It’s hard for projects to beat the returns offered by staked ether on a risk-adjusted basis.
Consequently, the asset and its yield are becoming a benchmark for the crypto economy in similar fashion to the fed funds rate and the traditional economy.
Slowly but surely, staked ether (stETH) is becoming a benchmark for the entire on-chain economy.
According to a new report from investment management firm ARK Invest, Ethereum’s monetary policy has turned staked ether into a unique type of asset – one that resembles sovereign bonds.
“The ETH staking yield is a gauge for smart contract activity and economic cycles in the digital asset space, much like the fed funds rate in traditional finance,” wrote Lorenzo Valente, a research associate at ARK Invest.
Comparing staked ether to sovereign bonds
Ethereum is designed in such a way that ether {{ETH}} holders can stake their tokens, essentially locking them up in the network in exchange for a yield. At the time of writing, the yield on staked ether generating a 3.27% annualized yield, according to CoinDesk CESR data.
There's also a so-called liquid staking token, stETH, from the Lido project, that Ethereum stakers can redeploy into DeFi protocols.
The fact that staked ether produces a yield makes the asset comparable to sovereign bonds, which are debt securities issued by governments to finance themselves. Investors can buy up this debt and earn interest on it over time.
But staked ether differs from bonds in several crucial aspects, the report said.
Some of the distinctions are positive. For example, while governments can default on their debt obligations – like Argentina did in 2020 – Ethereum cannot default on staked ether. The network is programmed to let users access their funds whenever they want, and the yield is designed to keep being issued no matter what happens, though the interest rate will vary depending on on-chain activity. Another big risk for bonds is inflation. If the government prints too much money, and the inflation rate outstrips the yield on bonds, investors end up losing purchasing power.
Ether can also suffer from inflation (as is currently the case) if network activity slows down so much that ether issuance ends up exceeding the ether burn rate – a mechanism that removes a fraction of ether from circulation every time a transaction is made. However, on-chain data makes ether’s inflation rate much more transparent. Data aggregator ultrasound.money shows, for example, that in the last 30 days, ether’s supply expanded at a rate of 0.33% per year.
But exposure to staked ether also comes with its own risks. Staked ether can be destroyed by the network, for example, if the used validators – entities with whom investors stake their ether; their role is to process transactions – suffer from an operational malfunction, or behave in a way that’s detrimental to the network. This is known as "slashing."
While government bonds come with political and regulatory risks, they aren’t going to be obliterated by an automatized system if anything goes awry.
Finally, a major appeal of sovereign bonds is their lack of volatility. If the country issuing them is stable, they are usually deemed low-risk investments, and are even sometimes considered cash-like instruments. Ether itself is highly volatile: at the time of writing, the cryptocurrency was up 65% in the last 12 months. Naturally, that means staked ether cannot be classified by investors in the same low-risk category as bonds.
“While both can be influenced by inflation, interest rate changes and currency depreciation, the nature of those risks and their implications can vary significantly,” the report said. “Additionally, ETH staking introduces unique risks related to network security, validator behavior, and smart contract bugs, which have no direct parallel in traditional sovereign bonds.”
Growing use in DeFi
Generally speaking, there are two different ways investors can stake their ether: by setting up their own validators, or by staking through specialized DeFi protocols like Lido {{LDO}} or Rocket Pool {{RPL}}. These protocols partner up with trusted validators and execute all the technical aspects of staking for their customers.
Importantly, they also provide liquid staking tokens (LSTs), which represent the amount of ether that has been staked by the investor into the network. That’s a massive benefit, because while their ether is locked away earning yield, investors can keep using stETH tokens (the most popular LST) for additional purposes – for example, as collateral in lending protocols.
That advantage is so great that stETH is beginning to replace ETH as the collateral of choice in the DeFi economy.
“Today, stETH supplied as collateral in DeFi totals ~2.7 million, or roughly 31% of the entire stETH supply,” the report said, noting that investors prefer it to other crypto assets due to the “capital efficiency it offers users, liquidity providers and market makers.”
“Currently the collateral of choice on Aave V3, Spark, and MakerDao, 1.3 million stETH, 598,000 stETH, and 420,000 stETH, respectively, are locked into those protocols and used as collateral to issue loans or crypto-backed stablecoins,” it added.
Becoming the benchmark
With stETH so widely used across the biggest DeFi protocols, staked ether is slowly forcing the rest of the crypto financial ecosystem to reorganize itself, the report argued.
That’s because projects need to convince investors that, on a risk-adjusted basis, their own assets will offer higher returns than simply staking ether, and compounding those returns, will provide.
“If the ETH yield is 4% after compounding over seven years, [a] closed-end fund would have to outperform ETH more than 31% [over that period of time], even without taking into account price appreciation,” the report said.
It’s one of the reasons why competing Layer 1 projects – like Solana {{SOL}} or Avalanche {{AVAX}} – all offer higher interest rates for investors to stake their tokens. The implication is that these assets are riskier and more volatile, and investors need to be incentivized with higher yields to hold them in the long run.
The demand for staked ether has also put pressure on DeFi protocols in the business of lending stablecoins, according to ARK Invest.
For example, Sky {{SKY}} (formerly MakerDAO) was forced to increase the interest rate on locked DAI (the protocol’s native stablecoin) following significant selling pressure and a decrease in its circulating supply, the report said. Furthermore, on Aave {{AAVE}} and Compound {{COMP}} investors are seeing increased rewards for lending stablecoins – because users would rather lend stETH and borrow stablecoins, than lend stablecoins directly.
In other words, the more stETH captures market share, the more the crypto economy will begin making choices based on staked ether’s yield. And that means staked ether could play the same role in crypto as the Federal Reserve’s funding rate does in the global financial system.
