The State of ETH Liquid Staking
Introduction
The Ethereum network began its shift to a proof-of-stake (POS) consensus mechanism with the recent release of Ethereum 2.0. People could now stake their Ether on the Beacon Chain to secure the blockchain and earn staking incentives in proportion to the number of tokens staked.
This imposed numerous limitations on individuals who wished to become validators.
- To stake on Ethereum 2.0, users were required to stake a minimum of 32 ETH to become a full validator, while holding less placed them in a staking pool.
- To participate in the validation and consensus of the POS blockchain, token holders had to stake their tokens for a set period in a wallet. This meant that the individual could not access or utilize their tokens until transactions are enabled.
The illiquid nature of staking has proved to be one of the greatest limitations as users who have staked their Ether into the Ethereum deposit contract may only unstake their tokens once the transactions are enabled for the release of staked Ether. The Shanghai upgrade, responsible for enabling transactions, is targeted to happen in March 2023, but currently has no official date.
Due to the long lockup period and unpredictable waiting times, these limitations have dissuaded many from staking their Ether. As a result, the concept of liquid staking gained traction on the Ethereum network, with more projects and protocols launching staking pools and staking-as-a-service platforms for token holders to maximize the returns on their idle Ether.
So what is Liquid Staking?
Liquid staking is an alternative to locking up a user’s stake while sidestepping the risks associated with illiquidity, complexities, and centralization. It allows for users to stake any quantity of Ether while being able to unstake their Ether without the requirement of transactions being enabled. This solves the problem of high barriers to entry and the illiquidity problem altogether.
A liquid staking provider takes token deposits, stakes those tokens, and gives the depositor a receipt which is redeemable for the staked tokens. The receipt through the issuance of a tokenized version of the staked funds — a type of derivative that can be transferred, stored, spent, and traded as a regular token. This representative token will allow users to maintain their ETH liquidity, whilst still earning staking rewards.
Liquid staking is achieved by depositing tokens in liquidity pools governed by decentralized autonomous organizations (DAOs) that generate new tokens that can be traded while still eligible for staking rewards. This mechanism is beneficial for both the user, allowing them to capitalize on market fluctuations and for the network, providing more decentralization, liquidity, and security.
The State of Ethereum Liquid Staking
Currently, only 13.81% of Ethereum’s total supply is staked on the Beacon Chain, which is low compared to other PoS chains such as Cardano, which has a staking ratio of 71.87%, Cosmos Hub, which has a staking ratio of 62.79%, and BNB Chain, which has a staking ratio of 97.14%. As mentioned previously, the primary reason for Ethereum’s low staking ratio is that staked Ether is locked in its current state and users are wary of the lengthy and uncertain staking timeline.
In contrast to other DeFi protocols like DEXs and lending protocols, liquid staking solutions saw a continuous increase in TVL over 2022. The Ethereum liquid staking landscape started growing in mid of 2021. Protocols for liquid staking, such as Lido, Rocket Pool, and Stakewise, enabled ETH holders to stake without running a full validator node. Since Ether is pooled on these protocols, there is no minimum staking requirement of 32 ETH per user. Now, users can stake fractions of Ether, lowering the entry barrier for staking.
In 2023, liquid staking is the largest staking deposition sector in the Beacon Chain, with a market share of 32.58% and almost 7 million Ether deposited, compared to 28.82% for CEXs. The rise of liquid staking on Ethereum can be largely attributed to the constraints in Ethereum’s staking mechanism.
The Landscape of Liquid Staking Derivatives (LSDs)
As we delve deeper into these liquid staking derivatives, we find that the vast majority of the locked value is concentrated in a handful of protocols, Lido in particular. Lido has exploded in popularity as the first protocol to implement a liquid staking derivative on the Ethereum network. With a market share of 29.12%, Lido is now the market leader in this new competitive landscape, having become the largest Beacon Chain staking depositor.
When pegged against competitors in the sector, Lido is currently the most dominant, holding 88.4% of the total Ether locked in liquid staking derivatives (LSDs), ahead of competitors such as Rocket Pool with 5.4%, and StakeWise with 1.35%. Over the past year, we have seen the total ETH deposited (excluding interest) in Lido rise by over 285%.
As the old adage goes, “With great power comes great responsibility.”
The dominance of Lido as an LSD and staking solutions provider could expose the entire Ethereum blockchain to the risk of a centralized attack. This was mentioned in an article by Danny Ryan, in which he also suggested that LSD protocols should self-limit in order to avoid centralization and protocol risk that could effectively destroy their product.
The Shanghai Upgrade
The upcoming Shanghai upgrade, targeted to launch in March 2023, will enable the withdrawal of staked ETH along with other additional minor improvements. The highlight of the Shanghai upgrade is the EIP-4895 proposal, allowing those who have participated in staking ETH into the Ethereum Deposit Contract to withdraw funds and redeem staking rewards.
Shanghai will give investors their first opportunity to unload their Ether, some of which have been staked since 2020. The estimated total amount locked is currently nearly 16 million, worth around $21.4 billion.
What can we expect to see after the upgrade?
With the release of the Shanghai upgrade, we foresee a rise in the number of users who stake their Ether. Due to the lack of withdrawal options prior to this release, many were hesitant to participate in staking. However, now that withdrawals are possible, a greater number of individuals will choose to stake their Ether and will likely opt for liquid staking solutions.
This will result in an increase in revenue and fees for LSD protocols as more ETH is staked. Additionally, some users may decide to transfer their staked Ether from the current leading projects to other protocols to achieve higher percentage returns and enhanced decentralization.
As mentioned by Ganesh Kompella, founding investment partner at Tykhe Block Ventures, “Many are anticipating “The Great LSD War” as liquidity hunters seek to support their staked assets and potentially revive their portfolios”. As all investors seek to maximize their profits, they will eventually gravitate toward protocols that enable them to achieve the highest returns.
Effects on LSDs
So why is the Shanghai upgrade advantageous for LSDs? Well, withdrawals will give users more confidence in staking their ETH, which will increase staking participation and have a significant impact on LSD revenue.
In addition, withdrawals will have an effect on the expense side of LSD protocols. Until now, most emissions have been spent on maintaining the staked ETH derivative/native ETH peg because there was no natural way to do so. In Blockworks’ 2022 Year End Review article, research analyst Dan Smith noted that the inability to directly arbitrage via withdrawals posed one of the greatest challenges for staking derivatives: maintaining price parity between $stETH and $ETH. Consequently, the Shanghai upgrade should help to alleviate price concerns while providing users with the option to obtain their ETH.
With more stable prices, liquidity will increase as more liquidity providers become comfortable with the reduced risk of a stETH to ETH depeg. With increased liquidity, ETH holders will be more likely to stake, as they will be able to sell their LSDs back to ETH if they cannot wait for unstaking.
Lido has maintained its position as the DeFi protocol with the highest TVL since 2 January, when it surpassed Maker. In the weeks leading up to Shanghai, governance tokens of liquid staking protocols have risen to all-time highs. Over the past two weeks, $LDO, $RPL, and $SWISE have gained more than 50%. As consumer sentiment continues to rise, this can provide a good indication of what to expect after Shanghai.
To appropriately assess the effects on LSDs, we must first monitor how each staking solution develops its withdrawal capability, which has not yet been specified, and the withdrawal queue waiting time, which is dependent on the total amount of unstaked ETH at any one time. As March approaches, we will presumably receive additional information from LSD protocols, and once withdrawals go live, we will be able to estimate the average exit queue period more accurately.
Outlook on Liquid Staking Landscape
On a broader scale, we could anticipate that the percentage of ETH supply staked (currently 13.3%) will increase to 25–30% in the short term and 45–50% in the long term, bringing it closer to the average of other chains (~ 60%). The majority of these would likely stem from LSD protocols such as Lido, Rocket Pool, etc.
When withdrawals are enabled, will there be no pressure to sell ETH?
Well, through a closer examination of the ETH staked, it is revealed that only 28.3% of ETH stakers are “in the money”. This means that the remaining 71.7% of investors are currently in the red, and we can anticipate that the selling pressure will be quickly absorbed.
With the exponential growth of liquid staking protocols and the release of the Shanghai upgrade, while addressing concerns regarding centralized exchanges such as FTX and Gemini, there is a need for decentralization. It is probable that each of these occurrences will have an impact on the landscape of liquid staking. So, let’s break it down and examine what lies ahead.
The Shift in Power of LSD protocols
While Lido remains the market leader in this respect, other protocols are also gaining significant relevance through the liquid staking market with Rocket Pool and Stakewise soon launching their V3 and newer players like Stader Labs, Frax and Liquid Collective entering the market. Although these protocols only have a minority market share, withdrawals will allow for stakers to move quickly between different solutions.
According to Kunal Goel, a researcher at Messari, “There was an expectation that liquid staking might become a winner-take-all market, but with Lido’s share likely capped, it is more likely to be an oligopolistic market structure like stablecoins with 3–4 major players.” In addition to previous concerns about Lido’s dominance and risk of vulnerability to centralized attacks, we can anticipate that other LSD will attract more investors and compete with Lido for market share.
In addition to fees and annual yield, key metrics to consider when determining which LSD protocols will likely be able to compete with Lido include their governance token mechanisms, number of node operators, liquidity of liquid staking tokens, and their individual liquid staking tokens’ composability with other DeFi protocols. With their first-mover advantage, Lido has created an ecosystem where $stETH can be used in other protocols such as Curve, MakerDAO, and AAVE. Thus, it will be crucial to observe how these other LSD protocols innovate and develop a staking solution that can compete with Lido.
The inflow of TVL from Centralized to Decentralized
In addition, after the collapse of FTX, there is significantly less trust in centralized service providers, CEXs, and staking solutions alike. Decentralized solutions are more secure and transparent as they are not controlled by a single entity. Additionally, decentralized staking solutions may offer better returns to investors due to their typically lower overhead and lower fees.
The decentralized nature of these solutions can also increase the availability and accessibility of staking for individuals and organizations. Decentralized trustless protocols can therefore expect an influx of TVL from centralized actors and further secular growth.
Innovation in DeFi Landscape
Given the rapid growth of LSD protocols, it is also critical to understand how this will impact the DeFi landscape. We are aware that Lido has surpassed Maker as the largest DeFi protocol and has grown at an impressive rate despite the bearish market conditions. But how will all of this affect the market after Shanghai in the long run?
From the above analysis, we can expect that Investors may move newly unstaked Ethereum to LSDs in order to take advantage of higher yields and DeFi composability. This could result in a struggle for liquidity amongst the major DEXs, such as Curve and Balancer, as they will seek to offer deep liquidity to attract investors. Importantly, protocols such as Aura and Convex may play a big role in liquidity provision and incentives. This scenario is especially interesting because it could create more competitive pressure among DEXs and lead to greater DeFi innovations and developments.
Concluding Thoughts
The landscape of liquid staking has flourished in 2022 and the first few weeks of 2023, as liquid staking derivatives have grown steadily despite the market downturn and even reached new monthly highs. With the Shanghai upgrade slated for release in a few months, we can anticipate an influx of Ethereum stakers, the majority of whom will likely opt for liquid staking solutions such as Lido, Rocket Pool, StakeWise, etc.
2023 could also be the year in which Lido’s market share declines due to the entry and expansion of competitors. As stakers gain greater control and mobility over their stakes, liquidity hunters may seek opportunities in the form of higher yields or token composability with other DeFi protocols. Overall, the liquid staking landscape appears bullish, especially with the Shanghai upgrade on the horizon and the possibility of additional stakers joining the race.
Written: 12/1/2023
