Author: magicdhz

Translation: Blockchain in Vernacular

Key Takeaways:

Governed by the Lido DAO, the Lido Protocol is an open-source middleware for transferring 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.

The liquidity of stETH and stETH as collateral are also growing on centralized trading platforms, indicating that institutions tend to replace ETH by trading and holding stETH.

By staking with a strong validator portfolio, stETH is lower risk and provides higher probability-adjusted returns.

As traditional finance seeks rewards for staking ETH, this may mean developing "traditional finance ETH" products, with stETH as a coordination tool to resist centralization trends.

1. Introduction: stETH > Traditional Finance ETH (ETF)

On May 20, 2024, Eric Balchunas and James Seyffart raised the odds of spot ETH ETF approval from 25% to 75%. ETH rose by about 20% in a few hours. However, at the request of the U.S. Securities and Exchange Commission (SEC), the issuer amended the S-1 registration statement to remove staking rewards from the ETF. As a result, investors holding the spot ETH ETF will not be able to receive staking rewards for Ethereum, probably because of the necessary regulatory clarity required to offer a staked ETH product. In any case, at current rates, investors who choose to hold the spot ETH ETF will lose about 3-4% annualized yield, which is brought by consensus and execution layer rewards. Therefore, in order to reduce dilution, there is an incentive to include staking in ETF products.

The Lido Protocol is an open source middleware that autonomously routes ETH pools to a set of validators based on delegation standards. The Lido DAO, governed by LDO holders, manages some parameters of the aforementioned delegation standards, such as protocol fees, node operators, and security requirements. However, the protocol is non-custodial and the DAO cannot directly control the underlying validators. With approximately 29% of the total stake on the network (9.3 million ETH, or $35.8 billion), stETH is an important infrastructure in the staking industry, with high performance, delegation, and other staking practice requirements.

ETHETFs may be the most convenient option for traditional financial investors to gain exposure to ETH today, but these products cannot capture the issuance of Ethereum or cryptoeconomic activity. As more traditional financial venues access tokens on their own, holding Lido's liquid staking TokenstETH can be said to be the best product to obtain ETH and Ethereum staking rewards because it has the following key uses in the existing market structure:

stETH is the most liquid and most 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 and reward-bearing L1 native asset on centralized exchanges (CEXes), growing as an alternative and form of collateral for spot ETH trading.

With the advent of ETH ETFs, stETH’s dominance is likely to persist as investors learn more about Ethereum and seek additional returns from consensus and execution layer rewards, which is beneficial for consolidating a stronger stETH market structure. Looking further ahead, as traditional financial institutions eventually incorporate staking into their products (calling it “traditional financial ETH”), Lido DAO’s governance and stETH’s growth become critical to maintaining a sufficiently decentralized validator set on Ethereum.

Therefore, “stETH > traditional finance ETH” because it offers better returns, has more utility than adjacent products, and serves as a coordination tool to combat centralization.

2. Lido Protocol

The Lido protocol's middleware is a set of smart contracts that programmatically distributes users' ETH to vetted Ethereum validators. This Liquid Staking Protocol (LSP) aims to enhance Ethereum's native staking capabilities. It mainly serves two parties: node operators and ETH stakers, and solves two problems: the entry threshold for validators and the loss of liquidity caused by locking ETH for staking.

Although the hardware requirements for running a validator on Ethereum are not as high as on other chains, in order to participate in consensus, node operators need to stake increments of exactly 32 ETH in the validator to receive Ethereum rewards. Raising so much money is not only not easy for potential validators, but allocating ETH under the 32 ETH limit can be extremely inefficient.

To simplify this process, Lido routes ETH from investors to the validator portfolio and effectively reduces the high economic threshold. In addition, through strict evaluation, monitoring and delegation strategies between node operators, Lido DAO mitigates the risks of the validator portfolio. Operator statistics and indicator data from the validator portfolio can be found here.

In return for their ETH deposits, investors receive stETH, and the value proposition is simple. Running a validator or staking ETH requires locking ETH in an account, while stETH is a liquid utility token that users can use in CeFi and DeFi.

1）stETH

stETH is a Liquid Staking Token (LST), a utility token that represents the total amount of ETH deposited into Lido, plus the amount of staking rewards (minus fees) and validator penalties. Fees include staking commissions collected from validators, the DAO, and the protocol.

When a user deposits 1 ETH into Lido, 1 stETHToken is issued and distributed to the user, and the protocol records the user's share of ETH in the protocol. This share is calculated every day. stETH is a certificate that users can redeem for their share of ETH in the fund pool. By holding stETH, users can automatically receive Ethereum rewards through the rebase mechanism. Basically, as rewards accumulate to the validator portfolio, the protocol will issue and distribute stETHTokens based on the account's share of ETH held in the protocol.

stETH rewards are a function of ETH issuance, priority fees, and MEV rewards. ETH issuance is a reward for validators participating in consensus and proposing blocks correctly. Currently, the issuance rate is 917,000 ETH per year (there are discussions about changes to this monetary policy). Priority fees are paid by users to prioritize the inclusion of transactions. MEV rewards are an additional source of income for running MEV-Boost, which promotes the market by providing validators with a portion of Ethereum block rewards. This portion of the reward is calculated as a function of the demand for Ethereum block space. According to mevboost.pics, validators realized approximately 308,649 ETH in revenue through MEV-Boost in 2023 (equivalent to $70.43 billion using the ETH price on January 1, 2024). Taking these factors into account, investors can earn an annualized rate of return ranging from 3-4% during 2024 just by holding stETH.

In short, unlike the spot ETH ETF, stETH is a liquid product that allows investors to own ETH and obtain Ethereum's cash flow. In addition, stETH is also one of the most commonly used assets in various DeFi environments.

2) Practicality of stETH

The key features that make stETH a desirable asset are liquidity and the ability to be used as collateral. Typically, it takes days for staked ETH to be withdrawn, as the amount of time a staker has to wait to exit the queue depends on the size of the queue. This can lead to a duration mismatch, 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 by simply listing stETH on a decentralized exchange (DEX) or centralized exchange (CEX). An astute reader will realize that eliminating the risk of duration mismatch shifts the risk to the willingness and ability of the secondary market to accept stETH inventory. Nonetheless, given the approval of a spot ETH ETF and the trends in stETH’s characteristics and underlying market structure, we can more than precedently expect further adoption of stETH and even deeper liquidity.

3) Liquidity of stETH

Notably, stETH reserves in liquidity pools declined in 2023 on both Ethereum and Rollups. This is because the DAO regulates incentive payouts for on-chain stETH LPs, meaning that LPs rewarded primarily by mining LDOs have withdrawn their reserves from the pools. By 2024, reserves had stabilized. The shift from subsidized LPs (who are typically more inclined to withdraw reserves when they are most needed) to real, non-subsidized stETH LPs is healthier for stETH's on-chain liquidity landscape. Despite these market corrective forces, stETH remains one of the most liquid assets in DeFi and ranks in the top ten by TVL (total value locked) on Uniswap.

During the same time period, both stETH trading volume and utilization in these pools increased. The trends in the following charts show:

  • Liquidity providers are more stable and consistent

  • The market liquidity for stETH has approached a more stable equilibrium point

  • More and more participants are more accustomed to trading stETH

These market structures provide a stronger and more organic basis for expansion than overspending LDO incentive fees on seasonal liquidity providers. As shown in the figure below, stETH's trading volume and liquidity are clearly dominant compared to other liquid staking tokens (LST).

Liquidity is very important and is arguably the biggest determinant of risk management in financial markets. The liquidity profile of an asset has a large impact on its risk-adjusted return, and thus its attractiveness to investors. This makes stETH a better option for investors and traders looking to earn Ethereum rewards, as demonstrated in a Blockworks panel discussion with participation from large crypto-native institutions such as Hashnote, Copper, Deribit, and Cumberland. The chart below shows the trend of crypto-native institutions adopting stETH on centralized trading platforms: More and more crypto-native institutions and market makers prefer to hold and trade stETH. Note: Global bid data for February and March is partially incomplete due to exchanges changing the rate limit of order book data.

4) stETH as collateral

stETH is also the most popular collateral in DeFi, even surpassing ETH and popular stablecoins such as USDC, USDT, and DAI. The figure below shows that since its launch, it has gradually climbed to this position, accounting for about one-third of the total market share.

Including stETH as a high-quality collateral option makes it more capital efficient and may help exchanges and lending platforms increase additional 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 volume of stETH trading on Bybit has increased nearly 10 times.

It looks like the market structure of stETH on-chain has reached a more stable equilibrium point, which may lay a solid foundation for a gradual long-term growth trend. Off-chain, we can observe more signs of institutional adoption as investors prefer to choose staked ETH over regular ETH. While we also expect other liquid staking tokens (including possibly liquid staking warrants) to gain market share, the existing market structure and dominance of stETH and the first-mover advantage should maintain its strong position in the market. In addition, Lido and stETH have some favorable characteristics compared to other staking options. Compared with other staking mechanisms, Lido's mechanism has three key characteristics: non-custodial, decentralized, and transparent.

Non-custodial: Neither Lido nor node operators will custody user deposits. This feature mitigates counterparty risk, and node operators will never get hold of user staked ETH.

Decentralization: No single organization validates the protocol, and technical risk is evenly distributed among a group of node operators, improving resilience, availability, and rewards.

Open Source: Anyone can review, audit, and/or propose improvements to the code that runs the protocol.

When comparing stETH with other liquidity staking tokens (LST) and staking service providers, according to Rated data, the difference in rewards between the top node operators by total stake is small, ranging from about 3.3-3.5%. However, considering the factors of operating a node, including operation and maintenance, cloud infrastructure, hardware, code maintenance, client type, geographical distribution, etc., the small difference in rewards contains a lot of risks.

stETH is less risky because it ensures exposure to multiple operators running different machines, codes, and clients in different locations and managed by many teams. Therefore, the possibility of downtime is lower and the risk is more dispersed by default; while other staking service providers are more centralized and have potential single points of failure. For more information on this area, Blockworks research analyst 0xpibblez wrote a detailed research report.

5) Probability of stETH excess rewards

Referring to the first graph below, we can observe that execution layer rewards (priority fees + 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, elevated activity levels coincide with more valuable blocks and therefore 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 will propose the next block, capturing the variability of execution layer rewards.

Because stETH is staked across a wide variety of operators and represents 29% of total stake, stETH is able to capture the variability of block rewards at a higher rate than independent validators, smaller operators, or validator sets with less stake. This means it will consistently receive a higher reward rate on average.

In other words, in the extreme case 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 probability of this happening is very low, about 1 in a million (32/32,400,000). They essentially won a lottery. On the other hand, Lido's validator set is more likely to capture valuable blocks, about 29% of the time. Therefore, users holding stETH are choosing and strengthening their chances of sharing more rewards.

In summary, another reason why stETH is a superior choice for gaining exposure to staked ETH rewards is that it generates extremely competitive rewards on a probabilistic and risk-adjusted basis.

3. Lido Governance: The growing importance of stETH to decentralization

The approval of the spot ETH ETF brings expectations for additional products, the most obvious one of which is a collateralized ETH product. During his bull cycle break, crypto native legend DegenSpartan wrote a post titled "How many Trojan horses can we launch?" In this short blog post, DegenSpartan wrote: "After the spot ETF, we can still expect more access in the [traditional finance] field, options, inclusion in fund portfolios, mutual funds, retirement accounts, fixed investment plans, structured products, dual currencies, Lambad loans, etc."

While U.S. capital markets will have greater exposure to ETH, bringing more permanent (structural) winds, it is unclear how traditional finance will integrate other digital assets or derivatives and their possible side effects on decentralization.

1) Traditional financial ETH and stETH

Philosophically, we believe that LST is the best way to maintain a sufficiently decentralized, secure, and high-performance set of validator nodes. Grandjean et al. calculated Ethereum's HHI index (a measure of market concentration and competitiveness) and found that Lido has improved decentralization (as shown by the lower HHI reading in the figure below).

While treating Lido as a single entity would result in a higher HHI (i.e. the network is less decentralized), 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 consists of a variety of independent and separate entities. While large LSPs (staking service providers) are risky, the implementation of appropriate governance mechanisms and protocol oversight, such as dual governance, should mitigate their severity. In addition, it is expected that the inclusion of DVT will further decentralize the set of operators.

That being said, given the economic incentives of staking ETH, or the dilution of holding native ETH, it is possible that traditional finance will eventually offer staking ETH products. Some possible (purely) hypothetical outcomes include:

Traditional finance clearly adopts stETH and all its benefits

Traditional finance works closely with Coinbase or other large institutional staking service providers to build this framework, in which cbETH or tradfiETH becomes the official staking ETH product of traditional finance

Traditional finance develops its own practices, investing in proprietary node operations, hosting its own staked ETH, and issuing tradfiETH products.

“While this is all well and good for BTC [and ETH], the future is somewhat unknown.” - DegenSpartan

We believe and have evidence that (1) is a better solution for the network from a hypothetical scenario, because in any case, if staking ETH moves towards the trend of traditional financial ETH, the staking risk on the chain will tend to be centralized. Therefore, in the case of highly capitalized existing players developing centralized staking products, as long as Lido remains sufficiently decentralized, both stETH and DAO are key factors in maintaining the overall consistency of Ethereum, because DAO manages the delegation of stETH and indirectly affects the performance, security, and decentralization of the network.

2) Risks

Volatility and Liquidity: When ETH volatility surges, investors prefer to sell stETH on the open market rather than wait in the withdrawal queue. During periods of high volatility, without sufficient liquidity, high sales volumes can cause the price of stETH to deviate from its 1:1 price peg with ETH, which brings subsequent risks until market conditions recover.

Loop risk: A common method of earning rewards (such as participating in 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 are fully leveraged to maximum capacity. In times of volatility, loopers are at risk of being liquidated, which can trigger amplified risks associated with volatility and liquidity.

Protocol and Governance: Risks associated with LSPs capturing significant market share. The protocol to which stETH is delegated is governed by a DAO. While the DAO is taking steps toward dual governance, which would reduce these risks, if stETH captures a majority of staked ETH, concerns about the concentration of ETH shares in LDO governance are warranted.

Smart Contracts: The Lido protocol is executed by a series of smart contracts. This includes deposits, withdrawals, delegated staking, penalties, and key management. There are unexpected errors or malicious upgrades in these systems related to smart contracts.

Competitors: The LST market is huge, and there are more re-staking protocols entering the competitive field. Traditional finance also has the ability to develop its own staking products, which may be more accessible to some investors given the current market structure.

Regulation: Although the approval of a spot ETH ETF may make staking service providers safer on average, there will still be regulatory scrutiny of staking ETH. Relevant legal discussions include (but are not limited to) the role of staking service providers, the distinction between "management" and "administration" under the Howey test, and whether LSPs are "issuers" (under the Reve test).

4. Final Thoughts

By today’s standards, stETH is arguably the best product for staked ETH participation. It is the most liquid LST on-chain, the most widely used form of collateral in DeFi, and these market structures are rapidly expanding off-chain, as evidenced by volume growth on exchanges, especially ByBit and OKX.

While there are risks to holding stETH, these strong market structures are likely to continue and could expand further driven by the properties of stETH, Lido's protocol, the growing need for overall consistency on Ethereum, and upcoming catalysts. These catalysts on the roadmap include distributed validator technology (DVT), dual governance, supporting pre-confirmation and allocating additional resources for re-staking stETH, and an improved governance structure that will help Ethereum research. More importantly, if traditional finance develops staking ETH products, stETH and LidoDAO will play an increasingly important role in the broader context of Ethereum.