Deep Dive Research
02 Feb 2023
A new class of DeFi protocols known as "liquid staking derivatives," or "LSD", enables users to earn staking rewards on various cryptocurrencies without having to actively manage the underlying assets.
Ethereum developers have stated that the Shanghai upgrade will enhance the blockchain's maximum transactions per second (TPS). The main improvement, coined as EIP-4895, allows stakers who have staked ETH into the Beacon Chain since December 2020 to withdraw ETH with low fees after 2 years.
According to Messari, although ETH's staking market cap stands out to be the highest, its total staked tokens only account for 14% (or 13.68% as per @hildobby’s Dune data) of total circulating supply which is much lower than other layer-1 blockchain including the giants BNB chain, Solana and Cardano. This is primarily because Ethereum requires a very ‘costly' minimum staking amount - 32 ETH.
Before EIP-4895 is introduced, staking ETH has always been a one-way path. Users who want to earn secured APY rewards from staking must lock up a certain amount of their ETH for a fixed amount of time, which means the assets cannot be transacted, traded, or used as collateral or in other words, illiquid.
Thus, users are required a minimum investment of 32 ETH and sophisticated technical skills to set up a validator node on the Beacon chain prior to the Merge if they want to stake their ETH.
However, liquid staking platforms, like Lido Finance, accept token deposits and perform the staking process on behalf of the depositors who do not have to hold and manage the underlying assets.
In exchange, the depositor receives a receipt in the form of an ERC20 token, such as stETH (staked ETH), which can be traded or used as a collateral on other platforms. Besides, they can redeem the receipt for their original staked tokens at any time.
Investors can earn additional yields from liquidity pool, lending, yield farming to derivatives besides earning rewards for staking.
For instance, after staking ETH on Lido, users receive stETH that can also be deposited on another platform such as Harvest to earn yields.
Staking through an exchange may be easier for an average user to navigate, but it also comes with the risk of centralization and the potential loss of all staked capital if the exchange is attacked.
An alternative option, liquid staking, simplifies the process by having built-in protocols that select trustworthy validators. In addition, these platforms hardly suffer from downtime with no history of slashing, while also allowing users to retain the liquidity of their staked assets.
The ability for a PoS network to validate transactions on the blockchain is determined by the amount of funds available in the validators' wallets and the amount staked. The more validators and the more funds that are staked, the stronger the network becomes.
Liquid staking offers a more secure option since the program relies on the proof-of-stake (PoS) network itself, meaning that even if a DeFi project fails, users can still rely on the base yield from the PoS network.
This incident refers to the possibility that a smart contract, which is a self-executing contract that automatically enforces the rules and penalties of an agreement, may have a flaw or be compromised. The consequence can range from loss of staked assets to a potential loss of confidence in the underlying protocol.
Liquidity pools, which are pools of digital assets that are used to provide liquidity to the underlying protocol, require a constant balance of assets in order to function properly. If too many users withdraw their assets at once, it can cause the pool to become illiquid, resulting in a loss of value for stakers.
This is also a concern for stakers, as the value of the assets staked in a liquidity pool can be affected by market conditions. If the value of the assets drops, stakers may lose money even if they are earning a return on their investment.
This refers to the risk that the team behind a liquid staking pool may not manage the project well, leading to a potential loss of staked assets.
Furthermore, it is important to note that not every liquid staking protocol allows the user to retain governance voting rights. This means that if a protocol is successful in attracting many stakers and delegating tokens to a relatively small group of validators, it could centralize governance ownership and essentially take control of the blockchain. .
Depegging takes place when the liquid staking service does not have enough runway (treasury) to imburse users.
The risk is a direct result from the fact that many of the derivative tokens rely on trading pegged to the native token. A significant imbalance of the native token could lead to additional selling and quickly pushing things down a death spiral.
According to DeFi Llama, users can earn as much as 121% when they stake their stETH in certain parts of the ecosystem.
It can be observed from the data in Figure 2 that Liquid Staking platforms are dominating in terms of ETH staked with up to 33.3%, outpacing CEX, which only accounts for 28.2% of total ETH Staked on all platforms.
According to Defi Llama (Figure 3), Lido has the highest Total Value Locked of $8.58B and commands more than 29.2% of ETH staked compared to both decentralized and centralized platforms (Figure 4), further solidifying its position as the most widely used protocol among all platforms. This wide adoption of Lido's services could signal that Liquid Staking is quickly gaining popularity in the DeFi space (since 2022).
It is likely that the price of ETH may drop after the Shanghai upgrade due to the fact that stakers are able to sell their coins in large outflows. However, the likelihood of a significant drop in price is relatively low due to the fact that the Ethereum network has a relatively small staking ratio of 14%, compared to other blockchains - as explained above.
Additionally, the protocol limits the number of coins that can be withdrawn per epoch. What they mean is even if stakers want to sell their coins immediately following the upgrade, it will take a significant amount of time for all of the staked ETH to be sold. With 17 million ETH currently in stake, it would take a year of constant withdrawals to fully drain the staked ETH for selling purposes.
Furthermore, 60.2% of staked ETHs are underwater, which means that if users are to sell their tokens at the time of the Shanghai upgrade, they could potentially suffer a loss since it is currently unknown if the market is in a bull run.
In our view, it is quite clear that these market participants with staked ETHs are long-term Ethereum supporters rather than short-term traders seeking gains from ETH’s Merge hype.
Liquid staking platforms, such as Stakewise, Lido, and Rocket Pool, are becoming more popular among Ethereum bulls as a way to earn rewards for staking their ETH. These platforms offer advantages such as the combination of yield strategies and ease of use, but also come with significant risks such as smart contract and liquidity risk, market risk and operational risk. It is important for investors to always stay informed about the latest developments, and take appropriate measures to mitigate risks before deciding to engage in liquid staking.