Liquid Staking

Introduction

Ethereum’s shift from proof-of-work to proof-of-stake enabled ETH holders to stake their tokens and help secure the blockchain network. As compensation for securing the network, stakers are rewarded with additional ETH tokens. At first, stakers were required to post 32 ETH (the minimum amount to run a node), and the user’s ETH tokens were to be locked until the Shapella upgrade was completed (successfully completed in March).

Due to the capital requirements and the illiquidity of staking ETH, a new financial primitive called a Liquid Staking Derivative (LSD) was created. LSDs (sometimes referred to as Liquid Staking Tokens, or “LSTs”) are protocols that enable ETH holders to stake their tokens but continue to use their collateral value in other DeFi applications and allows ETH holders to participate in staking without needing to provide a full 32 ETH or operate a node. LSDs allow users to deposit ETH into the protocol and receive a tokenized financial equivalent of their staked position. Each token is able to be redeemed on a 1:1 basis for the underlying asset, thus preserving their value. These derivative tokens have been integrated into the DeFi ecosystem, enabling additional financial strategies for ETH stakers while simultaneously offering them near-instant liquidity. 

There are two main ways in which staking rewards are passed on to users:

1. Rebase tokens – The first method of rewards is straightforward. Users will deposit their ETH into an LSD protocol and receive a rebase token (i.e. stETH) at a 1:1 ratio. As a user accrues staking rewards, their stETH balance will increase. When they are ready to unstake, the rebase token will be burned, and the user will receive ETH at a 1:1 ratio.
2. Rebase token wrappers – The second reward mechanism is via a token wrapper. Many DeFi protocols are not compatible with rebase tokens, so to solve this issue, LSDs implemented a different token type which represents a user’s total share of staked ETH. As rewards accrue, the price of the wrapped token appreciates in lieu of the balance increasing. Examples of wrapped staked tokens include rETH (RocketPool) and cbETH (Coinbase). Wrapped tokens can be unwrapped for an equal amount of staked ETH and exchanged for ETH. Rebase tokens and wrapped tokens are financially equivalent, but the wrapped versions offer more flexibility depending on a user’s needs.

Benefits of Liquid Staking

Liquidity

As alluded to in the introduction, one of the largest benefits LSDs offer users is near-immediate liquidity access. For example, if an investor holds 10 ETH in their wallet and they would like to earn additional yield on their assets, they can go to an LSD protocol such as Lido Finance and instantly deposit their ETH in exchange for stETH (staked ETH). If they decide after a few days or weeks that they are no longer interested in having their ETH staked, they can submit a withdrawal request and have their ETH back within 1-5 days.

Greater Staking Participation

In order to run an Ethereum node by yourself, 32 ETH are required. At current prices, 32 ETH is equivalent to over $57,000, leading to many smaller investors being priced out from becoming node operators. With liquid staking derivatives, users can stake as little as .01 ETH. Lower capital requirements enable smaller investors to increase the return on their ETH while simultaneously increasing the security of the network as LSD protocols aggregate all the ETH deposits to run nodes.

Composability

The popularity of liquid staking derivatives has led to staked versions of ETH becoming a staple across DeFi and has sparked what’s known as LSDfi (liquid staking derivative finance). Users can now take their staked-ETH derivatives and participate in traditional DeFi operations, swapping, lending, and borrowing against LSTs. The composability of LSTs adds another layer of potential yield for ETH holders. The combination of staking rewards and other interest-bearing strategies makes staked-ETH one of the most productive assets across the crypto space.

Market Landscape

The market for ETH staking has continuously grown over the last two years and has seen a sharper increase following the Shapella Upgrade, which enabled the ability to unstake ETH. The total amount of staked ETH has exceeded 22 million, with over 600 thousand validators.

Despite the steady increase in the amount of ETH staked and the number of validators, Ethereum’s staking ratio remains well below other blockchain networks. Ethereum’s staking ratio currently sits just under 19%, while its peer group’s average is 57%.

Of the 19% of ETH staked, liquid staking derivatives make up 43% of the market, equating to about 9.6 million ETH deposited into LSDs. The LSD market is largely dominated by one player, Lido Finance.

Lido’s success can be attributed to a first-mover advantage and the ability to integrate its staking tokens across DeFi protocols. Although they still represent nearly three-quarters of the LSD market, they have given up market share over the past year as competitors have entered the space.

A large drop-off in Lido’s market share can be seen at the time Coinbase launched its liquid staking solution, which has quickly gained in popularity due to ease of access for centralized exchange users.

To summarize the Ethereum staking and LSD market landscape, key metrics have been listed in the table below. 

Examining those numbers further, it can be seen how much potential growth there is for liquid staking providers. Ethereum’s staking ratio is about a third of its competitors’ average, while the Shapella upgrade has significantly reduced the risks for investors. The combination of a below-average staking ratio and less withdrawal risk creates a perfect formula for LSD growth.

Forecasting growth in the amount of ETH staked should serve as a base case and lead to significant TVL growth for LSDs. Holding the staking market share constant and conservatively estimating an increase in Ethereum’s staking ratio to 35% would lead to an additional $15.24 billion being deposited into LSD protocols, representing an 86% increase in TVL compared to current levels.^[1]

Given the advantages to liquid staking outlined earlier, it is reasonable to project that the percentage of ETH deposited into LSDs should increase going forward, especially considering the development of “LSDfi” or liquid staking tokens being integrated into DeFi markets. The below chart illustrates the explosive growth and popularity of new protocols utilizing liquid staking tokens.

In addition to the newer protocols utilizing LSTs, blue chip DeFi apps have integrated with staked-eth and make up over $5 billion in TVL.

Therefore, a more bullish scenario can be considered where Ethereum’s staking ratio rises to meet its competitors’ average at 57%, while the additional benefits of LSDfi protocols drive LSD market share up to 65%. In this scenario, TVL for LSD protocols would rise as much over $50 billion, tripling current levels. Such a large TVL increase should have a substantial impact on the native tokens of LSDs. Using current market share and Price/TVL ratios and adjusting for an increase in ETH deposits, both Lido ($LDO) and Rocket Pool ($RPL) have considerable upside potential in any scenario where Ethereum’s staking ratio increases.

Liquid staking protocols offer an interesting investment if one believes in Ethereum and the growth of the network. LSD protocols and their derivative tokens are quickly becoming a foundational part of DeFi and will likely continue growing in popularity as ETH holders look to put their assets to work.

Potential Tradeoffs of Liquid Staking

Smart Contract / Platform Risk

The largest risk in liquid staking is trusting a third party with assets. Investors open themselves up to smart contract risk along with any potential hacks or exploits. Additionally, the liquid staking provider has control of all ETH deposits, which is inherently more valuable than a derivative token in the case of something going wrong with an LSD protocol. It is important to mention that all the large liquid staking protocols have gone through multiple thorough code audits, and the results are all publicly published. A user can be relatively confident in their assets’ safety and security, but acknowledging the risk is important.

De-peg Risk

As mentioned in the previous paragraph, the LSD protocol fully controls all the underlying ETH, while stakers have a synthetic derivative that should be financially equivalent. There is a chance that a derivative token loses its peg value, making it less valuable than the underlying ETH. Stakers should be aware of this risk when depositing into LSD protocols or using as collateral to borrow against.

Slashing

In proof-of-stake networks, node operators are subject to slashing penalties when validators fail to follow protocol rules. LSD protocols spread their ETH across different reputable validators to mitigate the chances of any significant slashing penalties, but the loss of capital still remains a small risk. Additionally, LSD protocols such as Rocket Pool spread any slashing penalties across all stakers to minimize the impact for any single user.

Reward Dilution

Using a liquid staking provider gives investors the benefits of liquidity, lower capital requirements, and composability, but in return, their staking rewards get diluted as LSD protocols take a percentage of staking fees. For example, Lido gives 90% of rewards to stakers, and 10% goes to the Lido DAO. Investors can gain a higher yield if they were to run a node by themselves, but as mentioned, that requires higher capital requirements and more technical expertise. A caveat to LSD protocols taking a portion of staking revenue is that some LSD protocols incentivize staking on their platform via inflationary rewards using the protocol’s native token, counteracting the slight decrease in staking rewards for users. 

Conclusion

The shift of Ethereum from proof-of-work to proof-of-stake introduced the ability for investors to stake their ETH tokens and help secure the network. However, this shift has introduced capital requirements and illiquidity for stakers. To address these challenges, liquid staking derivatives were invented. LSDs give ETH stakers several benefits, including near-instant liquidity, less restrictive capital requirements, and composability across the DeFi ecosystem, making LSDs one of the most prominent sectors across crypto. Although the growth of LSDs has been impressive to date, there remains significant potential for further development as Ethereum’s staking ratio remains below 20%, well below comparable networks. Further, the emergence of LSDfi should continue creating new use cases for LSTs, presenting considerable upside potential for LSD protocols.

[1] DeFi Llama 6/8/2023

[2] As of 6/21/23