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Liquid Staking Derivatives

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Introduction

Traditionally, staking in Proof-of-Stake (PoS) protocol based networks has been about locking tokens for a certain time period and expecting a fixed, predetermined staking reward in return to secure the network. While it guarantees a return on staked tokens much like a bond, it also limits the opportunities of generating higher returns on those tokens as they remain locked and inaccessible.

The alternative is “liquid staking” which has become more popular as it opens up opportunities to efficiently utilize staked assets as collateral to trade, lend, and provision liquidity more quickly.

Liquid staking generally requires minting staked[token] which are a representation (a “derivative”) of the actual token that is being staked and used to secure the network, thus the term Liquid staking derivatives (LSDs) was coined.

Recently, the notion Liquid Staking Tokens (LSTs) also started to grow in usage - both terms are used interchangeably.

What problem does liquid staking address?

Liquid staking introduces various fundamental benefits to stakers by:

  • Making staking process simple - no need to worry about hardware setup and maintenance, there is significantly less technological background required compared to staking Ethereum on your own as a solo staker
  • Making staking less capital intensive - making it possible to get rewards on as small a deposit as users want, compared to the fixed amounts required in some PoS-Chains (i.e, Ethereum requires minimum 32 ETH staked)
  • Making staked assets productive - providing the st[token] as building block for other applications and protocols (e.g., as collateral in lending or other trading DeFi solutions).

Liquid staking provides an opportunity to maximize the potential of a staked asset.

How does liquid staking work?

As described above, a user can deposit their token in liquid staking solutions (either with centralized exchanges such as Coinbase or Kraken, or with liquid staking protocols such as Lido or Rocketpool) and will receive a representation of their staked token st[token] in return.

The st[token] now accrues the staking reward for staking token but can be used as collateral, to trade, lend or provision liquidity.

Liquid staking thus allows the user to get the best of both worlds - a reward on your staked tokens as well as the opportunities of using the token actively.

Why are there different staked tokens (e.g. in Lido, stETH and wstETH)?

Lido (and other LSD’s) offer two variants of st[token] known as stETH and wstETH.

Both tokens are fungible, but they differ in how they represent accumulated staking rewards. stETH utilizes rebasing mechanics, resulting in periodic increases in the stETH balance in your wallet (e.g. your balance is updated once every day).

Due to the rebasing nature of stETH, the stETH balance on holder's address is not constant, it changes daily as oracle reports come in. Many current DeFi apps (e.g. Uniswap, Maker, Sushiswap) are not designed for rebasing tokens and this can result in holders not receiving their daily staking rewards.

Therefore, Lido developed wstETH which maintains a constant balance while its value gradually appreciates in terms of stETH. Through a trustless wrapper, stETH can be converted to wstETH and vice versa, enabling efficient liquidity sharing between the tokens.

As the wstETH balance on a holder’s address remains constant, wstETH can be used in a wide selection of DeFi applications today.

Example

  • Alice locks 1 stETH and receives 1 wstETH against it
  • After a few days, Alice unwraps her wstETH and receives stETH - the stETH balance she now receives against her wstETH will have increased relative to the pre-wrapped amount, reflecting the rewards that were collected in stETH during the time Alice held wstETH

Staking market

On June 19th, 2023 more than 22.9 million ETH are staked, representing more than 19% of all ETH. At current ETH price of USD 1’730, this represents ~USD 40bn being staked.

Staked ETH metrics on 6/19/2023. Source:

Currently, Lido is the dominant liquid staking solution with ~7.25M ETH being staked with Lido, followed by three centralized exchanges Coinbase, Binance and Kraken.

ETH Stakers leaderboard on 6/19/2023. Source:

Lido

Lido (https://lido.fi/) is the dominant liquid staking protocol and is managed by the Lido DAO. Lido’s core focus is making the staking process simple and accessible to anyone, while allowing users to use their stTokens productively.

Lido has onboarded ~30 node operators are that were accepted by the Lido DAO through governance vote. The protocol distributes the pooled Ether from its users evenly between all active Node Operators in 32 ETH chunks. As withdrawals are requested, protocol publishes exit requests and Node Operators exit requested validators.

Lido is the dominating protocol in terms of TVL today and holds ~7.25M ETH, or ~31.6% of all staked ETH. As Lido has ~30 node operators, meaning ~1% of all staked ETH is which each of those node operators, which are hand-picked by the DAO.

Lido critisism

Critics highlight that there are two major risks with Lido today: Node operators hold significant amounts of ETH and don’t have to post collateral and are whitelisted by the DAO. There is no way for a small operator to become part of Lido as of today (planned for future versions of Lido).

Another centralization vector is that almost 1/3 of all staked ETH is being staked with just 1 protocol.

Rocketpool

Rocketpool (https://rocketpool.net/) is the second largest liquid staking protocol after Lido. Rocketpool aims to serve two user groups:

  • 1) Stakers that don’t want to operate a node themselves and those that wish to participate with smaller capital requirements (in Rocketpool as little as 0.01 ETH)
  • 2) Stakers that wish to stake ETH and run a node in the network to help generate a higher ROI due to commissions earned from stakers in group 1

From hobbyist node operators to full on node operation professionals, Rocket Pool allows you to earn a greater ROI staking inside the protocol vs. outside of it.

Once you deposit 16 ETH, the protocol will assign you 16 ETH from users who are depositing ETH and receiving rETH. Therefore, as a node operator you are staking your own 16 ETH and 16 ETH on behalf of the protocol.

Rocketpool has holds ~713k ETH, or ~3.2% of all staked ETH.

Comparison between Lido and Rocketpool

Lido handles the technical aspects of staking and delegates the node operation process to a handful of selected third parties.

Rocketpool functions as a decentralized network of node operators. Rocketpool decentralizes the staking process by allowing users to contribute to the network's staking infrastructure with smaller capital requirements both for staking but also validating the network (16 ETH vs. 32 ETH as minimum requirement for Rocketpool node operators).

Other staking options

Solo staking

Solo staking requires deep technical understanding as a user needs to set up a validator node. Additionally, it requires a minimum deposit (32 ETH in Ethereum’s case). The network requires reliant validators and high uptimes, slashing and offline penalties can get very severe if the staking is managed improperly and finally, the staked amount is locked up for a significant period.

Staking with a centralized exchange

Staking with a centralized exchange requries to trust the centralized party, which may act maliciously, be regulated or in other ways have different incentives than the user itself.

What can I do with staked tokens?

There are several use cases for staked tokens and many teams are working on expanding that offering. The core principle of liquid staking is making your staked assets productive - they allow you to do what you’d be able to do holding ETH that is not staked, such as:

  • Simply hold stETH and accrue network rewards
  • Trade stETH against other tokens
  • Use wstETH in a variety of DeFi protocols - as collateral in a lending protocol such as Raft Finance or to provide liquidity in on a DEX

Example Raft Finance

  • Alice locks 5 ETH in Lido and receives 5 stETH
  • Alice likes productive assets, so she decides to take out a loan with her stETH as collateral with Raft
  • Alice deposits 5 stETH in Raft, takes out a loan with a ~200% collateral ratio and receives 5000 R tokens against her collateral (Ris a stablecoin pegged to the US Dollar)
  • Alice can now use her 5000 R for anything she’d like - providing liquidity, exchanging it to other tokens - or, if Alice is bullish on ETH - she could buy more ETH
  • Alice now receives yield on her 5 staked ETH and has 5000 R - compared to simply holding or staking 5 ETH
Raft Finance allows users to borrow a USD-pegged stablecoin $R against stETH collateral (6/19/2023). Source:

LSDfi market

Like Alice, many users are excited about the possibilities staked tokens offer: currently, there are more than USD 430M of staked tokens used in various DeFi protocols (this excludes liquidity provisioning):

LSD value locked in protocols on 6/19/2023. Source:

More resources on the status quo of LSDfi today:

Benefits of liquid staking

Liquid staking introduces other various fundamental benefits:

  • No hardware or technological knowledge required Making the staking process simple compared to staking as a solo staker - no need to worry about hardware setup and maintenance
  • Removing high capital requirements Liquid staking solutions make it possible to get staking rewards on as small a deposit as users want (i.e, Ethereum requires minimum 32 ETH staked to become a solo staker)
  • Enabling capital efficiency Providing the st[token] as a building block for other applications and protocols (e.g. as collateral in lending or other trading DeFi solutions). Liquid staking gives an opportunity to greatly increase the capital efficiency of your holdings

Risks and costs of liquid staking

Liquid staking also introduces various risks and costs:

  • Staking fee In return for the benefits above, liquid staking solutions usually demand a fee for their services (Lido 10%, Rocketpool 15%, Coinbase 25%)
  • Liquidity and pricing risk Typically st[tokens] are less liquid than their token counterparts as there is only a certain % of the network staked and there are different providers for st[tokens]. Additionally, as there are risks associated with staking solutions, the st[tokens] might be priced at a discount compared to the original token
  • Counterparty risk (CEX staking) For CEX staking, users trust and depend on the centralized party not acting maliciously or being regulated and acting against the users’ interests
  • Smart contract risk For decentralized staking solutions, the user is relying on the smart contract of the protocol being secure and resistant towards exploits and hacks
  • Governance risk Decentalized staking solutions such as Lido are governed by the Lido DAO and the Lido tokenholders which can introduce changes to certain parameters of the protocol (such as the fee charged to the staker). Typically, the team building decentralized staking solutions such as Lido or Rocketpool also hold significant percentages of the token supply and are thus another attack vector that a staker needs to consider

Resources

A-Z

Coinbase Institutional on Liquid Staking (Link)

Hildobby’s ETH 2.0 staking dashboard (Link)

Lido documentation (Link)

Miti.ai’s LSD Journal (Link)

RocketPool documentation (Link)

SumCap LSDfi Summer Map (Link)

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Disclaimers

Not financial advice.

Tomahawk is an investor in raft.fi through its holdings of TEMP.