Will institutions get high on LSD?

Issue With Direct ETH Staking

On Sep 15, 2022, the Ethereum network successfully merged with its Beacon Chain, and this transitioned the entire Ethereum network from a proof of work (PoW) protocol to a PoS protocol. The miners that participated in the PoW protocol were completely replaced by validators staking their ETH tokens. This enables users to stake ETH in order to secure the network and receive staking rewards. These rewards generate an annual yield ranging from 3-6% in ETH. The network generates these yields through inflationary emissions, as part of ETH's tokenomics design, by verifying and proposing blocks at the consensus layer, as well as by collecting tips and fees from users performing transactions.

However, The Merge marks just one stage of Ethereum's transition to Proof-of-Stake, as staked ETH cannot yet be withdrawn. The next stage is the forthcoming Shanghai upgrade, which will enable staked ETH withdrawals. According to StakingRewards, only 14.43% of the circulating ETH supply is currently staked, which is significantly lower than the rest of the other PoS tokens (Cardano 71.22%, Solana 70.36%, BNB chain 97.72%, Avalanche 64.41%, and Polygon 40%). This is due to the risks and issues of staking ETH as there is no guarantee in the timeline and no way to unstake if you bond until the Shanghai upgrade is over. Some other limitations include: A minimum of 32 ETH is required, and users can only stake in 32 ETH multiples. There is no way to delegate stake to other validators directly on-chain without using third-party protocols. After withdrawals have been enabled, the lockup period for unstaking will be 27 hours.

Enter LSD

Ethereum’s PoS chain does not provide stakers with the withdrawal (unbonding validator stake) functionality they have come to expect in other PoS implementations like Cosmos, Tezos, and Polkadot. Thus it has conventionally been costly for token holders since they are required to lock up their assets, making them inaccessible for trading or withdrawal. Although this adds stability to the network, it can also lead to inefficiencies for stakers due to missed opportunities to trade or use the tokens for yield generation in DeFi protocols. 

Liquid staking allows stakers to convert their staked tokens into liquid staking derivatives(LSD) tokens that have an equivalent value to the amount staked. Thus with liquid staking, networks can benefit from the security and stability of staked tokens, while token holders can earn staking rewards and retain control over their assets. These tokens can be used on other DeFi protocols while still earning staking rewards. 

LSDs are a representation of a token holder’s staked assets. They confirm the staker’s participation in the staking pool, and the token can be used for lending, trading, or as collateral throughout the decentralized finance (DeFi) world. Another benefit is that by pooling ETH together in a Liquid Staking Protocol, stakers can bypass the 32 ETH minimum requirement. This allows smaller stakers to participate in PoS. Instead of having each user operate their own validator(s), the pool handles the operational aspect of staking in exchange for a small fee. 

Apart from Ethereum, other chains such as BSC, Avalanche, Solana, and even Cosmos blockchain have liquid staking derivatives. Stride, for example, is a Cosmos-based liquid staking platform that supports IBC-compatible tokens. When a user stakes on Stride, they receive not just staking rewards, but also Stride’s derivative tokens, stTokens (for example, stATOM). Users can exchange stTokens for the original (non-derivative) assets and their staking rewards whenever they want. This approach allows users to participate in other DeFi opportunities on the Cosmos ecosystem with their stTokens. Additionally, the LSD token can be used as a collateral on another blockchain by bridging them across using Interoperability infrastructure. Coinchange will be publishing a Research Report on Crosschain Interoperability of Blockchains in a few weeks, so keep an eye out for that. 

Key Players Offering LSD

Liquid Staking providers can either be centralized or decentralized. Centralized exchanges such as Coinbase have introduced a token called cbETH (Coinbase Wrapped Staked ETH) that lets you sell, send, or use your staked ETH position. This utility token represents staked ETH at Coinbase and you will continue to benefit from staking rewards while holding the token. There are no fees to wrap your initial staked ETH or rewards into cbETH. Since the exchange does the staking, the user does not need to run any infrastructure. Coinbase takes a 25% commission based on the rewards you receive from the network.

On the decentralized side, Lido DAO is one of the most popular and best liquid staking protocols. It functions with its native token, LDO. This is a governance token that is used to support ETH liquid staking. When users stake ETH on Lido, they receive stETH in exchange. stETH can be used across the DeFi ecosystem to yield more rewards. The APR for ETH on Lido DAO is 5.2%. Lido charges a 10% fee, which is evenly split between the DAO and node operators.

Frax Finance is a stablecoin protocol at its core. However, it opened its doors for ETH staking services in late October 2022, using a two-token design allowing users to stake ETH in exchange for frxETH. 1 frxETH always represents 1 ETH and the amount of frxETH in circulation matches the amount of ETH in the Frax ETH system. frxETH essentially behaves the same as wrapped ETH (WETH) and is complemented by sfrxETH, a version of frxETH that accrues staking yield. sfrxETH represents a deposit receipt in an ERC-4626 vault that receives all the profits from Frax’s set of Ethereum validators which received ETH deposits from frxETH holders. ETH staked through Frax Finance yields an 8-10% return, which is notably higher than what other liquid staking protocols offer. The higher yield is due to its proportion of the protocol’s total ETH staking rewards being redirected to only those depositors that choose to stake frxETH in the sfrxETH vault. While the rest of the depositors choose to receive rewards from the Curve protocol where the Curve frxETH / ETH pool provides an 8.8% APR paid out in CRV, CVX, and FXS tokens. Frax Finance charges a 10% fee on staking rewards. Of this fee, 2% is applied to the insurance pool (compensating validator slashing), and the other 8% goes to veFXS holders.

Rocket Pool is a popular liquid staking provider that is often compared to Lido. However, Lido functions with permissioned node providers while Rocket Pool is decentralized. In exchange for staking, users receive rETH that they can trade for RPL rewards. Rocket pool offers two services; you can either stake only 16 ETH and run your node (you get the other 16 ETH from other smaller depositors) or you could just deposit as little as 0.01 ETH and receive the rETH liquid staking token. rETH accrues staking rewards over time. Rocket Pool node operator charges a fee of 5% to 25% of staking rewards.

There are many other protocols offering liquid staking and you can find the complete list on DeFiLlama, however here is a screenshot of the top 10 by TVL for Ethereum: 

If choosing a particular protocol gets too tedious, there are others that offer diversified access to some of the above-mentioned protocols. For example, the Diversified Staked Ethereum Index (dsETH) is an index token of the leading Ethereum liquid staking tokens. The objective of the dsETH methodology is to give token holders diversified exposure to ETH liquid staking tokens, with a weighting that favors decentralized liquid staking protocols as measured by the number of node operators as well as the distribution of stake across node operators. Currently, the index is composed of rETH (Rocket Pool), wrapped stETH (Lido), and sETH2 (StakeWise). 

Is LSD Good or Bad?

LSDs can be risky, or so Danny Ryan, a researcher at the Ethereum Foundation thinks. 9 months ago he wrote a blog titled ‘The Risks of LSD’ where he wrote: 

“Liquid staking derivatives (LSD) such as Lido and similar protocols are a stratum for cartelization and induce significant risks to the Ethereum protocol and to the associated pooled capital when exceeding critical consensus thresholds.” 

He believes that Cartelization, abusive MEV extraction, censorship, etc are all threats to the Ethereum protocol and recommends that Lido and similar LSD products self-limit for their own sake and capital allocators should not allocate to LSD protocols exceeding 25% of total staked Ether. The funny thing is that there was a governance proposal titled “Should Lido consider self-limiting?” around July 2022, which overwhelmingly received a “no, don't self-limit” with 99.81% votes! 

Another popular argument is that staking derivatives may undermine the security of PoS by decoupling block production from staking and slashing, resulting in a principal-agent problem where block producers have no incentive to follow the protocol since they have nothing to lose.

However, this argument needs to be balanced against the potential advantages of staking derivatives. 

If staking derivatives reduce the cost of staking, it could result in significantly more ETH being staked, creating a virtuous cycle in which the increased liquidity of the derivative token leads to lower opportunity costs of staking and more ETH being staked, further increasing the liquidity of derivative token, and so on. Without staking derivatives, it is anticipated that only 15-30% of ETH would be staked. However, with staking derivatives, this number could rise to as much as 80-100%, since staking would no longer incur any additional costs compared to non-staking. 

Paradigm explains in their blog post, how LSD actually leads to higher economic security for Ethereum. Here is and example they provide to prove this point: 

• If 20% of all ETH is staked, and an attacker wanted to acquire 66% of all stake (a critical threshold to corrupt the chain), they would have to buy ~48% of all ETH in the open market and stake it, which would make the attacker own ~66% of the stake.
• If 60% of ETH were staked, but the stETH is liquid, then the attacker would have to buy 66% of all stETH, which also comes down to 40% of all ETH. Note that this has additional steps, where the attacker would first have to redeem the stETH to remove the honest validators and then re-stake their ETH.
• Above 60% staked, the share of all ETH the attacker would have to buy is now higher than 40% and only increases from there.
• If 100% of ETH are staked, then the attacker would need 66% of all stETH to get to the same threshold.

Thus if staking derivatives can increase the number of ETH staked above 60%, they would strictly increase Ethereum’s economic security instead of decreasing it.

Will Institutions Get High on LSD? 

JPMorgan, one of the biggest financial institutions in the world, estimates that the Shanghai upgrade will bring more investors to staking their ETH. According to their report, 

“Assuming the staking rate converges over time to the 60% average of other large networks, the number of validators could increase from 0.5 million to 2.2 million and the annual yield in ETH would fall from 7.4% today to around 5%.” 

The report also outlines that most of these funds will go toward platforms that “give liquidity to staking assets that would otherwise be locked into staking contracts by providing an equal amount of derivative token in exchange for ETH, which can be traded.”

However, the regulatory landscape is a tricky one to navigate. On Feb 9th, 2023, centralized exchange, Kraken, got into trouble with the SEC for offering ‘Staking-as-Service’ and was forced to stop the offering forever, in addition to paying a $30M fine for not registering their program as a security offering. It is important to note that staking itself was not classified as a security offering however Staking as a Service without proper risk disclosures was. Thus, for the time being, regulatory headwinds might thwart these services, at least in the U.S.

Concluding Thoughts

Staking pools and their staking derivatives are inevitable, as long as the benefits of creating and using them exist in a decentralized way. If a decentralized / non-custodial staking protocol that is sufficiently governance-minimized and permisionlessly lets users mint the LSD token gets sufficient adoption, it could be beneficial for the Ethereum ecosystem. However, we need to watch out for the regulatory updates in the space as it impacts the participation of institutional capital in the staking ecosystem. 

Disclaimer: Coinchange participates in Lido-based strategies. Please refer to the latest Coinchange Asset Allocation Report for detailed information. 

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