How Ethereum 2.0 is Transforming DeFi

In June, the SEC’s decision to drop charges against Ethereum marked a significant milestone in the platform’s journey toward maturity and broader recognition within the financial industry.

For those unfamiliar with the case, the SEC had alleged that Ethereum (ETH) was sold as an unregistered security, raising concerns that its sale did not adhere to certain rules and protocols. However, Ethereum’s advocates argued that because the network is decentralized, it doesn’t meet the criteria for an investment contract or security.

While the SEC chose not to pursue legal action directly, it opened the door to further discussions about decentralization. Some technical aspects of Ethereum’s architecture sparked important conversations about contract rights among influential entities. Although these discussions have largely remained internal, resolving these issues could strengthen the network’s upgrade goals and support true decentralization.

This is particularly relevant as the network seeks to embody the ideals of “Ethereum 2.0,” a version of the token and infrastructure that is stronger, more accessible, and more practical. Some argue that it has already arrived, while others point out that there are still gaps to fill before it can be fully realized.

Yes, Ethereum 2.0 has the potential to revolutionize DeFi and the broader ecosystem, but we can’t afford to take only half-steps. Significant progress is still needed to unlock its full potential.

Validator Centralization

By transitioning to a Proof of Stake (PoS) mechanism in September 2022, Ethereum now allows validators to stake ETH, with larger stakes increasing validation opportunities and rewards. This upgrade clearly highlights Ethereum’s pivotal role in DeFi, as it spurred the creation of countless innovative financial tools on the network for use cases such as lending and trading.

However, emphasizing token ownership over the number of validators risks concentrating power in the hands of a smaller group, which goes against the spirit of decentralization that cryptocurrency embodies. Moreover, staking requires 32 ETH, meaning that validators with a large amount of staked ETH could disproportionately influence network governance and decision-making. This could create a feedback loop that favors certain participants, concentrating power and wealth among a few.

In March of this year, Vitalik Buterin even expressed concerns about “lazy stakers,” those who participate in staking pools rather than staking individually—indicating the relevance of the centralization issue.

In essence, Ethereum represents a shift in the way financial services are designed, accessed, and used. However, relying on a small number of entities continues to pose risks and raises questions about how decentralized Ethereum 2.0 truly is.

The Shift to DeFi

Ethereum’s path toward centralization lays the groundwork for more complex issues in the future, such as increasing regulatory scrutiny and decreased network resilience. Ultimately, Ethereum’s future in DeFi and the broader blockchain ecosystem hinges on balancing technological advancements while minimizing centralization. And there are many ways to achieve this.

If properly implemented, concepts like Rainbow Staking could further enhance Ethereum’s adaptability while combating centralization. Essentially, Rainbow Staking allows users to stake ETH across multiple pools and strategies, effectively creating a “rainbow of rewards” where stakers receive benefits while reducing anti-competitive risks and building a more resilient ecosystem. The ETH validation process could be divided into “heavy” and “light” staking—”heavy” staking focuses on finalized validation services, while “light” staking focuses on censorship resistance of transactions.

For instance, liquid staking protocols like Lido or Rocket could provide heavy-service staking, while existing stakers could choose to run light-service operators. Rainbow Staking would ultimately lead to a more efficient, competitive network while giving liquid staking providers more diversity. However, implementing it isn’t easy and could disrupt the entire staking structure.

Beyond Rainbow Staking, Ethereum could also leverage the network-wide improvements introduced in its initial 2.0 updates, such as sharding. While sharding has been scrutinized due to security concerns, prompting the shift toward Layer 2 and zero-knowledge (ZK) development, it shouldn’t be abandoned entirely.

We’ve already seen evolution here, thanks to developments like “Danksharding” aimed specifically at Layer 2. Danksharding involves Proposer-Builder Separation (PBS), a departure from how Ethereum validators currently operate—proposing and broadcasting blocks entirely on their own. Instead, PBS shares the tasks across multiple validators.

Ultimately, Danksharding facilitates data availability, allowing validators to efficiently verify blob data while identifying missing data.

The goal is to enable users to complete Layer 2 transactions at the lowest possible cost, scaling Ethereum to validate over 100,000 transactions per second. This would allow dApps like Uniswap to process transactions at a lower cost and reduce transaction approval times.

However, Danksharding’s highly technical infrastructure and implementation overlook smaller rollups and may encourage centralization. Therefore, while the technology has fallen out of favor, its advantages in reducing hardware needs and enhancing scalability suggest it could be improved to benefit the next generation of Ethereum—perhaps Ethereum 3.0.

Conclusion: Navigating the Road Ahead

Ethereum 2.0’s significant strides in regulation and decentralization cannot be overlooked. Reducing the network’s reliance on small groups of participants for network operations and achieving legal victories are positive steps forward. However, the next phase of Ethereum as a network must involve adapting to evolving legal requirements to firmly establish itself as a transformative force in DeFi and mainstream blockchain usage.

Despite these hurdles, Ethereum 2.0’s current achievements have set the ecosystem on the right track. By focusing on the future and reaffirming its commitment to decentralization, Ethereum has the power to maintain its dominant position as an innovator in the blockchain space.