. It is used in long-only dynamic allocation strategies, broadcasting one of five possible daily values. The values correspond to the direction and strength of the trend in price and are calculated daily and derived from historical daily levels of the CoinDesk Ether Price Index (ETX).

CESR is a staking rate product. It is a daily benchmark rate that represents the mean, annualized staking yield of the Ethereum validator population. It provides participants in the Ethereum ecosystem with a standardized benchmark rate for staking and a settlement rate for derivative contracts. CESR can also help market observers and analysts generate deeper insights across Ethereum. It captures all relevant rewards for Ethereum validators, including consensus rewards and total priority transaction fees. The methodology accounts for deposits, withdrawals and “slashing” and reflects the portion of Maximal Extractable Value (MEV) earned by validators. Historical daily CESR rates can be aggregated to address any evaluation period or contract tenor. CESR is administered by CoinFund and calculated by CDI.

For additional information about our CESR and ETI offerings, contact us today or visit us at www.coinfund.io/cesr.