Source: IOSG Ventures

Compiled by: BitpushNews Mary Liu

Recap:

This article discusses the current state of the Ethereum staking market as Ethereum moves to Proof-of-Stake (PoS) and completes the Shanghai upgrade. The article delves into two questions: first, whether staking will become a winner-take-all market, and second, what the expected total staked ETH is. Currently, the ETH staking space is dominated by non-custodial staking platform Lido, followed by centralized entities such as Coinbase, Kraken, and Binance. We expect Lido’s market share to remain in the 30-35% range. Overall, we expect the Shanghai upgrade to result in a surge in new staking in the short to medium term, but we expect the percentage of staked ETH to remain moderate compared to other PoS chains.

Since the early days of Bitcoin and blockchain, there have been centralized intermediaries that provide crypto conversion services to different users. Only with the introduction of Ethereum did it become possible to build non-custodial dApps that enable users to trade their cryptocurrencies without a trusted middleman.

However, centralization still dominates key application verticals including trading, lending, and fund custody. The dangers of this centralization became very apparent in 2022, with lending platforms facing controversy and one of the largest exchanges, FTX, declaring bankruptcy after alleged fraud.

The novel track – NFT – was born from decentralized protocols and programmable blockchains, and was once the only area where centralized players could not keep up with the pace of decentralized opponents. But with Ethereum’s shift to proof-of-stake (POS) and the lack of native staking options for users, a new competitive track has emerged: staking pools.

Staking is an important feature of PoS blockchains because it provides a mechanism to secure the network and incentivize users to maintain its integrity. By requiring users to participate in the form of staked and slashable tokens, PoS networks can discourage malicious behavior and reward users who follow the rules and maintain the network.

Staking pools combine the resources of many different participants to stake a large number of tokens together, thereby increasing their chances of being selected to create a new block. In addition, staking pools can help small-scale validators who do not have enough tokens to stake individually to participate in the network and receive rewards.

Traditionally, staking requires locking up tokens for a period of time, which can make them illiquid and create opportunity costs for stakers. However, with liquidity staking, users can stake their ETH through a third-party service provider/protocol, which then distributes liquidity tokens representing the staked ETH, which can be freely traded or used as collateral while still earning staking rewards.

ETH staking has attracted interest from both non-custodial and custodial entities. The outcome of this competition could have a significant impact on the future of Ethereum. If centralized players begin to dominate the market, it would be a huge setback to Ethereum’s decentralized ethos.

As shown in the chart below, non-custodial staking protocol Lido is currently in the lead, accounting for 30% of the ETH staking market share. However, centralized entities such as Coinbase, Kraken, and Binance are not far behind.

Cumulative staked ETH; Source: Dune LIDO market share; Source: Dune

However, some influential representatives in the Ethereum community have been pushing to limit Lido’s growth. For example, Vitalik Buterin believes that staking projects, whether custodial or non-custodial, should set their own caps, proposing a 15% threshold.

On the other hand, some members ignore community pressure and believe that this market can easily become a winner-take-all situation, driven by factors such as liquidity, composability, network effects, specialization, and yield optimization. However, given the values ​​and goals of the Ethereum community and the desire for more distributed staking, the question of how much market share the leaders will control cannot be ignored.

While Lido is adamantly against the idea of ​​a self-imposed cap, it is unlikely that they will corner the market. Relatively speaking, Lido's share should not easily exceed the 30-35% range. Below, we will explore factors that may prevent Lido from becoming a "winner takes all" situation.

Impact of Shanghai Upgrade

While the Shanghai Hard Fork is expected to boost confidence in the staking vertical and encourage more depositors to use its products, the upgrade could weaken Lido’s moat.

First, as the market leader with the most liquid ETH token, Lido provides depositors with greater assurance that they can exit stablecoins or other assets at any time without a significant discount.

However, with near-instant withdrawals, this layer of defense disappears, as depositors can always convert back to native ETH within hours/days. This may lead depositors to be more willing to try novel designs or choose protocols that have other advantages over Lido.

Additionally, centralized players may offer products that support faster withdrawal options, which may affect user convenience.

Fierce competition

Furthermore, intense competition, which offers a different set of trade-offs for end users, has yet to truly challenge Lido’s market dominance. Until recently, Lido was pretty much the only viable decentralized staking protocol. Without Lido, centralized players would likely dominate the ETH staking market.

Today, however, most of Lido’s non-custodial competitors are maturing and emerging as possible alternatives for stakeholders who value decentralization. Additionally, while Lido has already distributed the majority of its tokens to various stakeholders, its competitors can still leverage innovative token designs to attract ETH depositors. However, while token incentives can indeed be powerful in gaining short-term traction, solid design choices and user experience determine the long-term winners.

Furthermore, a Lido fork is always possible, although its impact cannot be predicted. How much of a threat this fork would be to Lido depends on various factors, such as LDO governance decisions, timing, the innovation of the fork (e.g. at the governance level), and the legitimacy of the core contributors of the fork. Some community members may be closely watching the nascent Lido governance and waiting for any major mistakes to create a fork.

In addition, the staking market is still in its early stages and there may be waves of disruption. For example, re-staking has disruptive potential if successful. For example: The re-staking market Eigen Layer introduces the option for ETH stakers to accept additional risk and participate in protecting different middleware, thereby improving their resource utilization and finding additional sources of income beyond ETH staking returns.

While Eigen can serve as a complement to LSD, it can also interact directly with stakers. Since these participants manage their own hardware and have the ability to provide middleware, it is more likely to further incentivize individual staking. Therefore, Eigen is likely to take market share from existing LSD solutions.

Importance of L (liquidity) in LSD

Those who believe that LIDO can capture the entire market are basing this expectation on the premise that market leaders are entitled to network effects. Below we explore whether these effects are overestimated.

The traditional view is:

Users prefer to choose LSD with the best liquidity for withdrawal purposes The deepest liquidity makes LSD a collateral in many DeFi protocols, providing more use cases for its holders More use cases make this token more liquid, and the cycle repeats

First, as mentioned before, there is the opportunity cost and illiquidity issue. When withdrawals are not possible, LSD’s liquidity becomes a critical factor. But with the advent of near-instant withdrawals, this advantage is largely diminished. Nonetheless, Lido did take advantage of the period before the Shanghai upgrade to implement most of the integrations with leading DeFi protocols so that stETH holders can benefit from the composability of DeFi.

However, are token holders really so eager to use their ETH in on-chain applications?

Looking at the recent bull cycle, despite the hype around DeFi, NFTs, and gaming, as well as attractive liquidity mining programs, only a relatively small portion of ETH is actually used in smart contracts, with approximately 18.5% of ETH tokens being used in smart contracts at the peak of the bull run.

Source: ultrasound.money

Given this, it’s fair to ask: Will modest staking yields push that ratio above 20%, especially since high yields from past bull markets have failed to do so?

Additionally, it’s worth noting that not all DeFi protocols support rebase tokens like stETH, which has led to two standards in the Lido ecosystem — stETH and wrapped stETH (the latter of which is often traded at a premium due to its accumulated rewards). This creates friction for users who must wrap and unwrap stETH when using some of the top DeFi protocols, such as MakerDAO, Balancer, and Euler. Currently, most stETH tokens are concentrated in only two protocols, Aave and Curve.fi, further limiting the potential influence of the token in the DeFi space.

wrapped stETH adoption stETH adoption How big is the cake?

ETH currently has the lowest stake ratio among the larger PoS chains. Some people tend to make simplistic analogies and expect ETH stake to grow purely because other chains have much larger stakes. However, Ethereum is somewhat special for the following reasons:

There is no way to unstake (this is no longer true) There is no protocol-level staking that would introduce another layer of smart contract risk ETH’s status as a mainstream asset and a more diverse community makes it less susceptible to large-scale staking by insiders

We do hope that the Shanghai upgrade creates an environment for staking on a larger scale. Additionally, as new smart contracts and custody solutions become battle-tested, security risks will become less of a concern. However, given everything discussed above, the idea that 50%+ of ETH supply could soon be locked up in staking contracts seems crazy.

Lido's Fundamentals

While Lido is a multi-chain protocol, its fundamentals are inherently tied to Ethereum activity and ETH prices. Almost all of Lido’s TVL is on Ethereum, and the platform’s revenue comes from Ethereum inflation rewards and transaction fees. Lido collects 5% of staking rewards generated on its platform, with the majority (90%) going to stETH holders and the rest to node operators.

However, even when priced in ETH, Lido still sees volatility, likely due to the market reassessing Lido’s position in the staking vertical and the estimated size of the LSD market. These two factors are core drivers of Lido’s future revenue potential.

Source: CoinGecko

It is also important to understand the dynamics of ETH inflation, as it typically accounts for the majority of Lido’s revenue. According to Ultra Sound Money, a 1% increase in the total amount of ETH staked results in a 0.41% annualized decrease in base rewards. Therefore, an overall increase in staked ETH will not necessarily lead to a linear increase in staking protocol revenue unless there is a significant increase in on-chain activity to compensate for the decrease in base rewards.

market expectation

When we compare the price-to-earnings (P/S) ratios that the market is pricing the LSD project at with some other DeFi protocols, the market’s excitement about the liquidity staking vertical is evident.

For example, Lido, which is more conservative than competitors like Rocket Pool or Stakewise, still has a more attractive P/E ratio than the “old” DeFi protocol MakerDAO, with a P/E ratio of around 80, while Maker’s P/E ratio is 37.

MakerDAO is more than just a random benchmark, it has similarities to the staking vertical, as LSDs are essentially synthetic assets, similar to Maker’s DAI. It would not be surprising if some LSDs eventually even choose to issue their own synthetic stablecoins.

Lido's P/E ratio improved significantly when the Shanghai upgrade timeline became clearer, and then fell slightly due to lower LDO prices on the one hand and increased protocol fees on the other.

Unless Lido or Maker DAO begin exploring new narratives or experience any major idiosyncratic events, in the medium term we should expect some convergence in the P/E ratios of both projects.

Assuming Lido's P/E converges to 50 in the near term, and making a simplifying assumption of a 5% APY, Lido would have to grow its TVL by about 70% to justify existing price levels.

in conclusion

The nascent liquidity staking industry is likely to see significant volatility in the coming months as the market reassesses the overall size of the staking market and the positioning of individual participants.

Despite community calls to limit the size of a single validator pool, we expect to see Power-law Distributions in the space, where only a few players dominate market share. However, we do not believe this will lead to a winner-take-all market, and we do not expect any single company to control more than 35% of the market share.

Furthermore, we doubt that the Shanghai upgrade will bring the percentage of staked ETH in line with other major Proof-of-Stake chains, and we believe that ETH holders’ interest in staking is somewhat overestimated.

While Lido enjoys a first-mover advantage and is widely considered the safest way to hold ETH, it has yet to face competition from established competitors that could use token incentives to attract Lido’s depositors.

Disclaimer: IOSG is an investor in Stakewise, Swell, and Eigen Layer.