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The Ethereum Shanghai update is presently scheduled for this March. This will permit stake withdrawals for the first time since 2020 when users began staking their ETH. As the image below illustrates, ~15 million+ ETH is currently staked across several different providers. Unlocking the ability for withdrawals is no small feat.
Following a successful Merge, users are clamoring for the ability to collect their rewards and potentially unstake their ETH after nearly three years of being locked up. It will be interesting to see just how much ETH gets staked prior and what percentage of users look to unstake. However, not everyone can unstake at the same time, as there’s a cap on the number of ETH that can be unstaked over a given period. Should demand exceed this limit, a queue will form, and users will have to wait days (maybe weeks?) before successfully unstaking and taking ownership of their ETH. This article will discuss the logistics surrounding the highly-anticipated Shanghai hard fork and what withdrawals could mean for ETH and LSD tokens.
Previous timeline, as of now, appears to be overly optimistic with its dates. Source
The Shanghai upgrade has the potential to significantly benefit the Ethereum network by reducing the risk and uncertainty associated with one of the more sustainable yields in the cryptocurrency market. Unlike many other crypto projects that distribute tokens to generate yield, the staking yield for ETH is generated from transaction fees paid to the network. As a result, stakers may earn higher rewards as network activity increases. The current staking yield for ETH ranges from 4%-9%, primarily generated by transaction fees. The removal of withdrawal restrictions may also lead to an increase in the risk-adjusted exposure to ETH.
As of January 23, 2023, the first set of shadow fork testing has commenced for the Ethereum Shanghai upgrade.
How Withdrawals Works
The activation of Shanghai on the Ethereum network will result in the initiation of withdrawal credential changes, which will be processed in a similar manner to withdrawals. However, it should be noted that the network has a maximum capacity of processing 16 partial or full withdrawals per block, which is produced every 12 seconds. Additionally, the network can only process a maximum of 16 withdrawal credential changes per block. This implies that it will take approximately 100 hours for the network to complete updating the withdrawal credentials for the entire validator set of Ethereum. For validators whose withdrawal credentials are already in the 0x01 format, the network will automatically transfer their CL reward balance to the specified EL address without any additional action required from the validator node operators.
The proocol runs through the active validator every 12 seconds. Developers are currently discussing the possibility of limiting the network scan for withdrawals to a maximum of 1,024 validators at one time. This would prevent scenarios in which the network scans through the majority of the validator set, causing delays in block times due to a lack of eligible withdrawals to process. Based on the number of active validators on Ethereum as of December 24, 2022, it is expected that the scan for withdrawals will almost always result in the maximum number of 16 withdrawals being processed per block. It is worth reiterating that the network will automatically withdraw a validator’s CL reward balance, if the balance is greater than zero, to their specified Ethereum address.
All Beacon Chain withdrawals will be processed as system-level operations on Ethereum and will be pushed to the Ethereum Virtual Machine (EVM) instead of being processed by the EL as transactions. As a result, withdrawals will not be identifiable as normal user or smart contract-initiated transactions on the blockchain. Withdrawals will be identified as a new type of object in an Ethereum block and will possess its own dedicated data field in the block header. Additionally, there will be no gas costs associated with withdrawals as the maximum number of withdrawals that can be processed per block on Ethereum is sufficiently low, and the operational costs of processing these withdrawals is relatively insignificant in comparison to the costs of executing user and smart contract transactions.
The process of fully withdrawing a validator's staked ETH balance is subject to the same churn limit as new validator entries, meaning there is a maximum of 7 validator exits that can be processed on the Beacon Chain per epoch, which is roughly 6.4 minutes. In the ideal scenario, a validator makes it through the exit queue and is then put in the withdrawals queue. For the full balance of staked ETH to be withdrawn, the validator node operator must have already updated their withdrawal credentials to the new “0x01” format, as previously mentioned.
The network scans through the active validator set periodically, and processes a maximum of 16 withdrawals, partial or full, per block. It is worth reiterating that the withdrawals sweep is conducted according to validator index number and is likely to be limited to a maximum scan of 1,024 validators per block to prevent any delayed block times. It takes ~100 hours to process post-exit queue.
As of now, there are already 1,084 validators that have exited Ethereum and are currently waiting to enter the withdrawals queue, after the activation of Shanghai. 864 of these exits were voluntary, likely initiated by validator node operators who wanted to retire their staking operations and not be penalized by the network for going offline. The other 220 validators were exited forcefully through a process called slashing, which is a penalty imposed on validators for behaving against the rules of the network, mostly applied when validators misbehave, i.e., propose multiple blocks or multiple attestations in one slot.
Liquid Staking Derivatives (LSDs)
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.
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.
As of Q1 2023, Lido holds ~29% of all ETH staked (~4.7M). Starting in 2021 with just ~17k ETH deposited, Lido’s staking pool has grown to ~4.7m ETH. There are ~120k 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 has ~28 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.
Source: Delphi Digital