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Demystifying Liquid Staking Derivatives
Level 2 - Value Investor
MetaMask recently launched a Staking beta on its portfolio interface. This means normal users can now ‘stake’ their ETH on one of two popular Liquid Staking platforms - Lido and Rocket Pool.
Lido’s LDO token has also been one of the best performing DeFi tokens recently.
Today we go over the basics of staking.
Paid subscribers will soon receive our research report on the main LSD coins.
What is Staking
Ethereum transitioned to a Proof of Stake blockchain during September 2022.
Blockchains rely on privileged participants known as validators to verify user transactions and publish them by assembling them into a “block”. With Proof of Stake, blockchain security is assured by requiring each validator to lock up (or “stake”) valuable tokens. These tokens are forfeited (“slashed”) if the validator fails to follow the rules of the chain. Proof of Stake solves the “Nothing At Stake” problem.
Nothing At Stake
In a decentralized system, there are no “official” nodes run by a provider and responsible for ensuring transactions are processed. And as block production carries costs, it isn’t reasonable to expect volunteer operators to run the system. We therefore depend on the profit motive, but must set incentives to avoid abuse.
Block producers (validators) are incentivized with newly minted cryptocurrrency for winning the race to produce a block. In a global distributed network, multiple blocks may be produced at nearly the same time. The network must come to consensus on which block at the new block height will be the official accepted block.
Under Proof of Work, producing a block is so costly that the winning strategy is to support the current consensus (the longest chain). In Proof of Stake, no computing power is wasted ‘mining’ for blocks, so it would be rational to support all competing blocks to maximize rewards when the network resolves consensus. But this would delay finding consensus, which isn’t desirable - fast finality (transaction speed) is critical to decentralized public blockchains. This conflict between validator profit incentive and the needs of the network is called the “Nothing At Stake” problem.
The solution is to impose an economic cost for ‘equivocating’, or voting for blocks on competing chains. In Etheruem this is called slashing.
Ethereum needs validators to perform the work of processing transactions. Validators are rewarded with newly minted ETH. And to ensure they follow the rules of the network, validators must place a deposit which is at risk of being forfeited.
There is currently Ξ 6,828,160 staked (~$10.71b) of which 57% is staked directly and the remainder through staking pools.
How Staking Works on Ethereum
Staking on Ethereum means depositing 32 ETH to activate validator software. The user who is staking becomes responsible for storing the state of the blockchain, processing transactions, and producing blocks - this is all done automatically by the software, but the user must ensure their server is working and online at all times.
In exchange for this work, validators earn ETH.
Staking is the only source of native yield on Ethereum. Holding ETH should be more attractive as it’s now yield bearing, although the APY varies with the total staked.
To stake, you’ll need to be technically proficient (setting up and managing a server).
Funds cannot be unstaked until the ‘Shanghai’ upgrade. And. To ensure there are always enough funds staked to secure Ethereum, unstaking is rate limited.
Native staking presents three challenges:
technical barrier to entry
requires 32 ETH (~$50,000)
A sub-segment of the crypto industry has emerged from solving these problems.
Liquid Staking Derivatives
Liquid Staking Derivatives (or LSDs for short) are tokens issued by a custodian.
Their value is derived from the value of a claim on the staked ETH held by the issuer. These staking derivatives are called ‘liquid’ because they can be freely traded with other users on-chain through a DEX. This means a user who has staked through an LSD service can sell a token representing their stake to another user at the market price, receiving access to funds without waiting for the Shanghai upgrade (or for the rate-limited withdrawal queue to clear).
Examples of protocols offering Staking-As-A-Service and issuing LSD tokens are Lido, Rocket Pool, Frax Finance, and Ankr.
Users can earn yield on their staked ETH with lower minimum deposits than native staking: 16 ETH (~$25,000) on Rocket Pool or *any* amount on Lido.
Lido’s Staked ETH (“stETH”) is considered high quality collateral (backed by ETH). DeFi power users can borrow against their yield bearing staked ETH, or earn fees from LPing their stETH tokens in a DEX pool.
In exchange for providing these services, LSD providers expect to earn huge fees. Issuing Liquid Staking Derivatives is Stablecoins 2.0. Like stablecoins, you need to be discerning about which protocols have been built securely, and poorly implemented copycats which can become unbacked!
Stay tuned for our deep dives into the token issuers and whether we think this sector is still a good investment.
Autist Note: although each unit of LSD is backed 1:1 with an ETH deposit, these tokens should trade at a discount due to the technical risks implementing the Shanghai upgrade and the time value of money.
To Stake, Or Not To Stake
The main benefit of running a validator in Proof of Stake is keeping the network credibly decentralized. If enough “end users” do not stake, the chain becomes controlled by large corporations (Coinbase) who are subject to political and regulatory pressure. The value of ETH depends on Ethereum maintaining its international status as a credibly neutral base layer.
Consider for example a future where there’s an OFAC compliant Ethereum used by Americans and a decentralized EVM-compatible (Avalanche?) chain used by Russia, India, China, Brazil, and Africa. Ethereum would still be a top coin, but far less valuable (remember transaction fees are burned, directly accruing value to ETH holders proportional to chain use.)
Therefore anyone who can stake, should stake, and stake directly.
The other benefit of staking is the yield, crypto’s equivalent of the risk free rate.
The main drawback of staking through a service provider rather than running your own node is treatment of bribes. If you are in line to propose a block and a MEV bot includes a large bribe in the transaction, it’s yours. If you stake in Rocket Pool the bribes received by the pool are averaged out. And Lido charges fees on all revenue including bribes.
Although there is an element of luck, we think the opportunity to receive MEV bribes makes running your own node a no-brainer if you have the funds and technical ability to do so. After the Shanghai upgrade, we expect more competition so stake now!
For everyone else, the choice is between staking through a service provider or not staking at all.
Risk Management: Staking-As-A-Service
Once again, you’re being asked to trust an intermediary.
Although the market leader Lido is trusted by whales and secures nearly $8b, we would never trust a third party with our entire ETH holdings, that’s just bad risk management. None of the LSD providers are truly Lindy.
We think it is reasonable to stake directly, as the Ethereum deposit contract has been formally verified (proving adherence to specification, so we do not expect smart contract bugs will exist).
Using an intermediary like a staking service adds in various layers of risk, including additional smart contract and software risks.
Not Your Keys, Not Your Coins.
~13% of LDO staked ETH (largest TVL) is subject to DAO key management risk. Staking directly in the official Etherum staking smart contract is non-custodial.
Assuming you understand and accept the risks
smart contract risk in e.g. Lido’s software
technical risk in the Shanghai upgrade
the price risk inherent in holding an LSD which may be trading at a discount to ETH at the time you need liquidity
We think it’s fine to stake a portion of your ETH for the ~5% rewards.
To be clear we don’t think Lido will be hacked or fail. Just know the risks.
We also think it’s fine to forgo 1.25% and wait a few months to verify that the upgrade works as expected.
Whether to stake or not doesn’t move the needle in the short term, we think there’s likely more profit in owning one of the LSD provider tokens. Lido is currently collecting ~25bps on ~$8b of assets, one of the more profitable businesses in crypto!
Long term, holders of ETH should stake (directly if possible) to avoid dilution.
We’re doing a deep dive into Rocket Pool and Ankr for paid subscribers, but we’re happy to disclose that we wouldn’t trust the Frax LSDs at the moment due to some software security concerns highlighted in our prior research.
Have you staked? Or do you have questions or concerns not covered in this post?
Why not subscribe to ask us a question in our monthly Q&A.
Disclaimer: None of this is to be deemed legal or financial advice of any kind. These are opinions from an anonymous group of cartoon animals with Wall Street and Software backgrounds.