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Staking Options in Ethereum

ETH holders have a variety of options to stake their digital assets. These include solo staking, staking as a service (SaaS), centralized staking, and liquid staking derivatives (LSDs), each bringing unique benefits and trade-offs.

Solo Staking

This method is ideal for the dedicated Ethereum enthusiast, albeit it demands considerable effort, capital, and technical acumen. Despite these stringent requirements, solo staking contributes significantly towards decentralizing Ethereum and yields the highest rewards for users.

Centralized Staking

This simple and passive method requires minimal capital but demands complete trust in a third-party custodian. Although this option offers simplicity and instant liquidity, it contributes to the centralization of the network, an undesirable outcome for Ethereum's vision of decentralization.

Staking as a Service (SaaS)

SaaS is an excellent pathway for those seeking involvement via a trusted counterparty or organization. Although this method introduces counterparty risk, it offers the advantage of delegating the responsibility of running and managing the node to a third-party.

Liquid Staking Derivatives (LSDs)

Regarded as the most popular form of staking, LSDs cater particularly to those holding less than 32 ETH. Services such as Lido and RocketPool offer this staking method. On depositing ETH into the contract, the entity combines the stake with others to create a pool of 32 or more ETH, which is then allocated to a validator. This approach offers substantial user benefits, as these stakes are highly liquid in DeFi markets.

What Are LSDs?

Liquid staking is a process that allows users to stake their Ethereum (ETH) without locking up their tokens. ETH presently serves diverse functions within the contemporary decentralized finance (DeFi) ecosystem, from acting as collateral in lending and borrowing protocols to providing liquidity in decentralized exchanges. However, the act of staking Ethereum renders it non-rehypothecatable within these various protocols. Thus, Ethereum holders must decide between generating staking yields (and thereby countering protocol inflation) or deploying Ethereum in DeFi activities.

This is where liquid staking enters the equation. In this arrangement, Ethereum holders can deposit their Ethereum into a staking contract, and in return, they receive a tokenized derivative of their assets. In an optimal scenario, this derivative token can be used across multiple DeFi protocols as smoothly as ETH itself, all while continuing to earn the staking yield. 

Liquid staking is redefining how incentives are earned for holding and staking assets. Conventional staking requires depositors to lock up an asset for a pre-determined amount of time, and that asset cannot be used for any other purposes while staked. With liquid staking, users can still use their staked assets in other DeFi protocols while still earning rewards. This increases the overall yield while also providing stakers with additional flexibility and control.

Liquid staking works by using a liquid staking protocol like Lido, Frax, or Rocket Pool. A liquid staking protocol is a decentralized application (dApp) that allows users to stake their ETH and receive a liquid staking token (LST) in return. LST tokens are ERC-20 tokens, which means that they can be used on DeFi platforms and traded on exchanges.

When a user stakes their ETH with a liquid staking protocol, the protocol stakes the ETH on the Ethereum network on behalf of the user. The protocol then issues the user LST tokens in proportion to the amount of ETH that they have staked.

Users can unstake their ETH from a liquid staking protocol at any time. When a user unstakes their ETH, the protocol unstakes the ETH on the Ethereum network and returns the ETH to the user.

How LSDs work within the Ethereum Protocol

In the dynamic terrain of cryptocurrency, Ethereum stands out due to its unique block transaction framework. As part of this structure, users pay 1 ETH as transaction fees (including MEV) for a block. The ensuing process is a model of deflation and yield distribution. Here's a breakdown:

• 0.8 ETH is incinerated, leading to an effect similar to a share buyback that equitably benefits all ETH holders.
• The validator garners 0.2 ETH from these fees along with 1 ETH from block rewards, which represent newly minted ETH.
• The validator, funded entirely by users who have committed their ETH via Lido—a liquid staking protocol—shares all of its revenue with these ETH depositors.
• Lido exacts a 10% share (0.12 ETH) of the aggregate staking yield for delivering its service, dispersing the remaining 90% (1.08 ETH) to ETH holders staking through Lido.

Source: TokenTerminal

The net result reflects the redistribution and reallocation of ETH:

• 0.8 ETH is burned
• The validator acquires 0 ETH
• Lido receives 0.12 ETH (half of which is earmarked for covering node operation costs)
• ETH holders staking through delegation amass 1.08 ETH

Extracting Value: The Appeal of Liquid Staking Protocols

Liquid staking protocols, such as Lido, optimize the user experience. They distill the complex, maintenance-heavy task of staking into a streamlined process. Users can lock up their ETH, gain a transferable utility token (stETH), and enjoy rewards corresponding to validation activities—all thanks to Lido. In return, Lido retains a 10% fee from the overall profit, which is split evenly between node operators and the Lido DAO.

The complexity and capital-intensive nature of staking have paved the way for the success of liquid staking protocols. Traditional staking on Ethereum necessitates users to manage a node, commit a considerable amount of capital (32 ETH), and forgo token liquidity. However, Lido aggregates users' tokens to stake with validators, bypassing the 32 ETH hurdle. By refining the user experience, providing liquidity, and democratizing staking, Lido and similar protocols are unlocking an increasingly expanding market sector.

The democratization of staking empowers wider investor engagement. Besides Layer 2 blockchains, the liquid staking market sector ranks among the most rapidly growing sectors on Token Terminal. The successful implementation of the Shapella upgrade on April 12 has arguably mitigated the risks tied to ETH as an investment and a yield-generating asset.

Why Use LSD? What Are the Benefits?

In the evolving realm of cryptocurrency, liquidity staking protocols have emerged as a major magnet for users, offering multiple appealing factors. They provide a user-friendly environment, allowing participants to join in network validation and reap the ensuing profits without the requirement of owning 32 Ethereum (ETH) in their portfolio. This offers a relatively stable, low-risk avenue for investors seeking fixed-income products.

There are a number of benefits to using liquid staking. First, liquid staking allows users to earn yield on their ETH while still being able to use it. Second, liquid staking is more convenient than traditional staking, as users do not need to worry about setting up and managing a validator node. Third, liquid staking is more secure than traditional staking, as the ETH is held in a smart contract that is audited by security firms.

Moreover, tokens in staking can be retrieved anytime without any restrictive threshold. This provision lends considerable flexibility to investors. Furthermore, the use of representative tokens can liberate the liquidity locked in staking and channel it towards other ecosystem applications, such as Decentralized Finance (DeFi), thereby improving capital efficiency significantly. Beyond profits earned from validation, investors also stand to gain from governance earnings, providing a multi-faceted income stream.

The Power of Liquidity Staking

Liquidity staking empowers investors to earn yields on their staked assets while maintaining the leverage to trade, lend, or use the assets as collateral in other protocols. It allows investors to stake their assets without the need to become a validator, thus simplifying the process. This method illustrates how the fluid world of cryptocurrency is constantly innovating to bring more robust and user-friendly investment avenues to the forefront.

Decentralized solutions like Lido and Rocket Pool, which enable "liquid" staking are gaining traction as the space matures. In the case of Lido, users stake ETH and, in return, get tokens (stETH), essentially a derivative product of ETH that trades near 1-to-1 with ETH. This gives stakers more flexibility and liquidity since they can sell their stETH tokens on the open market or use the stETH tokens in other DeFi protocols. 

The price of 1 stETH should never, for economic reasons, exceed 1 ETH. This is because 1 ETH can always be used to mint 1 stETH and since stETH cannot be burned for its underlying ETH on the Lido protocol, the exchange rate relies on the open market and arbitrage. A number of factors come into play for the current (and historical) discount, including the fact that stETH has less liquidity, less utility (e.g., can’t be used to pay gas fees), and more technical (smart contract) risk than ETH. 

Lido

Lido is a liquid staking protocol for Ethereum that allows users to stake ETH without locking up their tokens. When users stake ETH with Lido, they receive stETH tokens in return, which can be used to earn yield on DeFi platforms or traded on exchanges. Lido is one of the most popular staking protocols for Ethereum, with over 4 million ETH staked as of March 2023.

Unique Value Propositions

Lido offers a number of unique value propositions, including:

• Liquidity: Lido allows users to stake ETH without locking up their tokens. This means that users can still use their ETH to earn yield on DeFi platforms or trade it on exchanges.
• Simplicity: Lido is very easy to use. Users can stake ETH with Lido in just a few clicks.
• Security: Lido is a secure protocol. The ETH that is staked with Lido is held in a smart contract that is audited by security firms.

Concerns

Lido is a well-designed protocol with a number of advantages. However, there are a few potential concerns that users should be aware of.

• Security: While Lido is a secure protocol, there is always a risk of security breaches. Users should only stake ETH with Lido that they are comfortable losing.
• Volatility: The price of stETH can be volatile. Users should be aware of this risk before staking ETH with Lido.

Traction

As of Q2 2023, Lido holds ~31% of all ETH staked (~6.5M). There are ~200k depositors. However, the top ~50 depositors are responsible for ~45% of all ETH staked, suggesting that a few large whales make up nearly half of the Lido stake. Additionally, the top 100 holders of LDO, the governance token for the Lido DAO, possess 93.1% of the entire LDO supply, according to data from Etherscan.

Lido market share,may 2023. Source: Dune Analytics

Lido has ~29 Ethereum node operators who handle the technical side of running validator node software. By controlling a significant chunk of staked ether and assuming more than 90% of the liquid staking market, Lido’s centralization issue increases the risk of undesirable events such as validator slashing, governance attacks, and smart contract exploits. 

Staking derivatives are the most efficient route for holders of PoS tokens that want to maximize yields and utility in DeFi but there are many implementations with their own benefits and tradeoffs. Users should take care to fully understand the nuances of each.

Lido Competition

The landscape of liquidity staking protocols is characterized by fierce competition, with differentiation mainly arising in two areas: (1) forming partnerships with other decentralized applications (DApps) to offer more use cases for minted certificates, particularly in profit-generating products; (2) extending operations across additional Layer 1 (L1) chains; and (3) enhancing the security standards of the protocol, including the verification process.

The future trajectory of liquidity staking protocols is intertwined with the long-term progression of the primary chain. Any significant disturbances, such as the LUNA crash, could spell disaster for these protocols. Additionally, factors like value-capturing abilities, and the development of the on-chain DeFi ecosystem, among others, significantly influence these protocols.

The anticipated deflation of Ethereum and the potential for increased returns from staking present notable opportunities for liquidity staking protocols, even amid bear market conditions.

Source: Blockworks

To learn more about Ethereum staking, try this article or to learn about Rocket Pool, specifically, check this out!