What is liquid staking (LSD) or how will Ethereum multiply its capitalization with this technology?

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According to ethereum.org, $54 billion is currently frozen on smart contracts in the Ethereum DeFi ecosystem, with $14.8 billion of those funds frozen on the protocols of operators of liquid derivatives staking (LSD). As interest in LSD grows, it is important to understand the technology and its benefits. LSD allows users to block base tokens on DeFi platforms and receive derivative tokens, providing increased liquidity for Ethereum coins. There are different types of wrapped tokens offered by liquid staking providers, and the use of LSD can offer flexibility in risk management and additional earning opportunities. However, there are also risks, such as centralization and regulation.

What is liquid staking (LSD) or how will Ethereum multiply its capitalization with this technology?

According to the official website ethereum.org, at the time of writing, $54 billion was frozen on smart contracts in the Ethereum DeFi ecosystem. At the same time, according to the data aggregator defilama, $14.8 billion of them were frozen on the protocols of operators of liquid derivatives staking ( Liquid Staking Derivatives, LSD). Interest in LSD can be traced both to the inflow of funds and to the attractiveness of the technology of big capital.

Source – ethereum.org

Source – defilama

On the eve of the Shanghai update, we studied the on-chain indicators of projects developing the Ethereum ecosystem, gathered information about ETH development plans, analyzed and described the technologies that allow Ethereum to greatly scale in the future 5-7 years, and prepared for you a series of articles about the future of Ethereum. The first of them is the technology of liquid staking derivatives (LSD). In the material, we will analyze what the LSD technology is, why it is considered a breakthrough for the blockchain space, how you can make money on the LSD trend, and consider whether this is a clear narrative of 2023 in the crypt. Let’s go!

Content:

1. LSD (Liquid Staking Derivatives). What is liquid staking?

2. Wrapped tokens. wETH, stETH, yETH.

3. Providers in LSD. Where can I put Ether in liquid staking?

4. Advantages of liquid staking. How LSD technology increases the liquidity of Ethereum coins?

5. Risks in liquid staking. Centralization and regulation.

6. Conclusions. Is liquid staking a trend in 2023?

To understand how it works liquid staking of derivative assets (LSD)you need to know what regular staking is. Briefly for beginners:

Staking – This is the process of freezing assets on blockchain smart contracts to maintain its functionality (participation in block validation). There is a reward for the staking process consisting of validation rewards. On average, the percentage for standard staking is about 3%-5%. These are the numbers for ETH. And we now take very liquid coins that have been on the rise for a long time. You can earn more on riskier coins or in the early stages of project development, but in the first case, the risks are significantly higher, and for the second, you need to spend more time studying the market and technologies.

The staking process is necessary to carry out transactions and any actions on the blockchain. Because block validation occurs only after consensus is reached on the Proof-of-Stake algorithm. In this article, we talked in detail about staking, mining, and Proof-of-Stake and Proof-of-Work consensus algorithms, so we will not stop there.

1. LSD (Liquid Staking Derivatives). What is liquid staking in simple words

The mechanism of liquid staking is that the user blocks the base token on the DeFi platform, receiving in return derivative (derivative) – wrapped token.

With normal staking, the assets that you freeze simply hang as “dead weight” on smart contracts and are displayed in TVL. A liquid stakebook by issuing a wrapped token allows you to use these assets again. Liquidity of wrapped tokens is provided by the protocol itself and by third-party DEX venues through liquidity pools. And to make it profitable for everyone (both those who provide liquidity and stakers), a commission is paid for using the inverted asset.

That is, for 1 staked ETH, you used to get your APR (percentage rate of return) (about 4% on Ethereum now, as well as on Polygon), and this Ether itself was not used anywhere. And now, for 1 ETH placed in the LSD protocol, in addition to APY, you can get a wrapped token (for example, stETH. Not equivalent, but 95% of the locked volume, the percentage varies depending on LSD providers). And the flipped asset can be reused in DeFi. Or put it in staking again, but on another platform, or exchange it on the secondary market (any DEX that has liquidity for this token) for another coin. Thus, this liquidity is released and re-enters the market. But is this liquidity in Ethereum, and where does dollar (fiat) liquidity come from? This is where DEXs come to the rescue with their liquidity pools. We explained how they work in detail in the article Farming crypts and not quite passive income. Bank contribution or liquidity pool? For further understanding, it is better to read it. But we will continue.

2. Wrapped tokens. wETH, stETH, yETH

Different liquid staking providers may issue different types of wrapped tokens to stakers. Let’s analyze them.

Rebase token. Tokens of the Rebase type work on the basis of an algorithm that issues or burns tokens automatically, distributing them among users. Such tokens are designed in such a way that their supply in circulation is automatically adjusted (increased or decreased) in accordance with fluctuations in the price of the token. Rebase tokens are similar to algorithmic stablecoins in that they have target prices.

Let’s consider from an example. You staked 1 ETH at X% and were immediately issued 1 wETH (derivative). The next day, taking into account the reward, the balance on the wallet will increase and may already be 1.01 wETH. This happens automatically without user intervention. The downside of rebase tokens is that not all DeFi platforms support them.

Reward tokens. This type of token does not increase quantitatively, but increases in price in proportion to the received reward. Its value is also automatically adjusted and depends on the size of the staking reward, but it can be fixed only when exchanging for the underlying asset.

Again, an example. You staked the same 1 ETH at X% and received a derivative in the form of yETH. Unlike the rebase token, the balance of yETH in the wallet will not change, but if you want to exchange yETH back to ETH, you will see that the next day it is not worth 1 ETH, but 1.01 ETH. This is a more popular type of wrapped token as it is more compatible with DeFi services. This model is most often used by LSD providers.

Combined tokens Rebase+Reward. It is a derivatives model that issues one type of token by default and allows you to convert it to another as needed. For example, by default, the provider issues a stETH rebase token, but it can be converted to wstETH, which already works under the reward model and is compatible with DeFi.

3. Providers in LSD. Where can I put Ether in liquid staking?

Liquid staking providers (or providers) are DeFi protocols that act as intermediaries between users staking their coins and validator nodes. They accumulate user funds, make a deposit, launch a node on Ethereum and pay a commission from the secured funds.

The use of the locked underlying asset by the LSD provider may differ depending on the principles of the protocol, for example:

  • Lido or Coinbase works centrally and independently deploys validator nodes to one degree or another. Such protocols are the most convenient for users, but not the most secure for the blockchain.

  • Rocket Pool unites validators and regular users on the platform and works in a decentralized manner, allowing anyone willing to launch a node through the platform. It’s a more secure architecture that doesn’t require trust, but it complicates the user experience.

The amount of fees charged also depends on the business model of the protocol, and their distribution is an important criterion when choosing an LSD provider, which we will consider using the example of specific sites, because it affects the final income of staking.

4. Advantages of liquid staking. What simple technology increases the liquidity of Ethereum coins?

Liquid staking platforms are becoming an increasingly large part of the DeFi ecosystem and an important blockchain security mechanism. Let’s summarize in this section all the advantages of liquid staking for users, validators and the development of Ethereum in general:

  • Flexible risk management: with direct staking with blocking in a smart contract, the user is temporarily deprived of access to the asset and cannot manage capital. That is, if, for example, ETH begins to fall rapidly, then the staker will not have the opportunity to sell it and reduce losses. Liquid staking tokens allow you to do this.

  • Additional earning opportunities: using LSD tokens, a staker can earn additional income by providing them as liquidity or collateral for a loan. At the same time, the basic asset will steadily bring income in the form of % of the secured amount.

  • Lowering the entry threshold into the ecosystem: moreover, both financially and technically. Even a small amount of ETH can be staked through liquid staking platforms, while direct staking requires a minimum deposit of 32 ETH. In addition, the staker does not need to run a validator node and, accordingly, does not bear the risk of losing the deposit due to node failures.

5. Risks in liquid staking. Centralization and regulation

If you consider liquid staking as a source of income, then you should understand that, as in any activity related to obtaining income, LSD has its own risks. And before diving deeper into this topic, it is better to study and understand them all. Let’s agree, we will present the risks we see ourselves in LSD, and you will conduct your own analysis of the technology, compare it to the possible profit and your earning strategy, and then decide whether it is worth pursuing this story or not. In our opinion, the following risks can now be identified in LSD:

  • Risks on the provider’s side: liquid staking platforms may be prone to hacking. And if the underlying assets are immediately deposited into a secure Ethereum contract, the derivative token may suffer from a hack, for example, from an uncontrolled emission that will collapse its price. However, so far we have not encountered any compromise of popular LSD providers.

  • Additional costs: ISPs in LSD charge a fee for using their infrastructure. Depending on the site, it can vary from 10% to 25% and affects the staker’s final profitability. With direct staking of the Ethereum smart contract, no fee is charged, that is, the final income is higher.

  • Debugging during the exchange: as the flipped token becomes a new marketable asset, its value can always match the value of the underlying asset. So, against the background of the crypto market turmoil in 2022, in June of last year stETH from Lido traded at a 4% discount to ETH with a nominal peg of 1 to 1. Also, when exchanging derivatives through DEX, slippage in the pool should be taken into account.

And the risk for the entire ecosystem. potential centralization of the blockchain: centralized LSD providers like Lido or Coinbase deploy hundreds of thousands of nodes, but at the same time have a very limited number of validators that are somehow connected to the site. With a high concentration of deposits, this can lead to an attack on the blockchain network, because the same Lido now has a little less than the total number of ETH staked and almost 31% of validators managed by only 30 operators.

6. Conclusions. Is liquid staking a trend in 2023?

Globally, Ethereum is perceived extremely positively by the crypto community today, all the narratives (LSD, L2, introduction of blockchain into production, new standard of wallets), as well as quick regulation, which did not seem strange, can give good mass adoption to Ethereum itself. After all, the position of the regulators regarding ETH is that it is a commodity.

Delphi digital believes that the amount of Ether connected will continue to increase and will reach its peak in 2024.

Source – Dephi Digital

So, the technology behind the projects is truly a breakthrough in the crypto industry. And despite the potential risks of the ETH price falling after the Shanghai update (which we’ll be sure to talk about in future articles in our Ethereum article series), TVL in LSD continues to rise, as does the dominance of liquid staking provider projects, demonstrating that All around, the buzz around LSD is unlikely to die down in the coming year.

And how many years do you think Ethereum will overtake Bitcoin in capitalization, and will it overtake it? Share your thoughts in the comments and thanks for reading!

This article was prepared for educational purposes. Everything said in it is not a financial or investment recommendation.

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