M3TA Deep Dive: Liquid Staking Derivatives (LSD)
This article delves into the rising trend of Liquid Staking Derivatives ahead of the Ethereum network's Shanghai upgrade in March.
Abstract
The Deep Dive’s focus is on examining the improvements and changes brought by the upgrade, and why Liquid Staking has become a preferred option over traditional ETH Staking. The popularity of Liquid Staking Derivatives and the impact of the Shanghai upgrade on their growth will also be analyzed.
The Deep Dive highlights the advantages of Liquid Staking, such as yield stacking, ease of use, and increased security, as key factors contributing to its growing popularity. Despite its benefits, Liquid Staking also carries potential risks that will be discussed. Additionally, the article sheds light on why Liquid Staking is driving ETH prices higher before the upgrade and what may happen to ETH prices following the upgrade.
Introduction
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. Users of Liquid Staking can benefit from the simplicity and security of staking on a platform while earning additional returns through yield stacking.
This Deep Dive article attempts to focus on the rising popularity of Liquid Staking Derivatives, the reasons why individuals choose them over regular ETH Staking, and the possible impact of the planned Shanghai update to the Ethereum network on their development.
Overview of the Shanghai Upgrade on Ethereum
The upcoming Shanghai update which is expected to occur in March 2023 is the next major technological advancement before implementing upgrades related to the Surge. Ethereum developers have stated that the Shanghai upgrade will minimize delays and problems in preparation for the Surge upgrade, which enhances the blockchain's maximum transactions per second (TPS).
Ethereum Shanghai upgrade is bound to make several changes to its system, but the main improvement will be EIP-4895: Beacon Chain Push Withdrawals as Operations. The ultimate goal of EIP-4895 is to provide more financial flexibility to people or validators who have staked ETH into the Beacon Chain since December 2020 by allowing them to withdraw their ETH with very low fees after more than 2 years of staking.
Why do Investors use Liquid Staking rather than Traditional ETH Staking?
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 word, 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, there are now liquid staking platforms that act as facilitators for investors looking to earn staking rewards without having to hold and manage the underlying assets. These platforms, to name one - Lido Finance, accept token deposits and perform the staking process on behalf of the depositor.
In exchange, the depositor receives a receipt in the form of an ERC20 token, such as stETH (staked ETH), that represents their staked tokens - also known as Liquid Staking Derivatives (LSD). This receipt can be traded or used as a collateral on other platforms, providing added flexibility and liquidity for the depositor. Thus, they can redeem the receipt for their original staked tokens at any time.
Additionally, these platforms allow individuals who may not have enough ETH for the staking process to participate and earn rewards through Staking as a Service options or Pooled Staking.
Liquid Staking Benefits
1. Yield stacking
Investors can earn additional yields through yield stacking, which is the process of earning rewards for staking while also earning other types of returns such as liquidity pool, lending, yield farming or derivatives.
For instance, after staking ETH on Lido, users receive stETH that can also be deposited on another platform such as Harvest to earn yields. This acts as a way to double your yield earnings on one token.
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.
2. Easy to use
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.
Independent staking requires a significant amount of time and effort, as well as a certain level of technical knowledge to properly research and select reliable validators. 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.
3. Secure
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.
Removing restrictions on staking, such as lock-up periods, can encourage more users to stake their funds, leading to an increase in the number of validators and the overall strength of the network. As a result, more and more people are turning to liquid staking platforms such as Stakewise, Lido, and Rocket Pool to earn rewards for staking their ETH.
Liquid Staking Risks
1. Smart Contract Risk
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.
In order to mitigate this risk, it is important to conduct thorough research and due diligence on the smart contract and the team behind it before deciding to engage in liquid staking.
2. Liquidity Risk
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.
To minimize this risk, it is important to monitor the liquidity of the pool and ensure that there is enough liquidity to meet the needs of the protocol.
3. Market Risk
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.
To mitigate this risk, it is important to conduct thorough research and analysis on the underlying assets and market conditions before deciding to engage in liquid staking.
4. Operational Risk
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.
To minimize this risk, it is important to conduct research on the team and the project behind the pool and ensure that they have a track record of success.
5. Voting rights
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.
To mitigate this risk, it is important to conduct research on the governance structure of the protocol and ensure that it is decentralized and fair.
6. De-peg
Another risky aspect that can't be ignored is depegging. 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.
This risk can be mitigated by diversifying the assets in the liquidity pool and monitoring the underlying assets' value and supply.
Overall, liquid staking in crypto can be a viable investment strategy, but it is important to understand and manage the various risks associated with it. By conducting thorough research and due diligence, staying informed about the latest developments, and taking appropriate measures to mitigate risks, investors can potentially avoid the potential losses associated with liquid staking.
Why Ethereum Bulls Are Turning to LSD
Ethereum bulls are turning to liquid staking derivatives (LSD) due to the benefits they are offered ahead of a key upgrade to the Ethereum network called Shanghai. As mentioned above, LSD projects, such as Lido Finance and Rocket Pool, allow users to stake any amount of Ethereum they can afford. In exchange, they receive another token, such as Lido's staked ETH token, "stETH". These tokens can then be used elsewhere in the ecosystem and earn high returns. 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.
One platform in Liquid Staking that deserves special recognition is Lido, which has established itself as a widely utilized platform in the DeFi community. According to Defi Llama (Figure 3), Lido has the highest Total Value Locked of $8.58B, 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.
Not convinced yet? As demonstrated in Figure 4, Lido also commands more than 29.2% of ETH staked compared to both decentralized and centralized platforms. This clearly highlights the growing demand for decentralized solutions and the fact that LSD has become a significant player in the DeFi ecosystem (since 2022).
What will happen to ETH after the upgrade?
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: “full validator exits are rate limited by the protocol, so only six validators may exit per epoch (every 6.4 minutes, so 1350 per day, or only ~43,200 ETH per day)”. 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 (Figure 5), 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.
Conclusion
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.
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