Addressing Ethereum Risks and Criticisms

This report intends to discuss the more nuanced aspects of Ethereum, addressing valid concerns from within and outside of the digital asset community and refuting potentially overstated criticisms. Looking ahead, it will be important for investors to actively monitor the topics addressed here as well as changes across the wider Ethereum ecosystem as any developments since the time of writing could directly impact Ethereum’s investment thesis.

Below are some of the most common criticisms against Ethereum and our responses, including:

1. The Ethereum Foundation and core developers control Ethereum.
2. Ethereum’s high fees will drive users away.
3. Ethereum is only used for financial speculation.
4. Proof-of-stake is less secure than proof-of-work.
5. Ethereum’s crowd sale is harmful to the current proof-of-stake system.
6. Ethereum is too complex.
7. Lido is a threat to Ethereum security.

Criticism #1: The Ethereum Foundation and Core Developers Control Ethereum

Ethereum governance happens entirely off-chain, leading to speculation surrounding the decision-making process. Ethereum’s social layer is designed to incorporate permissionless community-driven inputs, and core developers then attempt to achieve consensus on their relative priorities for implementation. 

Since Ethereum is an open-source public good, anyone can propose changes to the codebase. The Ethereum Foundation functions as a facilitator and, rather than wielding total control, it provides resources to various groups within the community. These teams work on the development, maintenance, and exploration of Ethereum’s technological frontiers. 

Ethereum core developers are team members that focus on upgrading, testing, and monitoring their respective Ethereum client software. Ethereum is made up of two clients (execution and consensus) that work together; therefore, teams focus on creating their own versions of either an Ethereum execution or consensus client. 

Currently there are five consensus clients and over five execution clients, each managed by dedicated teams. These teams are responsible for determining the best approach to developing the Ethereum software.¹ This signifies that Ethereum is resilient and can continue to operate and innovate even if one or more of the core development teams completely disappear.

The Ethereum Foundation is a non-profit organization that supports Ethereum and related technologies. Its main initiatives include the Ecosystem Support Program, organizing Devcon events, and facilitating the Ethereum Foundation Fellowship Program. These support channels fund various technological projects related to Ethereum, foster the community of developers and researchers, and bring talented individuals into the Ethereum community.² While the Ethereum Foundation decides who it supports within this ecosystem, the misconception that the Ethereum Foundation controls Ethereum overlooks the vast network of contributors and participants that make up the community.

From a wider perspective, the Ethereum Foundation supports the broader Ethereum ecosystem, of which core developers represent one part. Initially, the Ethereum Foundation may have leveraged its centralized power to shape Ethereum in alignment with the members’ vision. However, it has taken an increasingly supportive role through the initiatives presented, entrusting the community to decide Ethereum’s ultimate destination. Although this process may be less efficient than the former approach, it protects some of the core ethos of Ethereum, most notably, decentralized human coordination.

Now that we have identified the two groups as teams of developers and a supporting non-profit, how do these loosely connected actors make decisions?

Ethereum’s simplified off-chain governance process is outlined below.

1. Future changes are researched by Ethereum developers as well as miners, node operators, and other community participants, which may or may not be supported by the Ethereum Foundation and discussed publicly in online forums.
2. Specific upgrades are submitted formally via the Ethereum Improvement Proposal (EIP) process.
3. Core developers discuss changes and come to a social consensus on which to move forward with, leveraging forum-based discussions and other community channels to vote on each change as well as their respective priority levels.

This is an iterative process that may repeat multiple times for one Ethereum Improvement Proposal. The funnel signifies that anyone can actively participate in every step until the core developers ultimately decide to include it in their client implementations. 

The process highlighted above shows how the community partners with developers to attempt to achieve the best universal outcome for the protocol. However, there have been instances where social consensus could not be achieved on specific actions supported by core developers.

The clearest example of this was the DAO (decentralized autonomous organization) hack in 2016. A majority of the Ethereum community was in favor of reverting the blockchain to ensure that a hacker never took custody of the stolen ETH for the sake of network security. However, there were a minority of participants who disagreed and, therefore, never upgraded to the new chain that followed. 

This original chain, known as Ethereum Classic, still exists today. Its presence demonstrates that regardless of developers’ future attempts, network participants always retain control over which fork they follow, influencing the direction of network effects and value accrual. Although core developers may deploy upgrades on a technical level, support from nodes, users, and application developers are required for any upgrade to be accepted. 

Criticism #2: Ethereum’s High Fees Will Drive Users Away

Ethereum’s high fees are good for value accrual to the ether token but can be a challenge for users. However, price is a signal and Ethereum’s prices serve as an indicator that many users are still willing to pay for transacting on Ethereum. The recent rise in popularity of Layer 2 platforms provides plentiful options for users to transact at significantly less costs than base layer Ethereum. Currently, users must trade off some security for a better user experience when transacting on Layer 2 versus Layer 1. However, the shortcomings of Layer 2 security and liquidity are under development and the future trade-offs between the layers will continue to narrow.

Layer 2 platforms, which are separate blockchains settling on Ethereum periodically, are at the core of Ethereum’s ability to service mass adoption. While these separate blockchains typically accrue value to their own tokens, they still pay fees for storing their transaction data and proofs on Ethereum. Since these platforms have the capacity for massive transaction throughput, the long-term success of this specific type of application may provide sustainable revenue to Ethereum and ether holders if their applications become widely used.  

Throughout 2023, Layer 2 usage increased rapidly along with the value being stored in these ecosystems. This is a promising indicator considering the trade-offs in security and trust that are required to use these applications. As Layer 2 platforms continue to mature, the differences between security and liquidity of the layers will dissolve, providing users with similar guarantees to that of base layer Ethereum.

Criticism #3: Ethereum Is Only Used for Financial Speculation

Ethereum’s current main use cases are financial transactions mainly involving trading, borrowing and lending, and paying for digital assets. Throughout the 2022-23 bear market, large companies’ projects moved from proof-of-concept stages to full deployment on Ethereum. Much of this activity includes stablecoins, which have proven to be a lucrative business throughout 2023.

A commonly criticized aspect of Ethereum is the amount of speculative activity that it supports. Some of the largest consumers of gas throughout Ethereum’s history have been from trading related applications as well as NFTs. Yet there are some recent trends that highlight Ethereum’s potential to secure sustainable long-term revenue that isn’t reliant on pure speculation. The two interesting trends to watch over the next several years will be the value of stablecoins, their use for payments, and Layer 2 platform uptake. 

Layer 2 platforms present ETH holders a unique opportunity for potential future revenue because they provide users with competitively priced applications and are specialized to meet specific user demands. The upside for the base layer comes from the wide net that Layer 2 platforms cast for potential applications. If several of these Layer 2 applications become successful and obtain frequent usage, this could equate to sustainable revenue in the form of fees to the ETH holders. 

Many have argued that stablecoins have already proven to be Ethereum’s core application. Moving dollars across the globe instantly in a semi-permissionless manner is now seen as a substantial upgrade to legacy systems and is already facilitating a large amount of relative value transfer. 

The stablecoin USD volume blossomed from $8.5 billion in 2020 to $5 trillion in 2023.³ Although this extreme growth seems organic, it has stalled somewhat since the fall of Luna’s algorithmic stablecoin. In a dollar-denominated world, dollar-backed coins issued and used on public blockchain networks is likely to continue increasing.

The growing user base on Layer 2 platforms paired with the payment opportunities that stablecoins provide to a dollar-denominated world actively prime Ethereum for long-term sustainable usage.

Criticism #4: Proof-of-Stake Is Less Secure Than Proof-of-Work

Proof-of-stake and proof-of-work consensus mechanisms secure networks in similar but different ways, each with various trade-offs and attack vectors. Although proof-of-stake has not been in use as long as proof-of-work, Ethereum's history to date indicates that it has operated as intended, seemingly achieving the security necessary for its use case. While proof-of-work’s probabilistic security and simpler composition may make it more attractive for a simple money, proof-of-stake’s ability to garner a larger economic security threshold makes it a worthy consensus mechanism for other use cases. 

These trade-offs in the way systems align and connect individuals are important to understand because they are at the heart of distributed systems. Noteworthy differences between the consensus mechanisms are addressed here:

Arguably the largest difference not addressed in the table above is the ability to effectively resolve attacks once they have happened. Given the potential for both Bitcoin’s 51% attack and Ethereum’s various possible attacks at any time, the natural question arises: What if an attack does occur?

Ethereum resolution mechanisms, carried out by the more active social governance layer, ensure that the attacker gets ejected from the validator set and may lose all rewards and principle of their stake. In proof-of-work, there is no option to make the attacker's mining hardware useless without harming the rest of the miners.

Criticism #5: Ethereum’s Crowd Sale Is Harmful to the Current Proof-of-Stake System

Quantifying the crowd sale’s precise impact is challenging due to the participants’ anonymity. Nevertheless, Ethereum’s governance is not influenced by stakeholders, meaning that entities retaining their ether are subject to the same network rules as all other participants. While the mechanism of crowd sales can be unfair and benefit insiders asymmetrically, the network’s overall health and governance is still buffered by Ethereum’s high economic security model and the ability for Ethereum’s social layer to render an attacker’s stake worthless. In the case of Ethereum’s crowd sale, of the ~72 million ether distributed before genesis, 12 million ETH was allocated to early contributors and the Ethereum Foundation. Ethereum benefited from years under a proof-of-work system as well and, over time, ETH’s high usage and price appreciation has resulted in an increasingly large holder base.

The first 14 days of the ether offering started with a discounted exchange rate of 2,000 ETH for one bitcoin (BTC). Thereafter, the discount began to decline to a final rate of 1,337 ETH:1 BTC. The total sale period lasted 42 days where ether sold for roughly $0.29 to $0.40 per token. Roughly 60 million ETH was sold to the public before the network’s launch and an additional 12 million were distributed between early contributors and the Ethereum Foundation.

These sale and distribution numbers mean that 72 million of the current ETH supply of ~120 million, or 60%, was created outside of any consensus mechanism’s issuance. This does not account for the loss, burning (fees), or spending of that supply over time—nor does it account for any additional accumulation from purchases or staking rewards, all of which would raise or lower that percentage.

Below is a breakdown of balances on the execution and consensus layers respectively. Execution layer balances represent non-staked ether, while consensus layer balances represent staked ether.

Execution Balances as of 1/24/2024⁴:

 For further clarity, the six addresses listed in the 1 million + category include⁵:

1. Beacon Deposit Contract (Where validators deposit ETH)
2. Wrapped Ether Contract
3. Binance
4. Kraken
5. Robinhood
6. Arbitrum bridge

Consensus Balances as of 1/24/2024⁶: 

Criticism #6: Ethereum Is Too Complex

Ethereum’s most concerning complexity is the fluidity of its codebase. With hard forks occurring every six to 12 months, this is a recurring introduction of technical risk and associated smart contract risk to dependents. The argument against complexity is not that complexity is inherently bad, but that the protocol may not have enough developers and researchers looking at the first and second order effects from these ongoing changes. 

While there have not been any significant signs of bugs since 2016, Ethereum’s future roadmap continues to add complexity into the system. Therefore, there is reason for investors to allot some probability of a network disruption. To non-technical investors, the Lindy effect is a key driver for investors’ perception of technical risk. This means the longer that the codebase goes unchanged, the perceived risk of the code being exploited is increasingly lower.

To the outside world, code changes come with a lot of unknowns and investors have historically positioned themselves accordingly. However, what will it take for Ethereum to avoid this recurring heightened risk? The answer is to ossify portions of the codebase so that investors can become increasingly confident in its resiliency. This is an important step for investors’ willingness to store value in the asset because they can be sure that certain core functions of the system will remain untouched while still being able to add or adjust newer features. The future of code ossification remains to be seen, but for now, developers seem to have quite a full roadmap for the next several years. 

Ethereum has maintained the largest and most consistent developer activity of all digital assets, yet it is unclear if developer count has scaled appropriately alongside its codebase. Ethereum’s complexity is clearly a double-edged sword.

Criticism #7: Lido Is a Threat to Ethereum Security

Lido is a DAO-governed application that connects ether (Ethereum’s native token) holders to validator node operators, allowing all ether (ETH) holders to earn rewards on their coins by exchanging ether for a liquid staking derivative that represents their principal and rewards. Lido has 30+ separate node operators acting independently of one another to earn validator rewards. Lido governance, in its exact current structure, is an area of concern and may be prone to conflicts of interest for which solutions have been suggested by many in the community. 

Since Lido has a lot of staked ether within its application, natural concerns arise around what kind of damage it can cause to Ethereum security. While the Lido-DAO controls many key operations within the application, it appears that many risks are overstated, while some go unnoticed. The current ~33% staked market share significantly limits possible attacks that could permanently harm the Ethereum network with the most devastating possible impacts only harming liquid staked ether holders.

Structure of the LDO DAO

The LDO governance token is used to participate in votes to decide several important topics, including:

• Eligibility for staking

• Fee structures

• Expansion of the application to specific ecosystems

• Updates to smart contracts
  
  

Incentives 

Node operators are all known entities in varying jurisdictions. They are incentivized to keep the network secure and distribute rewards to liquid token holders because these customers represent their business’ future cash flows. The legal and business-related costs of their role incentivize them to operate in a way that continues to attract and maintain staked ether within Lido. However, liquid staked token holders trust the node operators completely because the ones controlling the hardware determine exactly how the validators are run.

LDO holders are incentivized to maintain staking dominance because a portion of the staking fees that Lido generates are directed to the Lido treasury that the DAO controls. This incentive alignment is also a form of economic security because malicious tampering with the Lido application for short-term profits would be sacrificing long-term cash flows.

It is important to note that LDO holders pose the greatest threat to those participating in the application. Since they can use their votes to change portions of the Lido codebase, the possibility of attack is greater. Currently, the highest concern attack vectors are colluding with node operators to steal all of the ether deposited into Lido and coercing node operators to censor transactions or participate in malicious activities that earn larger validator rewards.⁷

Under Lido’s current structure, application participants rely on trust and the economic security of future cash flows as a preventive mechanism, despite the potentially significant legal and social consequences.  However, members of the Lido community appear to understand the position they are in and have proposed various solutions to minimize trust and actively prevent large-scale attacks.

Lido has also prioritized mitigating smart contract risk by carrying out extensive audits for any upgrades and would likely avoid more well-known direct attacks on the network. However, as Lido continues to accrue more stake, the governance mechanism becomes more important to ensure a reduction in conflicts of interest and overall control of staking permissions and application changes.

Conclusion

Change is the only constant in the digital assets ecosystem, so it is important to continue adjusting your viewpoints. While many of these criticisms have been acknowledged over time, solutions continue to be implemented and new unknowns may arise.

Among the proposed criticisms, many are being actively solved for and may prove to be an overhyped phase of the development cycle. These include: 

• Lido is a threat to Ethereum security.

• Ethereum's crowd sale is harmful to the current proof-of-stake system.

• Ethereum is too complex.

• Ethereum's high fees will drive users away.

• Ethereum is only used for financial speculation.

Other notable criticisms appear to have more staying power in community minds, and only time and continued success may qualm these worries, including: 

• The Ethereum Foundation and core developers control Ethereum.

• Proof-of-stake is less secure than proof-of-work.

We will continue to monitor these developments and provide insight on the evolution of the Ethereum ecosystem as is required as an investor in an ecosystem where change is constant.

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