Liquid Staking Derivatives: unlocking DeFi opportunities for ETH validators

ETH heading into the Shanghai hard fork as a deflationary asset

Since the Merge, which fused the Ethereum mainnet with the PoS Beacon Chain, ETH’s issuance rate has decreased significantly to approx. 645K ETH per year (from 4 931K per year) and, given the burn mechanism initiated through EIP-1559, made ETH a deflationary asset.

As of January 23rd, the network has net burned 2 536 ETH during the last 130 days, whereas it would have issued 1 525 000 ETH if the transition to PoS did not happen. Stakers have successfully taken over the role of block validation from miners and have been earning staking rewards for their work.

The upcoming Shanghai upgrade (EIP-4895), among other minor updates, will enable staked ETH to be converted back to regular ETH via a withdrawal queue. The final deadline is yet to be released, yet it is estimated that the hard fork will likely happen at the end of March or early April 2023.

13,5% of ETH circulating supply in staking

More than five months have passed since our initial post about the Merge, and all the Beacon Chain-related metrics have improved across the board:

• There are currently 16,23M ETH deposited to the Beacon Chain staking contract vs. 13,40M in August,
• representing 13,5% of circulating supply vs. 11,2%,
• staked by 504K unique validators vs. 418K.

Basically, staking contract depositors can be categorized into five distinct groups:

• Liquid Staking Protocols (36%) – platforms providing liquidity to stakers through the issuance of a Liquid Staking Derivative (LSD), a digital token representing user’s assets locked in the staking contract.
• Centralized Exchanges (28%) – Kraken, Binance, Huobi and others that allow users to stake their ETH directly on exchanges.
• Whales (20%) – large ETH holders and holding entities taking care of their own staking assets such as V. Buterin, Tetranode and others.
• Staking Pools (14%) – networks allowing small ETH holders to pool assets together without maintaining any infrastructure in order to reach the 32 ETH deposit required to enter into the staking contract.
• And Others (2%).

Even during the last year's most chaotic and bearish sentiment-driven period, the trend of staking ETH and inflow of new depositors remained steady.

The amount of staking deposits has been growing after bottoming out in July-August 2022, signaling a renewed confidence in the Ethereum roadmap implementation post-Merge. Interestingly, there was an uptick in weekly deposits during the FTX/Alameda Research bankruptcy news, which may have pushed market participants to shift away from centralized providers and double down on decentralized networks. The largest category by market share and growth rate is Liquid Staking Protocols.

Liquid Staking Protocols freeing liquidity in the Ethereum PoS

Liquid staking protocol (LSP) allow users to earn staking rewards without locking assets or maintaining staking infrastructure. Users of these protocols can deposit staking tokens and receive tradable liquid tokens in return. These liquid tokens can be used for lending or deposited as collateral to borrow against in DeFi protocols.

Liquid Staking Protocols propose solutions to issues associated with standalone ETH staking – illiquidity and immovability. Also, it allows foregoing the work required to operate staking nodes, as slashing and offline penalties stack up very quickly if the staking is not appropriately managed.

Tokens issued by LSPs represent user’s staked Ethereum. Some of them accrue staking yield in a separate repository (stETH, sETH2), while the staked principal will become redeemable at a 1:1 ratio after the Shanghai hard fork commences.

On the other hand, some staking derivatives like rETH or cbETH accrue yield in the derivative token itself, thus inflating future redemption value vs. ETH (e.g., 1cbETH will be redeemable for 1ETH+ accrued staking rewards)

The first and by far the most popular protocol that launched a liquid staking derivative (LSD) is Lido (stETH), which opened for public use on December 2020 and since then has attracted close to 5M ETH to its decentralized application equaling $8 billion of value at today’s prices (ETH at ±$1630) from more than 100K unique depositor addresses.

The most prominent Lido competitor in terms of deposited ETH is Coinbase (cbETH) which initially held users’ staked ETH locked on the exchange and transformed into an LSD at the end of August 2022. Coinbase currently holds 1,1M staked ETH.

Following the top two, there are RocketPool, StakeWise and Frax Finance’s ETH LSDs grossing significantly lower yet rapidly growing market shares with 182,000, 84,000 and 72,000 ETH staked, respectively.

In exchange for staking with a certain protocol, users are paid out a yield denominated in ETH that differs between providers due to varying fee structures and incentives that these protocols choose to implement. In theory, LSD staking yield should consist of the following components:

• Staking issuance rate of ETH: 4,1% APR as of January 2023.
• MEV earnings: profits generated by validators from block sequencing and shared among stakers.
• Tips: fees earned from network participants paying for priority inclusion into a block.
• Extras: Additional incentives (if any) offered by the LSD platform.
• Charges (negative impact): Any fees the protocol charges for facilitating the network and handling the infrastructure are deducted from the yield paid out to stakers.

Most providers offer 4.5 – 5% staking yield, an otherwise considered competitive rate if not for FRAX ETH, which currently pays out more than 8% per year.

This advantage comes from a superior market positioning of the whole FRAX ecosystem. FRAX Finance has amassed a hefty reserve of CRV/CVX during active participation in the Curve & Convex wars. Therefore, FRAX can influence liquidity to stimulate a higher staking yield than its competitors.

It is expected that FRAX ETH will aggressively carve out market share from other LSD platforms until it reaches a significant enough size to render additionally offered incentives inconsequential.

Trading LSDs

Since the launch of liquid staking derivatives, their theoretical value was not always on par with the market value. This is mostly explained by the inability to redeem staked assets back to ETH and the perceived time lag until this functionality is integrated into the core PoS consensus mechanism.

LSDs gave stakers instant liquidity. However, market participants traded these instruments at a discount, as there was (and perhaps still is) an inherent risk that the withdrawal process would be delayed or encounter technical issues. At some point in June 2022, stETH traded at a 5% discount, while cbETH was trading 8% below fair value.

These discounts presented an opportunity for those confident in the Ethereum roadmap. The most risk-averse approach was to buy discounted assets below their fair value and wait for the re-peg.

A more sophisticated and risk-taking trade included interaction with lending/borrowing protocols to play the re-peg on leverage using rehypothecation of assets, also referred to as ‘looping’ in DeFi.?

A trader willing to execute this trade would, for example, put ETH as collateral, borrow stETH, swap it to ETH, set it as collateral again, and borrow stETH again to run the loop. The loop could be either implemented manually using AAVE or Compound or through looping-optimized platforms like Euler Finance and Morpho via Instadapp.

This trade structure allowed to maximize exposure to stETH through leverage but also increased the risk of a further widening de-peg resulting in liquidation of collateral.

However, if correctly monitored, it generated returns from:

• Staking yield comes from holding staked assets (stETH), multiplied by the leverage.
• Potential re-pegging if stETH recovers vs. ETH, multiplied by the leverage.
• Additional incentives offered for borrowing and supplying assets to a particular protocol (MORPH, EUL tokens).

At the moment, LSD-related discounts have shrunk significantly and do not represent interesting opportunities anymore, with the only exception cbETH, which is traded at 1,84% lower than the fair value publicly available through Coinbase’s API.

Interestingly, at the same time, rETH is trading at a 1,20% premium and has been trading above the fair value since November. However, the difference cannot be arbitraged because the RocketPool deposit pool is limited. For every 16 ETH from stakers, the node operator must complete the staking deposit with another 16 ETH. If there are not enough node operators so far, it is not possible to exchange ETH for rETH and arbitrage the market price down.

RocketPool is expected to initiate an update allowing stakers to pool more than 16 ETH and reducing the ETH requirement for new node operators, which will help to decrease the rETH premium.

With the Shanghai upgrade imminently approaching, the likelihood of withdrawal implementation also grows. Furthermore, vanishing LSD discounts have validated the LSD protocol business cases and spiked interest in their respective governance tokens.

Over the last two months, LDO, Lido Finance’s native token, has grown in price by more than +150% versus the dollar, while FXS and RPL grew respectively by +129% and 92%, significantly overperforming ETH’s price increase.

The world after Shanghai hard fork

• Shanghai upgrade probably ends up as a ‘sell the news’ event for LSP governance tokens. However, Liquid Staking Platforms continue to grow and accrue more staked ETH due to the benefits they offer - instant access to liquidity and DeFi through LSDs.
• More ETH circulating supply goes into the staking contract as market participants look to generate yield on a deflationary asset with renewed confidence in the ability to unstake.
• FRAX ETH becomes the fastest-growing liquid staking platform in the short to mid-term by taking advantage of the synergies offered by FRAX Finance infrastructure and the ability to stimulate higher staking yields through CVX/CRV treasury.
• Shanghai update does not have a material negative price pressure on ETH as (1) the majority of staked ETH is already liquid (Liquid Staking Platforms and Exchange Staked ETH), and the ones holding in locked staking are likely ETH maximalists looking to continue staking and earning ETH rewards. Moreover, (2) a sizeable portion of ETH stakers are underwater in dollar terms and have no incentive to ‘take profit’ by selling the unstaked ETH unless to test the withdrawals or move ETH to higher-yielding LSD alternatives.

• LSD discounts become arbitraged and obsolete while borrowing rates increase to minimize the effect of looping to benefit from leveraged staking yield.
• New use cases get introduced to utilize the Ethereum PoS network to secure other applications and protocols (e.g., Eigenlayer) while offering additional rewards for ETH stakers.

In conclusion, we reckon Liquid Staking Derivatives to benefit the entire Ethereum ecosystem. The mechanism democratizes the work of "mining" to retailers while giving instant liquidity to their assets. LSDs under PoS have an ample margin for innovations, aiming to transform Ethereum as a deflationary liquid asset, providing yield from network utilization in one of the most efficient ways to many use cases and complementary applications.