#3 Liquid Staking

Gm anon! Welcome to the third edition of defined, where we help you understand the liquid staking narrative that’s been permeating crypto. 

Background 

Ever since the new year, crypto twitter has been filled with threads and tweets on how LSD or liquid staking derivatives might be the dominant narrative in crypto this year. 

All the liquid staking coins have been steadily pumping, with the largest one, $LDO, up 136% in the last 30 days. All this begs the question- what is liquid staking, and what makes it the biggest thing in crypto right now?

Before we dive into what liquid staking is, it is important to build some background first. 

Sometime last year, ETH witnessed the merge, marking a shift in the consensus mechanism used from proof of work to proof of stake. In the proof of work model, validators had to compete to solve a mathematical puzzle to put a block on-chain. In the proof of stake model, validators have to stake the native asset of the chain (for example, ETH for the Ethereum network) to put a block on the chain. 

The merge was not an easy process- it’s similar to shifting the engine of a flight in mid-air. So, a side chain called the beacon chain was created on December 1, 2020, with a proof of state consensus mechanism. Initially, it did not process mainnet transactions, instead reaching consensus by validating its own account balances. 

After the merge, the beacon chain became merged with the previous mainnet chain- now validating transactions and adding blocks. 

The proof of stake model not only made the network more efficient in terms of power consumption but also now allowed users to stake their ETH to secure the network and earn rewards for the same. (current rates range b/w 3-6%)

The problem with staking, however, is that it is capital inefficient- the asset is locked up and cannot be used unless it is removed; think of it as a fixed deposit where your money is locked. 

This is where liquid staking comes in. 

In liquid staking, when you stake your asset (say ETH) in a liquid staking protocol, you get a derivate of the asset in return. This derivative asset can be lent to earn more yield, used as collateral to borrow assets and so on. Liquid staking essentially makes the process of staking capital efficient. 

Liquid staking providers allow you to unlock the liquidity of your staked assets, in return taking 10-15% of staking rewards as revenue for allowing you to unlock liquidity. 

The Shanghai Update 

Currently, the ETH staked to secure the network cannot be used. However, the Shanghai update, which is coming in March (might be even later), will allow staked ether to be unlocked. 

This will drive more people to stake their Ethereum, which means they will be able to use their Ethereum instead of losing out on potential gains. 

Currently, only 13.87% of the circulating ETH supply is currently staked, which is significantly lower than the rest of the other PoS tokens. The prevailing narrative is that this will increase once the Shanghai update comes around. 

However, it could happen that people who have staked their ETH for a while might sell once the update goes live and it might be a ‘sell the news’ type of situation. 

Although the underlying ETH is locked until the Shanghai upgrade is completed, liquid staking providers issue a derivative token backed one-to-one by the assets staked on the platform. 

The shift to a proof of stake network marked the perfect background for liquid staking, given that majority of the protocol coins have to be staked. 

Major LSD protocols

All the liquid staking protocols differ in the way they provide the same. A brief introduction to some of the major ones is below. 

#1 Lido Finance

Lido Finance was launched in December 2020, just a couple of weeks after Beacon Chain went online. This is no coincidence. Beacon Chain was an experimental PoS Ethereum network designed to pave the way for The Merge.

To make PoS staking funds available for use in dApps, the Lido platform tokenizes those funds as staked tokens. Different networks have different staked tokens. They are named by adding the “st” prefix to the tokenized network’s token. For Ethereum (ETH), for example, it is stETH.

These staked tokens are tied to their respective native tokens in the same way as stablecoins USDT or USDC are tethered to the dollar at a 1:1 ratio. Despite the fact that this implies that 1 stETH is equivalent to 1 ETH in value, it is still possible for a staked token's price to fluctuate due to supply and demand on the secondary market.

One thing to note is that Lido is a mediator; basically, all tokens deposited into Lido are staked on the respective PoS chains- ETH deposited will be staked on Ethereum and so on. In turn, Lido’s smart contract sets staking rewards and manages staked token withdrawals, plus the 10% fee from staking rewards.

Lido is the market leader in liquid staking currently, with more than $8B in TVL. Post the news of the Shanghai update, the TVL of Lido has been steadily increasing, displacing Maker DAO as the major de-fi protocol in terms of TVL. 

#2 Coinbase 

Coinbase, currently one of the largest CEXs, also enjoys a good position in the liquid staking market. Quite a late entrant, it has quickly risen up to second place in terms of liquid staking, enjoying a 17% market share, while Lido and Rocketpool have a 76% market share and 3.5% share, respectively. 

Similar to how Lido finance gives stETH in return, coinbase gives cbETH in return. Users who stake ETH on coinbase will get ETH2, which they will, in turn, be able to wrap to receive Coinbase ETH. Holders of cbETH will be able to move these tokens to a self-custodial wallet and trade them off the Coinbase platform. 

Market sentiments seem to be in favour of coinbase’s liquid staking program, with analysts at JP Morgan prophesying an increased revenue thanks to liquid staking. 

#3 Others 

Currently, Lido and Coinbase control the lion’s share of the market. However, there are a number of other protocols innovating in the space and trying to come out on top. 

Rocketpool finance, which recently got listed on Binance, is one of them. Though it has a market share of just about 3.5%, Rocket Pool was built with the intent to allow anyone to trustlessly stake as little as 0.01 ETH to a network of decentralized node operators. 

Stakewise too offers staking pools, bypassing the limit of 32 ETH that the chain mandates as the minimum for a validator to stake 

FRAX is an interesting project- frxETH acts as a stablecoin loosely pegged to ETH. sfrxETH is the version of frxETH which accrues staking yield. All profit generated from Frax Ether validators is distributed to sfrxETH holders. By exchanging frxETH for sfrxETH, one becomes eligible for staking yield, which is redeemed upon converting sfrxETH back to frxETH.

There are also a few that CT seems to think are undervalued, such as $SGT( Not financial advice), which has a market cap of $900k with a TVL of about $25M staked ETH. However, it is important to note that the protocol was exploited by an insider and the only reason it has that much ETH is that people are stuck. Sometimes, it is important to distinguish the signals from noise; CT is filled with accounts which might be putting their voice for shady tokens in the hunt to find the next 1000x gem no one is talking about. Always do the due diligence, anon.

At the end of the day, CT does recognise narratives that play out. And this just might be the strongest narrative of the year.

So, keep a watch on liquid staking, anon. Until next time!