March 2023 – Liquid Staking Derivatives

  1. Introduction
  2. Staking Derivatives explained
  3. A Buyer’s Guide to Liquid Staking Protocol
  4. LIDO Finance (LDO)
  5. Rocket Pool (RPL)
  6. Risk Associated with LSD
  7. Conclusion

Introduction

The Proof-of-Stake (PoS) mechanism provides a better scaling solution, energy efficiency and increased speed over the earlier Proof-of-work mechanism.

PoS requires validators to validate the transactions on the blockchain. To become a validator, one must pledge some cryptocurrency for the vesting period. The validator is then not allowed to take the cryptocurrency out for the vesting period. When you stake your cryptocurrency in the blockchain, you will not be validating the transaction individually but the computer network will.

Staking on the blockchain incentivizes the validators with staking rewards. This is kind of an income to crypto owners. If the validator approves any fraud transaction, they will have to pay the penalty which will be deducted for the staked amount. The only problem that this creates is it decreases the liquidity of that cryptocurrency in the market. Moreover, it stops the validators from participating in other trading activities related to that crypto currency. This gave rise to staking derivatives.

Staking Derivatives explained

Ethereum upgraded from proof-of-work to proof-of-stake consensus in 2022. This allowed the users to stake 32 ETH to participate in consensus, validate transactions, and create blocks, in order to secure the network. Doing this earns stakers ETH rewards, while doing it poorly can result in lost ETH due to penalties. 

The drawback of this is that the users were not allowed to withdraw the staked ETH until the Shanghai Upgrade in April 2023. This is what gave rise to staking derivatives. Users can now go to a liquid staking derivatives platform and give them their Ethereum to stake and in return they receive a token which represents the staked eth and its rewards (like a derivative). This token can further be traded or used in a DeFi app as an asset. This allows the user to use their staked eth to earn rewards as well as to use them as a liquid asset. 

The idea of being able to invest the same money twice is lucrative to everyone and so everyone is turning to Liquid Staking Derivative Protocols with their money. 

A Buyer’s Guide to Liquid Staking Protocol

There are many LSD Protocols in the market that provide different kinds of incentives. One of the biggest LSD protocols is LIDO with over 13.22 billion dollars in assets. 

Here is a comprehensive comparison of different LSD protocols.

Above chart shows the top LSD Protocols in terms of total value locked. Let us explore some of the top protocols in detail.

LIDO Finance (LDO)

LIDO was founded in December 2020 when Ethereum announced that it will merge with the Beacon chain and upgrade to Proof-of-Stake consensus mechanism. They had the early mover advantage and were backed by Andreessen Horowitz and Coinbase Ventures. With the growing demand of staking as a service after the PoS upgrade, LIDO has come out to be the frontrunner in the business.

The Liquid staking protocol is managed by Lido DAO. The DAO is responsible for managing Lido, ensuring stability, building/deploying/updating the staking protocols, and accumulating the service fee. We can deposit ETH to be staked on Lido’s staking page and receive stETH which accounts for the staked ETH and the staking rewards. This will allow us to do different DeFi activities using stETH.  10% of the ETH staking rewards is the commission of LIDO and is split between the node operators and DAO treasury. Only LDO token holders can add new node operators.

LIDO has two distinct tokens representing deposited assets – stETH and wstETH. 

stETH implements rebasing mechanics, which periodically increases the stETH balance to reflect accrued staking rewards. It is liquid, and can be transferred, traded, or used in DeFi applications. Tokens are mined upon ether deposit at 1:1 ratio and can be redeemed for ether at the same ratio. stETH token balances are updated daily through a process called rebase.

wstETH is an ERC20 token that represents a user’s share of the total supply of stETH. It has static balances and does not undergo rebases. The need for wstETH arises because stETH is not supported on many dApps due to its rebasing feature. 1 wei in shares equals 1 wei in balance for wstETH, meaning the balance remains unchanged. wstETH balance can only be changed through transfers, minting, and burning, providing stability in the balance.

LDO token is one of the top performing tokens with its price going more than 2x in the past 1 year with 87% of its token in circulation.

ROCKET POOL (RPL)

Rocket Pool claims to be the most decentralised community owned liquid staking protocol. A minimum of 0.01 ETH is required to participate in the protocol and receive rETH in return. rETH is fully compatible in the DeFi landscape. Insurance mechanism protects the rETH’s value against node slashing and downtime. The insurance is paid by the node operators staking RPL as collateral for any penalty they incur. Anyone can become a node operator in this permissionless protocol by staking 16 ETH (instead of 32) and a minimum 10% of that ETH’s value in RPL as collateral (as an insurance promise to the protocol). The more RPL is provided as insurance, the more RPL rewards can be earned.

The Rocket Pool protocol is run by two DAO’s each with a unique set of responsibilities.

Protocol DAO (pDAO): It is the brain responsible for shaping the direction of the protocol. The new improvement proposals are voted on by the node operators within Rocket Pool. The voting power is decided by the effectively staked RPL.

Oracle DAO: There are two types of nodes in Rocket Pool, regular bonded nodes and the oracle nodes that comprise the Oracle DAO. Anyone can become a regular node by staking 16 ETH and RPL as collateral. Oracle nodes provide the on-chain duties and are rewarded for doing so. Oracle DAO members relay the consensus layer oracle data back to the protocols contract on the main chain. Oracle nodes are rewarded 15% of RPL inflation annually. 

Being a validator in Rocket Pool can be quite rewarding, one can earn the staking rewards from the staked 16 ETH and earn more rewards in RPL for providing the service as a validator.

Risk associated with LSD

  1. Lido controls most of the staking power with close to 30% ETH staked through the platform. If it exceeds over 33%, there will be a risk of centralization attack. This will make the decentralized ecosystem redundant.
  2. Assets received from liquid staking protocols are market dependent. Any rapid movement in the market sentiment can significantly affect the value of the token holdings
  3. Not all the platforms support liquid staking. With the DeFi ecosystem still developing, there are a few platforms that offer liquid staking as a service. There are not a lot of tokens of token supported by regular staking platforms. This limits the holder of the assets to limited investment opportunities with the token (e.g. stETH, rETH).
  4. Liquid staking rewards are not consistent across all platforms. The yield rewards for liquid staking can vary from platform to platform, even for the same token. It is important to compare the yield rewards offered by different liquid staking platforms before choosing one. 
  5. There is no hard regulation on the way of operation of the liquid staking protocols. All the protocols follow different logic but are vulnerable one way or another. So be careful, before investing in one.

CONCLUSION

The Shanghai Upgrade fuelled the adoption of LSD protocols. What the future holds, is open to speculation. If you believe Liquid staking has a bright future ahead, then you should research the tokens before adding them to your portfolio. DAO tokens of LSD are quite lucrative to everyone right now because of their increasing prices and great return. 

But liquid staking is not only about trading the tokens. It gives a new power to the DeFi ecosystem. LSD protocols have made it easier for anyone without the technical know-how to stake their ether and help in keeping the network secure. Most of the LSD protocols are decentralised and community owned, representing the key belief of Ethereum. 

As promising LSD protocols look, they do come with several risk factors involved. The mass adoption of liquid staking remains a challenge. It will be interesting to see what the future holds.