Author: Magicdhz, Blockworks; Translated by: Baishui, Golden Finance
Summary
The Lido Protocol, governed by the Lido DAO, is an open-source middleware that routes ETH, stETH, and Ethereum rewards between a group of validators and ETH stakers.
stETH is the most liquid LST and the most widely used form of on-chain collateral.
stETH liquidity and stETH as collateral on CEXs are also growing, indicating institutional interest in trading and holding stETH as an alternative to ETH.
stETH is staked among a strong set of validators, has lower risk, and offers higher probability-adjusted rewards.
As TradFi seeks staking ETH rewards, this could mean developing a “tradfiETH” product, with stETH serving as a coordination tool to combat centralization.
Introduction: stETH > tradfiETH (ETF)
On May 20, 2024, Eric Balchunas and James Seyffart revised the odds of approval of the spot ETH ETF from 25% to 75%. ETH rose by about 20% within hours. However, the issuer amended the S-1 registration statement to remove the ETF's staking rewards, as required by the SEC. As a result, investors holding the spot ETH ETF will not receive staking rewards for Ethereum, likely due to the regulatory clarity required to offer a staked ETH product. Regardless, at current rates, investors who choose to receive the spot ETH ETF will lose out on the ~3-4% APR on consensus and execution layer rewards. Therefore, there is an incentive to add staking to the ETF product in order to mitigate dilution.
The Lido Protocol is an open-source middleware that automatically routes ETH in a pool between validator sets based on delegation criteria. The Lido DAO is governed by LDO holders and is responsible for managing some parameters of the above delegation criteria, such as protocol fees and node operator and security requirements. However, the protocol is non-custodial and the DAO has no direct control over the underlying validators. stETH represents approximately 29% of the total stake in the network (9.3 million ETH, or $35.8 billion) and is a critical infrastructure for the staking industry, maintaining high standards in terms of performance, delegation, and other staking practices.
ETH ETFs may be the most convenient option for TradFi investors to gain exposure to ETH at the moment, but these products do not capture Ethereum issuance or cryptoeconomic activity. As more and more TradFi venues join the token themselves, holding Lido’s liquidity staking token stETH is arguably the best product to gain exposure to ETH and Ethereum staking rewards because it has key utility in the existing market structure:
stETH is the most liquid and highest-traded ETH collateral asset on decentralized exchanges (DEXes).
stETH is the most widely adopted form of collateral in DeFi, surpassing the largest stablecoin USDC and ETH itself.
stETH is the most liquid, reward-based native L1 asset on centralized exchanges (CEXes) - both an alternative to spot ETH trading and a form of collateral.
As ETH ETFs emerge, investors learn more about Ethereum and seek additional returns from consensus and execution layer rewards, stETH’s dominance is likely to continue - a beneficial tailwind for solidifying a stronger stETH market structure. Looking ahead, as TradFi institutions eventually add staking to their products (calling it “tradfiETH”), Lido DAO governance and the growth of stETH will be critical to maintaining a sufficiently decentralized validator set on Ethereum.
Therefore, “stETH > tradfiETH” because it offers better returns, unlocks more utility than adjacent products, and acts as a coordination tool to combat centralization.
Source: FINMA, Taurus
Lido Protocol
The Lido Protocol's middleware is a set of smart contracts that programmatically distributes a user's ETH to a set of vetted Ethereum validators. This Liquidity Staking Protocol (LSP) is designed to enhance Ethereum's native staking capabilities. It primarily serves two parties: node operators and ETH stakers, and solves two problems: the barrier to entry for validators, and the loss of liquidity caused by locking up ETH for staking.
Although the hardware requirements for running validators on Ethereum are not as high as other chains, in order to reach consensus, node operators need to stake increments of exactly 32 ETH in validators to receive Ethereum rewards. Raising such a large amount of funds is not only non-trivial for potential validators, but allocating ETH within the constraints of 32 ETH intervals can be very inefficient.
To simplify operations, Lido routes ETH from investors and delegates this ETH to the validator set, effectively lowering the high economic barrier to entry. In addition, Lido DAO reduces the risk of the validator set through strict evaluation, monitoring, and delegation strategies across node operators. Operator statistics and metrics containing data from the validator set can be found here.
In return for their ETH deposits, investors will receive stETH, and the value proposition is simple. Running a validator or staking ETH requires locking ETH in an account - in contrast, stETH is a liquid utility token that users can use in CeFi and DeFi.
stETH
stETH is a Liquid Staking Token (LST), a utility token that represents the total amount of ETH deposited with Lido plus staking rewards (minus fees) and validator penalties. Fees include staking commissions collected from validators, the DAO, and the protocol.
When a user deposits one ETH into Lido, a stETH is minted and issued to the user, and the protocol records the user's share of ETH in the protocol. This share is calculated daily. stETH is a receipt that the user can redeem for their share of ETH in the pool. By holding stETH, users can automatically receive Ethereum rewards through the rebasing mechanism - essentially, when ETH rewards accumulate to the validator set, the protocol mints and distributes stETH based on the account's share of ETH in the protocol.
stETH rewards depend on ETH issuance, priority fees, and MEV rewards. ETH issuance is the reward validators receive for participating in consensus and correctly proposing blocks. Currently, the issuance rate is 917,000 ETH per year (and there are discussions about changing this monetary policy). Users pay priority fees to prioritize transaction inclusion. MEV rewards are an additional source of income for running MEV-Boost, which facilitates a market for validators to earn a portion of Ethereum's block rewards. This portion of the reward depends on the demand for Ethereum block space. According to mevboost.pics, in 2023, validators realized about 308,649 ETH through MEV-Boost ($704.3 million at ETH prices on January 1, 2024). Taking these factors into account, investors can earn a variable annual interest rate of 3-4% throughout 2024 simply by holding stETH.
In summary, unlike the spot ETH ETF, stETH is a liquid product through which investors can own ETH assets and earn Ethereum cash flow. In addition, stETH is also one of the most used assets in various environments in DeFi.
stETH Utility
The main utilities of stETH that make it a desirable asset include liquidity and the ability to use it as collateral. Typically, it takes days to withdraw staked ETH, as the amount of time a staker has to wait depends on the size of the exit queue. This increases the potential for maturity mismatches, where the value of ETH changes dramatically between a withdrawal request and redemption.
The core value proposition of stETH is its liquidity. Instead of waiting in an exit queue, stakers can exit their staked position simply by selling stETH on the market on a DEX or CEX. Astute readers will realize that eliminating maturity mismatch risk shifts the risk to the willingness and ability of the secondary market to accept stETH inventory. That being said, given the approval of a spot ETH ETF and the attributes and underlying market structure trends of stETH, there is greater precedent to predict further adoption and deeper liquidity for stETH.
stETH Liquidity
Notably, stETH reserves in both Ethereum and rollup pools declined throughout 2023. This was due to the DAO moderating incentive payouts to on-chain stETH LPs, which meant that LPs had withdrawn their reserves from the pools. In 2024, reserves reached a stable level. The shift away from subsidized LPs (who are generally more inclined to withdraw reserves when they are most needed) to real, non-subsidized stETH LPs is much healthier for stETH's on-chain liquidity profile. Despite these market forces, stETH remains one of the most liquid assets in DeFi and is in the top ten by TVL on Uniswap.
During the same period, both stETH trading volume and stETH usage in these pools have increased. The trends in the figure below indicate that: (1) LPs are stickier and more consistent, (2) the market has approached a more stable equilibrium for stETH liquidity, and (3) more and more participants are more willing to trade stETH. These market structures are a stronger and more organic foundation for expansion than over-investing in LDO incentives on seasonal LPs. As shown in the figure below, stETH's trading volume and liquidity are far ahead compared to other LSTs.
Liquidity Does Matter (ICYMI)
Liquidity is arguably the biggest determinant of risk management in financial markets. The liquidity profile of an asset greatly affects its risk-adjusted return, and therefore its attractiveness to investors. This makes stETH a great choice for investors and traders looking to earn Ethereum rewards, as confirmed during Blockworks’ panel with large crypto-native institutions including Hashnote, Copper, Deribit, and Cumberland. The chart below shows the trend of crypto-native institutional adoption on CEX: more crypto-native institutions and market makers prefer to hold and trade stETH. Note: Global bid data was incomplete during parts of February and March because exchanges changed the exchange rate limits for order data.
stETH as collateral
stETH is also the preferred form of collateral in DeFi - it even surpasses ETH and popular stablecoins such as USDC, USDT, and DAI. The chart below shows that it has gradually climbed to this position since its inception, accounting for about 1/3 of the total market share.
Using stETH as a high-quality collateral option improves its capital efficiency and may help exchanges and lending platforms generate more trading volume. In February of this year, ByBit announced that it would increase the collateral value of stETH from 75% to 90%. Since then, the stETH trading volume on ByBit has increased nearly 10 times.
It appears that the on-chain market structure of stETH has reached a more stable equilibrium, which could lay a solid foundation for a long-term gradual growth trend. Off-chain, we can observe sparks of more institutional adoption as investors would prefer staking ETH over regular ETH. While we also expect other LSTs (possibly including LRT) to gain market share, stETH's existing market structure and dominance, as well as its first-mover advantage, should maintain its strong position in the market. In addition, Lido and stETH have many favorable features compared to other staking options. Compared to other staking mechanisms, Lido's mechanism has three key features: non-custodial, decentralized, and transparent.
Comparison of stETH and other staking
Compared to other staking mechanisms, Lido’s mechanism has three key characteristics: non-custodial, decentralized, and transparent.
Non-custodial: Neither Lido nor node operators have custody of user deposits. This feature mitigates counterparty risk — node operators never have custody of user staked ETH.
Decentralized: No single organization validates the protocol — technical risk is evenly distributed across a group of node operators, improving resiliency, uptime, and returns.
Open Source: Anyone can review, audit, and/or suggest improvements to the code that runs the protocol.
When comparing stETH to other LST and staking providers, the difference in rewards between top node operators is small, between 3.3-3.5% by total stake, according to Rated. However, given the factors that go into operating a node (including devops, cloud infrastructure, hardware, maintained code, client type, geographic distribution, etc.), small differences in rewards carry a lot of risk.
stETH is less risky because it ensures exposure to a diverse set of operators running different machines, code, and clients in different locations across many teams. As a result, the likelihood of downtime is lower and risk is dispersed by default; other staking providers have more centralized operations and more potential central points of failure. For more information on this area, Blockworks Research analyst 0xpibblez has written an in-depth research report.
The probability of stETH receiving excess rewards
Referring to the first graph below, we can observe that execution layer rewards (priority fee + baseline MEV) are more variable than consensus layer rewards (issuance). The second graph below shows a zoomed-in view of this variation over the past month. This is due to the cyclical nature of on-chain activity, whereby during certain periods, increased activity levels coincide with more valuable blocks, and thus higher execution layer rewards, whereas consensus layer rewards are constant. This means that realized staked ETH rewards are a function of the probability that a validator proposes the next block, capturing the variation in execution layer rewards.
Since stETH is staked across many different operators, representing 29% of all staked ETH, stETH has a much higher probability of capturing changes in block rewards than a single validator, a smaller operator, or a validator set with less stake. This means it consistently generates higher returns on average.
In other words, at one extreme, when a single validator proposes a very valuable block, even if the total reward is much higher (e.g., earning 10 ETH in a block by staking 32 ETH), the chance of this happening is low, about 1 in a million (32/32,400,000). They will essentially win the lottery. At the other extreme, Lido's validator set is more likely to capture valuable blocks, about 29% of the time. Therefore, by holding stETH, users can choose and increase their chances of sharing more rewards.
In summary, another reason why stETH is a better choice for earning staking ETH rewards is that it generates highly competitive rewards on a probabilistic and risk-adjusted basis.
Lido Governance: stETH’s growing importance to decentralization
The approval of the spot ETH ETF brings expectations for more products - most notably collateralized ETH products. During the bull cycle hiatus, crypto native legend DegenSpartan wrote an article titled "How Many Trojan Horses Can We Launch?" In the short blog post, DegenSpartan wrote: "After the spot ETF, there is still more access to be expected on the [TradFi] side. Options, Funds of Funds, Mutual Funds, Retirement Accounts, DCA Plans, Structured Products, Dual Currencies, Lombard Loans, etc."
While U.S. capital markets will have greater exposure to ETH, bringing more permanent (structural) tailwinds, it is unclear how TradFi will integrate other digital assets or derivatives and what side effects they might have on decentralization.
tradfiETH and stETH
Philosophically, we believe that LST is the best way to maintain a sufficiently decentralized, secure, and well-performing validator set. Grandjean et al calculated Ethereum’s HHI (a metric used to assess market concentration and competition) and found that Lido has improved decentralization (as shown in the lower HHI readings in the figure below).
While treating Lido as a single entity results in a higher HHI (i.e., a lower degree of network decentralization), we do not believe that this description of Lido accurately reflects Lido's presence in the market, as the protocol is not managed or controlled by one organization or entity, and the validator set is composed of a variety of different independent entities. While large LSPs are risky, implementing appropriate governance mechanisms and protocol oversight (e.g., dual governance) should reduce the severity of the risk. In addition, the addition of DVT is expected to further decentralize the operator set.
That said, given the economic incentives to stake ETH (or the dilution of holding native ETH), it makes sense for TradFi to eventually launch a staked ETH product. Here are some possible (pure) hypothetical outcomes: (1) TradFi explicitly adopts stETH and all its benefits; (2) TradFi works closely with Coinbase or other large institutional staking providers to build this framework, in which case cbETH or tradfiETH becomes TradFi’s canonical staked ETH product; or (3) TradFi develops its own practices, invests in proprietary node operations, hosts its own staked ETH, and issues a tradfiETH product.
“While this is great for BTC [and ETH], where it goes next is uncharted territory.” — DegenSpartan
We believe, and have evidence to suggest, that hypothesis (1) is the better solution for the network, because in either case, if staked ETH tends to tradfiETH, the chain is at risk of staking centralization. Therefore, in a state where well-capitalized incumbents develop centralized staking products, as long as Lido remains sufficiently decentralized, stETH and the DAO are important components of maintaining the consistency of Ethereum, and more broadly, because the DAO manages the delegation of stETH and thus has a significant impact on the performance, security, and decentralization of the network.
risk
Volatility and Liquidity: When ETH volatility spikes, investors will be more willing to sell stETH on the open market rather than wait in a withdrawal queue. In the absence of liquidity, periods of high volatility combined with high selling volume may cause the price of stETH to deviate from its 1:1 ETH price peg, which creates follow-on risks until market conditions recover.
Loop risk: A popular method of earning rewards (such as farming for airdrops or liquidity mining incentives) is for users to take a leveraged position, lend stETH, borrow ETH, buy stETH, lend additional stETH, and repeat the cycle until they fully leverage to capacity. In times of volatility, loopers are at risk of being liquidated, which can trigger amplified risks associated with volatility and liquidity.
Protocols and Governance: There are risks associated with LSPs taking a large market share. The protocol to which stETH is delegated is governed by a DAO. While the DAO is taking steps to achieve dual governance, which will reduce these risks, if stETH accounts for the majority of staked ETH, then there is reason to worry about the concentration of ETH staked into LDO governance.
Smart Contracts: The Lido Protocol is executed by a set of smart contracts. This includes deposits, withdrawals, delegated staking, slashing, and key management. There are unforeseen bugs or malicious upgrades in these systems related to smart contracts.
Competitors: The LST market is large, and other rehypothecation protocols are entering the space. TradFi is also in a position to develop its own staking products, which may be more accessible to some investors given the current market structure.
Regulation: While spot ETH ETF approvals may result in higher average security for collateral providers, staking ETH will still be subject to regulatory scrutiny. Public legal discussions include (but are not limited to) the role of collateral providers, the distinction between “management” and “administration” (under the Howey test), and whether LSPs are “issuers” (the Reve test).
Summarize
By today’s standards, stETH is arguably the best product for gaining exposure to staked ETH. It is the most liquid LST on-chain; it is the most widely used form of collateral in DeFi; and these market structures are rapidly expanding off-chain, as evidenced by growing volume on CEXs (most notably ByBit and OKX). While there are risks to holding stETH, these strong market structures are likely to continue, and perhaps even proliferate, given the properties of stETH, Lido’s protocol, the growing need to align with Ethereum, and upcoming catalysts. These catalysts on the roadmap include Distributed Validator Technology (DVT), dual governance, support for pre-confirmations and allocation of additional resources for re-staking stETH, and a revamped governance structure to aid Ethereum research. More importantly, if TradFi develops a staked ETH product, stETH and the Lido DAO will play an increasingly important role in Ethereum.