Lido, the dominant player in the rapidly growing liquid staking space, is in the midst of a dramatic potential governance overhaul. Lido Improvement Proposal 28 (LIP-28) strengthens stETH holders’ governance power by giving them voting power directly. This improvement addresses possible conflicts of interests between LDO and stETH token holders. This article explains the proposed changes in more detail. It examines what these changes would mean for Lido’s competitive advantage and the broader DeFi ecosystem.

Understanding Lido and Its Governance

With Lido, no users can instantly stake all their ETH. In exchange, they get stETH, a liquid token that represents their staked Ethereum and rewards earned to date. This stETH can then be deployed into other DeFi applications, freeing up liquidity for staked assets. Right now, governance decisions for Lido are mostly in the hands of LDO token holders. LIP-28 is intended to change this dynamic. It takes a big step further by introducing a dual governance system which acknowledges how important stETH holders are to the Lido ecosystem.

The heart of the problem is the misalignment of interests that can be created. In comparison, stETH holders’ interests lie only with the security and yield of their staked ETH. This divergence in perspective can lead to deep divisions when important governance proposals arise. What once helped one community now harms another community. LIP-28 is a positive step to address these conflicts and establish a more balanced and representative governance model.

The proposal reflects the collective understanding that stETH holders are the most aligned with the health and security of the protocol. In many cases, they’ll care about it even more than LDO holders. After all, the value of stETH is intimately connected to the reputation and robustness of the Lido protocol. By giving stETH holders a direct voice, LIP-28 aims to ensure that their concerns are adequately addressed in governance decisions.

LIP-28: Empowering stETH Holders

LIP-28 implements a Dual Governance mechanism which gives stETH holders direct voting power in parallel with current LDO token holders. This is not a straightforward sum of votes cast — it is an intricate and thoughtfully crafted process that has checks and balances embedded within it. The heart of this mechanism lies in the two-tiered threshold system, as well as the “rage quit” mechanism.

The Two-Tiered Threshold System

The two-tiered threshold system gives stETH holders a greater say in governance proposals. It operates as follows:

  • Proportional Timelock (1% Threshold): If the amount of stETH committed to opposing a proposal reaches 1% of Lido's total Ethereum TVL (Total Value Locked), a proportional timelock is activated. This timelock delays the execution of the proposal, giving stETH holders time to evaluate the potential impact and coordinate a response. This allows for more in-depth discussion and ensures that stETH holders have a chance to voice their concerns before a decision is finalized.

  • Rage Quit Mechanism (10% Threshold): If the amount of stETH locked against the proposal surpasses 10% of Lido's Ethereum TVL, a "rage quit" mechanism is triggered. This mechanism halts the execution of the proposal entirely until all escrowed assets are withdrawn. This effectively gives stETH holders a veto power over proposals that they deem detrimental to the protocol or their interests.

This is truly a safety net system. Third, it prevents harmful proposals from going into effect unless the stETH holder community successfully fights back with a strong enough voice. The team has intentionally set the thresholds high in order to ensure that the mechanism isn’t activated over trivial concerns. This practice is particularly important to guarantee that it really stops the truly awful choices.

How It Works in Practice

Now let’s say a proposal is made to change the distribution of Lido’s staking rewards. Many stETH holders may feel that this amendment would be harmful to their returns. Here's how the Dual Governance mechanism would work:

  1. Initial Proposal: The proposal is submitted and open for voting by LDO holders.
  2. StETH Holder Opposition: StETH holders who disagree with the proposal begin locking their stETH against it.
  3. 1% Threshold Triggered: If the total amount of stETH locked reaches 1% of Lido's Ethereum TVL, a proportional timelock is activated. This delays the execution of the proposal.
  4. Continued Opposition: StETH holders continue to lock their stETH, further demonstrating their opposition.
  5. 10% Threshold Triggered: If the total amount of stETH locked reaches 10% of Lido's Ethereum TVL, the "rage quit" mechanism is triggered.
  6. Proposal Halted: The execution of the proposal is halted until all escrowed stETH is withdrawn. This effectively kills the proposal unless significant changes are made to address the concerns of the stETH holders.

This is a prime example of the value-added benefit of their Dual Governance mechanism, working. This empowers stETH holders to protect their interests and future-proof the Lido protocol.

Potential Impact on Lido and DeFi

If LIP-28 were to be implemented, it would mark a huge blow to Lido as well as the DeFi space as a whole. Let's consider the potential benefits and risks:

Potential Benefits:

  • Increased Protocol Resilience: By giving stETH holders a greater voice, LIP-28 can make Lido more resilient to attacks and bad governance decisions. A more engaged and empowered community is more likely to identify and address potential problems before they escalate.

  • Improved Governance: The Dual Governance mechanism can lead to more balanced and well-considered governance decisions. By requiring proposals to be vetted by both LDO and stETH holders, it ensures that all stakeholders' interests are taken into account.

  • Enhanced Decentralization: LIP-28 promotes greater decentralization by distributing power more evenly between LDO and stETH holders. This can make Lido more resistant to censorship and control by any single entity.

  • Attracting More Stakers: A governance model that prioritizes staker autonomy and DAO accountability can attract more users to Lido. Stakers are more likely to trust a protocol where they have a direct say in its direction.

  • Setting a Precedent: LIP-28 could serve as a model for other DeFi protocols looking to improve their governance structures. The Dual Governance mechanism could be adapted and implemented in other contexts to address similar conflicts of interest between different stakeholder groups.

Potential Risks:

  • Governance Gridlock: The Dual Governance mechanism could potentially lead to governance gridlock if LDO and stETH holders consistently disagree on proposals. This could slow down the development and evolution of the Lido protocol.

  • Complexity: The two-tiered threshold system adds complexity to the governance process. This could make it more difficult for users to understand and participate in governance decisions.

  • Potential for Manipulation: While the thresholds are designed to prevent manipulation, there is always a risk that malicious actors could find ways to exploit the system. For example, a group of stETH holders could collude to trigger the "rage quit" mechanism for purely selfish reasons.

  • LDO Token Value: Some LDO holders may perceive the Dual Governance mechanism as a dilution of their power, potentially leading to a decrease in the value of the LDO token.

  • Smart Contract Risks: As with any smart contract implementation, there is always a risk of bugs or vulnerabilities that could be exploited. The LIP-28 implementation will need to be carefully audited to minimize this risk.

Perspectives of LDO and stETH Holders

Grasping the interests of LDO and stETH holders is key to assessing the real-world effects of LIP-28.

Some LDO holders might welcome LIP-28 as a way to improve the long-term stability and sustainability of the Lido protocol. They may be right in thinking that a more engaged and empowered stETH holder community will lay the bedrock for their long term public good. Other LDO holders would be concerned about losing their power. They are concerned about the possibility of governance gridlock developing. They may counter that the status quo governance model is already working and LIP-28 is not needed.

stETH holders are likely to view LIP-28 as a positive development. In turn, they get a direct say on how decisions affecting their staked assets are made. This provides an opportunity to protect their bottom line. If they are smart, they will be very pleased with the autonomy and accountability to come from the Dual Governance mechanism. Other stETH holders may be wary of the added complexity of the system and risks of manipulation.

Conclusion

Lido’s Dual Governance proposal (LIP-28) is a promising move in the direction of more decentralized and participatory governance, a critical dynamic within the nascent DeFi space. LIP-28 focuses on making sure stETH holders have voting power in a decentralized manner. In addition, it implements a two-tiered threshold system to address conflicts of interest and increase the resilience of the protocol. This innovative governance approach does have its risks. It does provide significant advantages, such as greater public involvement, better governing, and more beneficial forms of decentralization. All great things LIP-28 will achieve depend on the smart contracts getting implemented properly. It depends on LDO and stETH holders’ willingness to communicate in good faith and negotiate towards a mutually beneficial solution. Lido development is dynamic and ongoing. The Dual Governance mechanism provides an interesting case study for other DeFi protocols looking to give more power to users and build longer-lasting, more resistant ecosystems.