Introduction
When it comes to the various DeFi primitives, there’s no denying that liquid staking is one of the major ones. As per DefiLlama, if we divide all the DeFi protocols based on different categories, then liquid staking protocols will come in at a staggering combined TVL of $12.36 billion, only behind lending protocols and DEXes. Doing some quick mafs, we can see that this constitutes ~26% of the total DeFi TVL. That’s significant!
In case you’re unfamiliar, in a nutshell, liquid staking derivatives (LSDs) allow users to stake the native coin of a PoS blockchain, whilst maintaining liquidity - as the name suggests.
If you directly delegate your stake, you’ll be forced to lock your tokens, thus sacrificing liquidity and optionality.
LSD protocols issue a receipt token of sorts, which signifies your stake i.e. stETH, rETH, stSOL, mSOL etc. A user can freely trade this receipt token in the open market if there is liquidity available in their respective pools. For example, the stETH-ETH pool on Curve Finance allows users who staked their ETH with Lido to receive stETH as their receipt. They can then choose to sell this stETH for ETH using Curve or other DEXs like Uniswap. Sometimes the stETH derivative will trade slightly below the peg of its corresponding asset, this can be seen as the premium for being able to properly exit the position if needed. Only a finite $ amount of stETH can be swapped for ETH before stETH depegs. At that point, you’d expect arbitrageurs to come sweeping in and take the reverse trade i.e. buy cheap stETH. This will change somewhat following the Shanghai Upgrade.
The user can at any time redeem this receipt token for the underlying coin. The value of this receipt token will always appreciate against the value of the underlying coin at the rate of the staking APR. I’ll explain how it works in detail with an example.
Here, it’s important to differentiate between rebasing and non-rebasing token rewards in regard to LSDs. What I just mentioned is the non-rebasing mechanism, wherein, the receipt token grows in value over time rather than in quantity. The opposite of it is the rebasing mechanism, wherein, the receipt token grows in quantity over time - signifying the accrual of the staking rewards. As such, in the rebase mechanism, for every rebase, you’ll accrue more of the receipt token. Whereas in the non-rebase model, as time goes by, the receipt token will linearly appreciate in price against the underlying token, as the receipt token accrues the staking rewards. You can think of rebase as quantity accruing, and non-rebase as value accruing.
So, for example, let’s suppose ETH staking yields 5% APR, and I want to stake 100 ETH. What a liquid staking protocol will do, is it’ll take my 100 ETH as a deposit and stake it on my behalf. In return, it’ll issue me a newly minted receipt token.
The protocol will ensure there’s liquidity for this receipt token, so I can freely trade it anytime and exit my position. Let’s suppose I decide to hold to receipt tokens for a year. After a year, when I decide to withdraw my initial deposit, I will burn the receipt tokens and receive 105 ETH - the principal amount plus the staking rewards.
Note, that for most LSD implementations, the amount of the receipt token will not rise, but the value of the receipt token will rise against the underlying coin - to signify the accrual of the staking rewards - as explained above. The number of receipt tokens you’ll receive will depend on the exchange rate at the time - as the underlying coin is always depreciating against the receipt token. At inception, the exchange rate will be 1:1, but it will start deviating as staking rewards start accruing. Also, the peg to the underlying coin will be maintained, as a receipt token is only issued when there is a deposit. As such, the protocol always has the underlying asset to back the receipt token. If the receipt token trades at a discount or a premium, arbitrageurs can come in and fix it - as explained above. In the process, they’ll profit too, but the peg will be restored. I hope this example gives you a basic understanding of how a liquid staking derivative works. Also, this is the most popular implementation by some of the large liquid staking providers, as you’ll learn soon, there are other implementations too.
For the purposes of this article, I will focus primarily on ETH staking and the related LSD ecosystem. However, before we dive deeper into it, we’ve gotta understand the current ETH staking outlook - to be better positioned.
Shanghai Upgrade
The Shanghai upgrade enables ETH that has been staked to be unstaked, through a withdrawal queue, poised to take place around March 2023 - although it could be delayed.
Staking Rewards reports only 14.13% of the circulating ETH supply is currently staked, lower compared to other PoS coins, due to the uncertainties and risks associated with staking ETH, such as uncertain timeline and inability to unstake until the Shanghai upgrade is complete.
Once the Shanghai upgrade is implemented, ETH staking may become more attractive as users will have the option to stake and unstake freely, overcoming one of the major obstacles in staking ETH.
While the Shanghai upgrade enhances Ethereum's fundamentals, it is possible that the hype surrounding the upgrade may lead to a "sell the news" event. This is because many ETH holders who staked their tokens may wish to sell after years of holding, causing a potential drop in price and bearish sentiment in the short term.
However, the data shows that most ETH stakers are currently in losses. This could prompt them to hold on to their bag, potentially perpetuating a bullish outlook for ETH.
Source: Dune Analytics
To be honest, at this point, it’s anyone’s guess what’ll happen when the Shanghai upgrade finally rolls around - in the short term. However, in a long enough duration, it’s safe to assume that the overall demand for ETH staking will rise, as people can freely unstake at will. I mean, other PoS coins such as ADA, SOL, BNB, and AVAX sit at over 60% staking ratio, while ETH is at a measly 14%.
The thesis that is doing the rounds on CT is that more users will be incentivised to stake ETH post-Shanghai. Delegating their stake directly will be less capital efficient. Therefore, they’ll rely on an LSD for their staking needs. The LSD protocol will, as a result, accrue fees and real yield. This may result in appreciation of their underlying protocol token.
What Are Liquid Staking Derivatives?
As I alluded to above, simply put, LSDs allow users to stake the native underlying coin of a PoS blockchain and remain liquid. The lockup nature of ETH led to the creation of LSDs, which, enable users to receive a receipt token for staking ETH with a liquid staking provider. This receipt token is commonly referred to as a Liquid Staked Derivative (LSD). An LSD is fungible, transferable and fractional, just like any other ERC-20 token.
Liquid Staking Providers
Liquid staking providers offer staking liquidity solutions in exchange for a portion of the staking rewards, typically 5-10%. With the Shanghai upgrade, ETH LSDs are expected to gain popularity as the risks and difficulties of ETH staking decrease. This will lead to increased revenue for liquid staking providers, a positive sign for the liquid staking sector.
To meet the expected demand, MetaMask has integrated staking directly into its wallet, making it easier for users to stake ETH and earn approximately 5% yearly rewards in ETH. Currently, they support Lido and Rocket Pool with plans to add more.
Here’s a list of some of the most popular liquid staking providers and their LSD for ETH:
ProviderLSDLidostETHRocket PoolrETHFrax FinancefrxETHStakewisesETH2AnkrankrETHBinancebETHCoinbasecbETH
Do note that these aren’t all of the ETH liquid staking providers. Each implementation is slightly unique, while, at a broad level, very similar.
Benefits
The major benefits of using a liquid staking protocol to delegate your stake, instead of directly staking should be apparent. In case it isn’t, these are the major ones:
- Capital Efficient: LSDs allow users to enjoy the APR from staking ETH and at the same time use the receipt tokens in other DeFi activities such as providing liquidity, borrowing against their collateral etc.
- Liquidity: LSDs also allow users to exit their position any time. They need not wait for any withdrawals to start processing. Even when withdrawals are enabled, you can best bet there’ll be a cooldown period. With exposure to an LSD, the user can decide to sell directly in the open market or wait for the withdrawal. As such, LSDs do not sacrifice liquidity.
The use case for liquid staking derivatives is very clear. They solve a major pain point. It’s no surprise that they’ve captured a large share of the DeFi TVL.
Key Players
I briefly touched on the main liquid staking providers. It’d be worthwhile to study their implementation of the ETH LSD, and how it is different or the same.
Lido
It’s safe to say that Lido is the market leader in the ETH LSD space. They command an impressive ~75% market share. They were the first liquid staking provider and popularised the entire opportunity. However, their market share can only drop, in my opinion. Given the competition and how popular they already are.
When you deposit ETH with Lido on its staking page, you receive stETH, a receipt token that represents your staked ETH and acts as an LSD. This allows you to engage in DeFi activities or simply hold it to receive automatic ETH staking rewards in the form of stETH. Recall, this is a slightly different implementation from the norm in which the user accrues more stETH.
Lido retains 10% of these rewards, dividing it between node operators and the DAO treasury.
Initially, stETH faced limitations as a rebase token, where its balance increased with staking rewards, leading to issues when providing liquidity as rewards are added to the LP pool, which is meant to maintain a constant quantity balance. To address this, Lido has introduced wrapped staked ETH (wstETH), which grows in value over time instead of balance. Again, this is the more traditional implementation these days.
Key Observations
- The governance token $LDO does not accrue any revenue from the staking fees.
- Most $LDO unlocks have happened, with less inflationary pressure in the future.
Coinbase
By market share, Coinbase comfortably sits in the second spot. Institutions, as well as American retail participants, definitely rely on Coinbase for liquid staking. My issue with their solution is that it doesn’t have many DeFi use cases compared to some of the other options.
On top of that, this blacklisting function in the cbETH contract is very worrying.
Info: https://etherscan.io/token/0xbe9895146f7af43049ca1c1ae358b0541ea49704#writeProxyContract
Key Observations
- Institutional demand for liquid staking will definitely rise. Especially post Shanghai. Coinbase is well-positioned to capitalise on this surge in demand.
- With Coinbase Prime, lower fees will attract institutional investors.
- One-click staking could be a very easy way for retail users to gain access to ETH staking.
- On the other hand, this product could be targeted by the SEC following the recent revelations around the Kraken staking product.
Rocket Pool
If you wanna learn more, you can watch Grant’s recent interview with Darren, one of the co-founders of Rocket Pool. You can head straight to the said interview here.
Rocket Pool is trying to build a decentralised liquid staking protocol. Lido is seen as a fairly centralised service provider, whereas services like Coinbase and Binance are completely centralised.
To understand Rocket Pool, let’s explore things from the node operator point of view:
To stake Ethereum independently, a single user must put up 32 ETH, which is a costly amount of money, currently around $50,000 USD.
Rocket Pool offers a convenient solution with its easy deposit/withdrawal process, accessible to anyone without technical expertise. Unlike Lido, which restricts node operator roles to LDO token holders, anyone can run a Rocket Pool node by depositing a minimum of 16 ETH and 1.6 ETH worth of RPL, the governance token. Therefore, Rocket Pool is focusing more on adding individual validators than delegators. With increased delegation, a large % of the stake will concentrate towards a limited amount of validators.
The required ETH will continue to decrease, aimed at reducing entry barriers and promoting decentralisation. Stakers joining the network will receive rETH, a token that increases in value like wstETH, matched with the 16 ETH put up by node operators. Following the Atlas upgrade, this will reduce to a minimum of 8 ETH.
Operators receive additional RPL rewards, yielding higher than solo staking. Rocket Pool takes a 5-20% fee from rewards and gives it directly to node operators.
Key Observations
- ETH deposits have been steadily growing over the months, signifying their value proposition is connecting with the people.
- Node operators earn inflationary RPL rewards.
Frax Finance
Frax Finance began as a stablecoin (FRAX) and has since developed its own automated market maker exchange (Fraxswap), money market (Fraxlend), inflation-linked stablecoin (Frax Price Index), and recently launched a liquid staking service for ETH, converting ETH into frxETH, a Liquid Staked Derivative.
In the last couple of months, frxETH has gained a significant amount of market share. This is primarily because staking ETH with FRAX provides 6-10% returns in ETH, higher than other ETH LSDs, which typically offer around 5%. Providing liquidity in the frxETH/ETH pair also earns a 10% yield in CVX, CRV, and FXS, with the majority being CRV issuance, reducing dependence on FXS incentives that could negatively impact its price. The small FXS incentives encourage a positive cycle, where an increase in FXS price leads to higher staking yields, more ETH staking with Frax, increasing its intrinsic value and price, and so on.
Staking ETH with Frax mints frxETH, which represents your staked ETH and is a liquid token. Unlike other ETH LSDs, frxETH does not accrue value and does not undergo rebasing. To earn yield, you must stake frxETH with Frax to receive sfrxETH, which grows in value by 6.8% annually, higher than the 5.1% yield from Lido and the 4.4% yield from Rocket Pool.
The reason sfrxETH has a higher yield is that all unused frxETH generates yield for sfrxETH, meaning the less frxETH staked, the higher the APR for sfrxETH. Additionally, Frax has a significant amount of CRV/CVX in its treasury, allowing for more bargaining power to direct incentives to its frxETH LP tokens on Convex Finance.
Frax's ETH LSD currently offers a higher staking income compared to other options in the market while also boosting LSD liquidity on Curve. To earn the high APR yield, users must provide ETH and frxETH LP on Curve and stake it on Convex. Despite this high yield, some users may choose to stake their frxETH to sfrxETH instead, resulting in an even higher APR for sfrxETH.
Key Observations
- Offers the highest ETH staking APR by far.
- 8% fee from the staking yield is used to buy back the FXS token.
A Comparison
LidoCoinbaseRocket PoolFraxLSDstETHcbETHrETHfrxETHAdvantageWell integrated with DeFiWill promote institutional liquid stakingWill decentralise the ETH validator set8 ETH minipoolsCan sustainably offer the highest staking APRDisadvantageNo value accrual towards LDO tokenLimited use cases in DeFi,blacklist function &high potential of regulatory backlashRPL is highly inflationaryFrax algo stablecoin?VerdictWill continue to lead the market for the foreseeable future, but the market share will declineWill see use in America and from institutional participants, who’re looking for an easy solutionWill attract potential validators with the incentives, however, RPL inflation is a concern Most innovative solution at the moment, but one not without risks attached
Future Prospects
Guess what? This isn’t all. There are still interesting developments happening in the space as we approach the Shanghai upgrade. I would like to outline two of them.
Stader’s launch of ETHx
Stader Labs is a well-renowned liquid staking protocol in the crypto world. However, up until now, they did not have an ETH LSD. Well, that is about to change with ETHx. If their deployment on other chains is something to go by, then we must be excited about the upcoming liquidity incentives in the SD token.
Redactedcartel’s launch of an ETH LSD
The folks over at redacted are taking a unique approach to things. Their upcoming stablecoin, DINERO, will be overcollaterlised with their ETH LSD. Now, this looks unique and innovative.
Conclusion
It’s safe to say that the LSD wars are warming up. There are many competitors in the space, fighting for the same liquidity. I’m certain there’ll be multiple winners. The space is large enough to absorb a good number of them. It’s anyone’s guess who those will be. This article can be seen as a broad-level general overview of the sector. It’d make sense to dive deeper into anything specific that piqued your interest.
Well, that’s all for today, folks. Again, I hope you found this analysis interesting and helpful.
