Tokenizing ETH yield

Introduction

Even if you got interested in DeFi this year, you certainly have heard about liquid staking. Though it may sound cryptic, liquid staking is just one form of regular staking where users delegate their tokens to a validator node on a Proof-of-Staking (PoS) blockchain network. With regular staking, you cannot withdraw your assets from the pool once they are locked up. The problem should be obvious: If there are other opportunities to earn more yield, you are not able to exploit them. So, you have an opportunity cost. You have market risk as well; if the price plunges before your crypto is unlocked, the value of your holdings will go down which easily can outweigh the yield you received from staking.

Liquid staking was offered as a solution to fix these problems. For depositing their crypto into a staking pool via a third-party liquid staking provider, users receive derivative tokens the value of which comes from the price of the underlying digital asset. In the case of ETH, the largest altcoin and around which the biggest LSD (liquid staking derivatives) market has been built, the value of LSDs is pegged to the ETH price.

Liquid staked tokens

First, let’s define what a liquid staking derivative (LSD) is. In finance, traditional or decentralized, a derivative indicates a security deriving (that is where the term “derivative” comes) its value from an underlying asset. An option on Apple stock or BTC futures are derivatives because the prices of both the option and the futures contracts depend on the price of Apple share and Bitcoin respectively. In the context of blockchain networks, LSD is just a digital asset representing a token staked into a DeFi protocol. Even if you stake your stake your tokens within a protocol, you can use LSDs on other decentralized applications.

For the Ethereum blockchain LSDs were a popular product up to Shapella upgrade. While ETH holders locked their Ether holdings to secure the blockchain, LSDs gave them flexibility to utilize their tokens elsewhere if they wished to do so. The Shapella upgrade unlocked a great amount of ETH which increased the need for liquid Ether staking protocols. At the time pf writing, more than $18 billion is deposited into LSD protocols with their TVL surpassing even that of DEXes.

Liquid staking is beneficial not only for users but for the whole DeFi as well. It is believed that over time it will result in more decentralization because it lowers the barriers of entry. An increase in the number of validators will create a more robust and secure PoS network. On the Ethereum network, for example, if you want to be a validator, you have to invest at least 32 ETH which is a huge sum for the majority of retail users. Liquid staking makes it possible for users to contribute to the decentralization, stability, and security of the blockchain network with the amount much less than 32 ETH, and to earn yield in exchange for locking up their tokens.

ETH Liquid Staking

The liquid staked ETH market is huge. It has grown even more since Shapella upgrade on April 12. The number of locked ETH coins increased by 4.4 million bringing the total number to 22.58 million. The main reason for the demand probably comes from large ETH holders who prefer to stake their coins instead of passively owning them. Given that deflationary forces may cause ETH price to surge, it is relatively safe to assert that this trend will continue.

The market is not without problems though. There are risks associated with other DeFi sectors:

• Smart contract risk which is inherent to almost all DeFi sectors / protocols / apps.
• Counterparty risks should not be ignored either; there’s always a chance that a third-party liquid staking service provider won’t fulfill his obligations.
• You have to consider regulatory risk as well. With the recent war of SEC against the largest centralized exchanges (CEX) and their staking services, it is not unlikely that one day SEC will come after the liquid staking solutions.
• Depeg risk. it may be a strong statement, but I’ll say it anyway. Whenever you hear “derivative” in DeFi, you have to assume the depeg risk, that is the price of the derivative asset will deviate from the price of the underlying asset. Since LSD tokens are traded on the secondary market, occasionally their prices can fall below the peg; this was the case in 2022 June in the aftermath of Terra blockchain collapse when stETH/ETH was trading at 0.93. This was due to a popular recursive borrowing stETH strategy. Aave adding stETH as a collateral in 2022 February made the strategy possible – deposit stETH as collateral, borrow ETH against your collateral, and buy more stETH with ETH. When there was strong market liquidity and relatively less volatility in the markets, depeg stETH/ETH worked well. But liquidity crunch several months later sent the peg below parity. This is detrimental not only to one protocol and its liquidity providers, but also to the liquid staked ETH market. When the derivative asset experiences a significant depeg, users tend to withdraw their funds which leads to liquidity crunch and may impact all LSD protocols.

However, the most important issue with the current market is centralization. The biggest player in the field is Lido in which hands concentrated about 90% of liquid staked Ether. If we exclude Coinbase, which is a centralized exchange and thus should not be considered DeFi, Lido seems the only significant player in the Liquid Staked Ethereum market. At the time of writing, it has 16 times more ETH locked than the second-largest protocol, Rocket Pool has.

Not only for the TVL (Total Value Locked) but also for the number of depositors Lido is the market leader as the chart below shows:

But here is the problem. If some sector of the market is dominated by one actor, then this is not true decentralized finance. Depeg from ETH price or a critical smart contract bug would severely affect the LST (liquid staked token) market. There’s also regulatory risk – sanctions or charges by regulatory bodies can disrupt the system regardless of how big it is at the moment. The stakes (pun intended) are just too high to remain LST market centralized in the hands of one big actor.