Introduction
Ethereum is preparing to transition to a Proof-of-Stake (POS) consensus algorithm in September. The staking community has been buzzing with excitement in what has been dubbed one of the biggest events in the history of the network. Up until the merge, if investors want to stake their ETH, they would need a minimum deposit of 32 ETH and advanced technical knowledge to set up a validator node on the Beacon chain. This is not feasible for the majority of investors and is what led to the development of liquid staking derivatives (LSDs). Liquid staking solutions have eliminated these inconveniences and have allowed investors to enjoy the benefits of secure, non-custodial staking backed by industry leaders.
Staking Derivatives – Why is this needed?
The staking industry has experienced exponential growth since the inception of the Proof-of-Stake (POS) consensus mechanism. Staking has become a popular way for investors to earn a yield on their holdings and to play a part in securing the network. Traditionally, staking on POS-based projects involves lockup periods where your assets cannot be traded or withdrawn. This creates a few problems for investors:
- Illiquidity
- Immovability
- Accessibility
Staking derivatives were developed to solve this problem by minting a token that represents the staked coins. This token can be used as one would use any other token, allowing investors to earn staking rewards whilst being able to transfer, store, trade, and earn yield across decentralized finance products.
Benefits of Liquid Staking on Ethereum
Liquid staking allows investors to get the benefit of staked coins as well as the returns from trading, leveraging, and investing your coins in other Defi protocols. Liquid staking solutions offer investors a few benefits:
- Making the staking process simple, there is no need to manage or set up hardware
- No limit on the deposit size which makes it possible for smaller players to take part
- Liquid staking allows you to take part in other Defi protocols
At present, if you wanted to do solo-staking on Ethereum you would need to have 32 ETH, advanced technical knowledge on running and maintaining a node, be willing to accept the potential slashing risk for validator downtime, and need to accept the duration risk of potential further Merge delays. This represents a very high barrier to entry for most investors and further supports the case for liquid staking on the network.
The state of Ethereum Staking Derivatives
Liquid staking has grown tremendously since it was launched by Lido Finance, shortly after the Beacon chain went live in 2020. Over 13 million ETH has been locked in the Ethereum 2.0 deposit contract, representing ~ 11% of the total supply of Ethereum. The market has shown an appetite for this staking derivative as the number of liquid-staked ETH has swelled to over 4.5 million. This constitutes ~ 35% of the total ETH locked in the deposit contract on the beacon chain.
The liquid staking market has been dominated by one player – Lido Finance. The team at Lido pioneered the first liquid staking derivative ‘stETH’ on Ethereum which has since grown to command over 90% of the liquid staking market share. Over 4 million ETH has been staked on Lido, representing a market share of ~ 90.4% and over 70 000 unique depositors with an average deposit of 59 ETH. The closest competitor is Rocketpool, whose team developed the ‘rETH’ liquid staking derivative which currently has a ~ 4.4% market share.
The stETH peg
stETH is a derivative of ETH and strictly speaking, does not need to trade 1:1 with ETH. It is subject to market forces and price discovery that can result in a deviation or discount to the price of 1 (native) ETH. Throughout the history of stETH, there have been periods of deviation from a 1:1 ratio with ETH. There are a number of reasons for this that are beyond the scope of this article, but what is relevant is that stETH can be redeemed for one ETH after the Merge. Until then, it can and will most likely deviate from 1:1. The peg risk is discussed more in-depth under the ‘Liquid Staking Risks’ section.
stETH (Lido) vs rETh (RocketPool)
The top two liquid staking options on Ethereum are Lido (stETH) and Rocketpool (rETH). Both protocols have different architectures in their protocol design, we will briefly look at the main differences and the trade-offs with each.
Lido ETH
Users can deposit their ETH into the Lido smart contract and receive stETH in a 1:1 ratio. stETH is an ERC-20 token that is tradeable and can be used in De-fi protocols like any other ERC-20 token. Lido is non-custodial but it is not a permissionless protocol.
What makes Lido permissioned?
Lido has taken the approach of carefully selecting professional validators to maximize earnings and limit slashing penalties. The protocol has a committee to choose the best-in-class validators to minimize staking risk, currently, the selection is made from operators who have applied to participate in Lido. There are some problems with this approach:
- Once operators are in the set, there is little incentive to improve
- There are not many professional node operators that run their own infrastructure, this can lead to Lido running out of candidate pools
The risk is that if this process of selection continues in the long-run, it will lead to a full-blown cartel and result in a dystopian outcome for Ethereum. The core issue here is that decision-making power is concentrated in the hands of a few $LDO token holders, which can be a centralization risk and is discussed in depth later in the article.
Rocketpool ETH
Rocketpool was designed to be community-owned, decentralized, trustless, and compatible with Ethereum 2.0. Rocketpool caters to two main groups of users:
- Participants that want to stake their ETH
- People that want to run a node in the network
Rocket Pool strives to embody the core ethos of Ethereum and DeFi, specifically the non-custodial, trustless nature that allows self-sovereignty to truly thrive. Users can deposit their ETH into the Rocket Pool contract and receive rETH, in a 1:1 ratio. This is also an ERC-20 token that can be traded and used in De-fi protocols.
How does Rocketpool differ from Lido?
Rocketpool differentiates itself from Lido by being permissionless. A permissionless protocol means that everyone is available to participate in the consensus process and become a node operator in the network. It is not dependent on a voting process to decide who can or can not be a validator on the network.
Rocketpool nodes only need to deposit 16 ETH per validator. This is coupled with 16 ETH from the staking pool (which stakers deposited in exchange for rETH) to create a new ETH2 validator. This new validator is called a minipool. In addition, node operators need to stake at least 1.6 ETH worth of the Rocketpool governance token (RPL), which is used as a form of collateral if validators are punished for slashing. This protocol design aligns the incentives of all parties to minimize trust assumptions and automate the process to join the network.
The tradeoff
Rocketpool cannot scale as quickly as Lido can because the growth of Rocketpool is subject to the 16 ETH that is required to set up a node and is dependent on new node operators joining the network. On the contrary, Lido can continuously distribute ETH to its validator set at any time, which allows it to scale much faster. But the tradeoff for Lido is the centralization risk and trust assumptions in its validator set.
Risks of Liquid Staking Derivatives
There is no free lunch when it comes to liquid staking. Lido has outlined a number of potential risks when staking ETH using liquid staking protocols :
- Smart contract security risk
- ETH 2.0 Technical risk – Staking derivatives are being built upon technology that is still under active development. There is no guarantee that there are no bugs on ETH 2.0
- ETH 2.0 Adoption risk – stETH is built around the Staking Rewards that can be earned on the Beacon chain. If ETH 2.0 does not get adopted there could be serious fluctuations in the value of ETH and stETH
- DAO key management risk – Some of the ETH staked via the Lido DAO is held across multiple accounts backed by a multi-signature threshold scheme to minimize custody risk. If the signatories lose their keys, get hacked or go rogue, there’s a risk that these funds become locked.
- Slashing risk
- stETH price risk
- Centralization and liquidity risk
- Cartelization risk
These risks should be taken seriously by investors and the Ethereum community. We will zoom in on the key risks that the market leader Lido Finance poses to the Ethereum network:
Cartelization risk
As Lido continues to grow and dominate the liquid staking market on Ethereum, a cartel-like situation can arise. As network effects take hold and more usage around stETH increases liquidity and its utility as collateral, it incentivizes users to stake with the market leader. If the amount of ETH staked with Lido exceeds the critical consensus thresholds, they could achieve higher profits compared to capital that is not pooled. This is mainly because of things like:
- Coordinated MEV extraction
- Block-timing manipulation
- Censorship from Lido governance token holders
All of this can lead to the cartelization of block space. In this case, it would not make economic sense for capital to be staked elsewhere as the cartel offers outsize rewards which in turn will reinforce the cartel’s hold on staking.
$LDO token distribution
The Lido protocol operates as a DAO, which means token holders must vote on governance proposals and (hopefully) make wise decisions. While this seems like a democratic voting process, ~ 63% of $LDO tokens are controlled by early investors, developers, founding team members, and VCs. The top 16 addresses on the network hold enough $LDO to influence decisions in governance proposals. This means that decisions on the protocol are centralized. The problem is that if Lido grows large enough to control over 50% of staked ETH, it could perpetuate a 51% attack on the network.
You might argue that it would never be in the interest of $LDO holders to do such a thing, but have you considered a regulatory censorship attack? In the event that a government forces its hand, it can censor blocks on the network by cracking down on $LDO token holders to censor blocks on the network. The $LDO token holders are a much easier target than having to deal with the entire Ethereum network.
De-peg risk
In the case of Lido’s stETH, it does not need to trade at a 1:1 peg with ETH (strictly speaking). As stETH cannot be redeemed for ETH until after the merge happens, you are trading a liquid asset (ETH) for an illiquid asset (stETH) and are compensated with yield. If you did want to exchange your stETH for ETH, you could do so on an exchange or via a liquidity pool on Curve for larger positions. The problem is that if there is a liquidity crunch and too many people want to sell stETH for ETH, it can cause the stETH price to fluctuate and fall below 1:1.
Given that stETH is being used as collateral in different protocols, if someone is highly leveraged they can be liquidated if stETH trades at a significant discount against ETH. If many people are levered up on stETH (Which they are) it puts stETH at risk of a potential liquidation cascade when there is enough selling pressure.
This is what happened in the recent collapse of Terra, 3AC, Celsius, and Voyager. During the Terra collapse, the main liquidity pool on Curve lost more than half its TVL. The sharp contraction of liquidity led to a liquidity crunch as reflected in the pool’s imbalance which left the stETH price exposed. Given the poor market sentiment and bad debt caused by Terra’s collapse, both pool imbalance and liquidity on Curve for stETH failed to recover. Consequently, the lack of liquidity meant that there was no other avenue for large stETH holders such as Celsius, 3AC, and Voyager to cover their positions, resulting in the downfall of these firms.
What happens to liquid staked ETH post-merge?
Ethereum is set to complete the merge to a Proof-of-Stake consensus mechanism in the week of September 19th, 2022. This marks one of the biggest single events in crypto and has attracted a lot of hype and speculation from market participants. What does this mean for Ethereum staking derivatives and when will staked ETH on the beacon chain be unlocked?
When is the ETH locked in the ETH 2.0 staking contract unlocked?
The merge will not enable withdrawals as this is planned for another upgrade that is expected to occur after the transition has taken place. Once the ETH is unlocked, it will likely be released slowly as there will be an exit queue for validators to exit.
Will the staking yield go up or down?
Liquid-staked ETH will start benefiting from transaction fees and maximal extractable value, meaning yields should go up. Keep in mind that there are a lot of factors that will influence the yield so it’s difficult to predict exactly what will happen.
Will stakers dump their ETH?
It is unlikely that stakers in the ETH 2.0 smart contract will just market sell their stack once the merge is completed. An investor who has set up a node and has 32 ETH staked over the past few years is invested in Ethereum’s future. It would not make sense for them to sell and get rid of their validator node after everything they did to set it up in the first place. In addition, the tokenomics of ETH becomes a lot more favorable and attractive for holders of ETH – all pointing to bullishness after the merge.
Conclusion
Liquid staking solutions on Ethereum have made it possible for investors to earn staking rewards whilst being able to transfer, store, trade, and earn yield across decentralized finance products. This is a step in the right direction and has been a great addition to the crypto space by solving the illiquidity, immovability, and lack of accessibility problems that come with normal staking. While liquid staking derivatives are not risk-free products, they are being adopted throughout Defi protocols and look set to become the standard way to stake and use your crypto assets.