Original author: Lawrence Lee
On April 13, 2023, Ethereum's Shapella (Shanghai at the execution layer and Capella at the consensus layer) upgrade was officially launched. This upgrade mainly supports the retrieval function of staked ETH. At this point, ETH's PoS process can finally be considered "completed". In this article, we will discuss possible changes in ETH Staking yields in the future, discuss the competitive situation of the Staking sub-track, and the potential impact of LSDfi on the ETH Staking ecosystem.
ETH Staking Then and Now
Before we begin, we still need to briefly review ETH Staking. Unlike the vast majority of PoS public chains currently online, Ethereum's PoS does not support chain-native proxy delegation, and also limits the maximum staking size of a single node (profitable) to 32 ETH. The benefits of this staking method are obvious. It can minimize the possibility of a single entity directly controlling a large node to influence the Ethereum consensus, and keep the Ethereum network as decentralized as possible. However, since the operational complexity of node operations is quite high for ordinary users, in addition to solo staking where users stake by themselves, in practice, three other types of staking methods have gradually emerged: staking pools, liquid staking, and cex staking. The characteristics of these four staking methods are as follows:
Solo staking means that the staking user handles the entire staking process and subsequent maintenance by himself. Its main disadvantage is that it has high requirements for equipment, funds, knowledge, and network.
Staking pools, to a certain extent, eliminate the need for network and hardware for staking users. Staking users only need to pay a certain fee to ask a professional staking service provider to stake the 32 ETH they provide to obtain returns. At the same time, this method can also ensure that the withdrawal private key is still controlled by the staker himself, and the control over the funds is also high. However, it still has high requirements for the staker's funds and knowledge. In some categories, this staking method is also called Staking as a service.
Liquid staking goes a step further based on staas outsourcing the specific operation of nodes to professional node operators. The staking pool will uniformly collect users' ETH for staking operations, allowing users to stake any amount. At the same time, the staking pool will issue users a staking derivative LSD (Liquid Staking Derivatives/Tokens, we will use LSD to replace it below). LSD currently has a wealth of use cases in DeFi, which we will introduce in detail later. Of course, in the liquid staking model, all staked funds essentially belong to the contract of the staking pool. For staking users, they need to trust the staking pool. In some categories, this staking method is also called Pooled staking.
Cex staking handles the entire staking process by cex, which also allows users to stake any amount. Staking certificates (such as Coinbase's cbETH and binance's bETH) are usually issued to users.
Below: Historical changes in the relative share of ETH staking
Source: https://dune.com/hildobby/eth 2-staking (Note: Due to the complexity of statistics, the proportion of solo staking is difficult to count. In most statistics on staking classification, there is a category of "unidentified" (Unidentified in the above picture). According to recent analysis by Rated, 6.5% of the total staking volume is currently provided by solo stakers)
From the above figure, we can clearly see that, except for the 2 months after the beacon chain was launched, until April 2022, due to the fact that Cex naturally has a lot of user-hosted ETH, as a natural interest-earning channel, CEX Staking quickly became the leader in Staking, which is not what the Ethereum Foundation and community members want to see. With the investment of institutions such as Paradigm in Lido, and the good liquidity and composability gradually built by stETH, Lido has developed rapidly, and subsequently also led to the development of the entire liquid staking type. Up to now, liquid staking has always occupied a leading position in the track.
After Shapella was successfully launched, the staking share of CEX showed a significant decline, and a considerable number of users who originally staked ETH in CEX began to switch to liquid staking and solo staking (Unidentified).
According to the specific staking entities, Lido currently occupies 31.8% of the total staking market share. Ranked 3rd to 5th are three centralized exchanges, ranked 6th is another liquid staking service provider Rocket Pool, and ranked 7-10 are all Staking pools.
Source: https://dune.com/hildobby/eth 2-staking
ETH Staking Future Yield
The level of staking rewards is a determining factor in whether ordinary users participate in staking. To explore the future development of ETH staking, we need to understand the composition of staking rewards and future development trends. We know that after the Merge, staking Ethereum can not only obtain rewards at the consensus layer, but also rewards at the execution layer. Currently, the APR of these two parts totals 5.4%.
Source https://ethereum.org/en/staking/
The rewards of the consensus layer are the ETH issued by the Ethereum network. The release of the rewards will increase with the increase of the total amount of pledged, but the APR of pledge will decrease with the increase of the total amount of pledged ETH. The current APR of the consensus layer reward is 3.4%. The market generally estimates that the ETH pledge rate will be around 25-30% by the end of this year. When the pledge rate reaches 30%, the APR reward of the consensus layer will be roughly 2.4%. This reward is much lower than the rewards of most PoS chains, and it is also a reflection of the Ethereum Foundation's principle of "minimizing ETH issuance".
The rewards for the Ethereum staking execution layer include two parts: 1. The network's priority fee, which is the portion of the gas paid by the user excluding the portion that is destroyed; 2. MEV. The common feature of these two parts is that their returns do not increase with the increase in the number of staked ETH. This part is the main variable of ETH staking rewards, and we need to study it further.
Source https://transparency.flashbots.net/
Source: https://dune.com/LidoAnalytical/lido-execution-layer-rewards, where CL_APR represents the consensus layer revenue; EL_APR represents the execution layer revenue
Flashbots counted the total income of the proposer (i.e. validator) since the merger. Lido also counted the consensus layer income and execution layer income APR of Lido since the merger. As shown above, the trends of the two are consistent. Lido also counted the comparison of consensus layer and execution layer income. We will use Lido's chart for detailed analysis.
We can see that after the Merge, the APR of the consensus layer is slowly decreasing as the total amount of staking increases, while the APR of the execution layer varies greatly, averaging around 1.5%, making the staking income reach 5%. When on-chain activities are frequent (such as the meme season in May), the APR from the execution layer will even exceed the APR of the consensus layer, making the yield on staking Ethereum close to 10%. Staking income, as the "risk-free rate" of the Ethereum network (see Mint Clips | How to define the native benchmark interest rate in the crypto world?), is very attractive to ETH holders.
So how will the execution layer income evolve in the future? We first need to understand the proportion of priority fees and MEV in the execution layer income of stakers. We can refer to the detailed analysis of the income data of various roles in the Ethereum execution layer ecosystem from January to February 2023 by MEV data service provider Eigenphi:
Source: https://eigenphi.substack.com/p/value-allocation-in-mev-supply-chain
We can see that in 2 months, the priority fee and MEV basically constituted the Ethereum staking income (Validator fee) of the execution layer in a ratio of 55%: 45% (44.12 million: 34.72 million).
We will now explore the future trends in priority fees and MEV.
Priority fees on the Ethereum network Source: https://tokenterminal.com/terminal/projects/ethereum
In terms of priority fees, since the launch of EIP-1559, the current market has gone through a wave of bull-bear conversions. We can see that the priority fee is closely related to the market heat. During the bull market in 2021, the average daily priority fee can be close to 10 million US dollars, and during the bear market in 2022, the average daily priority fee is around 800,000 US dollars. In the Meme Season in May this year, the average daily priority fee can reach about 3 million US dollars. In the future, the priority fee will continue to fluctuate with market fluctuations, and this part of the income is ETH-based, and will continue to fluctuate with the market in the future.
In terms of MEV, it is more complicated. In addition to MEV, which cannot be fully analyzed from the chain, its composition mainly includes arbitrage, sandwich attack and liquidation. We have not found the latest trend data of MEV after Merge. However, the Ethereum Foundation has long had a negative attitude towards MEV. One year ago, they proposed the PBS (Proposer-builder seperation) plan, one of the purposes of which is to eliminate the impact of MEV on the income of small stakers. Recently, Justin Drake, a researcher at the Ethereum Foundation, proposed a plan called MEV burn, which plans to destroy all MEV in the next 3-5 years as another force for Ethereum's deflation. Although this plan is still in the planning stage and involves many trade-offs of interests, from the perspective of Ethereum's successful transition from PoW to PoS, they have the ability to "convince" key stakeholders in the ecosystem to abandon their interests and realize the Ethereum roadmap.
Therefore, MEV, which accounts for approximately 20% of the current total staking income, will most likely shrink or even disappear in the medium to long term because it does not conform to the value orientation of the Ethereum Foundation.
Another marginal factor worth noting is L2. Driven by the Ethereum roadmap centered on Rollup, more and more transactions will be transferred from Ethereum L1 to L2, which will inevitably reduce the MEV and priority fees on the Ethereum mainnet. At present, the MEV/priority fees of L2 are handled by L2 itself and have nothing to do with the pledgers of the Ethereum mainnet. Especially after the Cancun upgrade further reduces the fees of ETH L2, it may drive the further vigorous development of L2, and the overall handling fees + MEV that L1 can obtain may also be further reduced.
In summary, in terms of the composition of ETH staking income, taking into account the impact of MEV burn and L2, when the ETH staking proportion reaches 30%, the ETH staking income will most likely be reduced to the 3% level (including the 2.4% consensus layer income and an executive level income of 0.6%). This rate of return will have a significant impact on users' enthusiasm for participating in staking.
Liquid Staking will still be the mainstream of staking, and its concentration may further increase
The Shapella upgrade activated the withdrawal function of ETH, making ETH staked by Solo staking and Staking pool also gain liquidity. The core reason why Liquid staking has developed rapidly in 21-22 is that the liquid staking protocol can provide liquidity to LSD, thereby realizing the exit of staking in disguise. Therefore, the Shapella upgrade has significantly reduced the advantages of liquid staking. Although solo staking still has a considerable operating threshold, the number of tools serving solo stakers is increasing, and the threshold of solo staking will gradually decrease. In addition, solo staking also has the orthodoxy of maintaining the decentralization of the Ethereum network and has been strongly supported by the Ethereum Foundation.
Why do we still believe that liquid staking will maintain its dominant position in the staking arena, and even that concentration may further increase?
The main reason is composability. LSD has good composability, which means the possibility of obtaining higher returns/higher capital efficiency. Users who participate in Staking are naturally sensitive to returns, and they tend to choose staking methods with higher returns. Due to the high composability of LSD, it actually provides staking users with higher returns.
At a time when the basic return on staking is 5.6%, LSD can easily get a 10% APR. Take Lido's stETH as an example:
Source: https://defillama.com/yields? token=STETH
We can see that at present, stETH LP can easily obtain an APR of more than 50%. Taking into account the capital occupation of paired assets, the total APR can also exceed 25%. The stETH single currency can also obtain an APR of more than 25% in Asymetrix (LSD's pool together) and Ribbon (options protocol) (although it may face some risks). When combined with stETH's own 5.6% APR, the total income of users staking through lido will reach 30%.
In addition to high returns, stETH has also been widely integrated in DeFi blue-chip protocols: Maker, Aave and Compound all support stETH (wstETH) as collateral, and the gap between its collateral parameters and ETH is not large. There is still more than 1.1 billion US dollars of liquidity in Curve's stETH-ETH, which makes it easier for stETH holders to obtain liquidity whether directly swapping or pledging loans.
These advantages are not available to solo staking and staking through staking pools. In particular, if the ETH staking yield drops to only 3% as we mentioned above, considering the equipment, knowledge, time and energy that solo stakers and pool staking have to pay for a 3% yield, people will most likely choose a simpler and more profitable solution.
Ethereum community users are willing to maintain the decentralization of Ethereum, but they also need to consider the opportunity cost. "Maintaining the decentralization of Ethereum is important and cool, but I still want to choose 30%."
LSD and LSD-Fi
After the Shapella upgrade, many LSDfi projects have appeared on the market. Their common feature is to attract users' LSD deposits and carry out various financial applications. Many people think that we will encounter a LSDfi summer.
Source: https://dune.com/defimochi/lsdfi-summer
We will not discuss the pros and cons of specific LSDfi projects in this article, because in my opinion, LSDfi has not created a certain business category, but only allows LSD to be used as collateral for many businesses. In essence, the business of these protocols is still stablecoins, yield aggregation, Dex, and interest rate services. Whether their business can be successfully carried out still depends on their understanding of the stablecoin, yield aggregation, Dex, and interest rate service markets. Among the LSDfi projects that have actually launched products, we have not seen any projects that can get rid of Fork and pure Yield farming games. Of course, there are still more high-quality LSDfi projects that have not been launched, and we also look forward to more innovations relying on LSD in the future.
What we want to discuss is the impact of LSDfi on the entire Staking industry.
LSD holders must have two characteristics: they hold ETH on the chain and have some understanding of DeFi; they are sensitive to yield (that’s why they stake). These two characteristics make them the target users of any DeFi entrepreneur on the Ethereum network: they hold ETH on the chain, so they can perform on-chain operations and may have some understanding of their business; they are sensitive to yield, so incentives can be used to influence the behavior of these users. In fact, when DeFi has developed to today’s relatively mature stage, there are still many ETH holders who only hold ETH on centralized exchanges.
Source: https://etherscan.io/accounts
Based on this wave of LSDfi craze, more and more LSD projects will be initially launched, and they all have brand new tokens, which means they have brand new market budgets. What happened on unshETH, Agility, and Lybra may happen again on LSDfi in the next 3-6 months. LSD will continue to have an APR far exceeding ETH's on-chain income, which may form a self-reinforcing flywheel effect between LSD and LSDfi: the more LSDfi, the higher the income provided, and the more motivated ETH holders will be to convert their ETH into LSD; more and more LSD will incentivize DeFi protocols to target these users, attracting them by providing high income and thus getting through the cold start phase of the protocol.
Eventually, all DeFi protocols may be called LSDfi in a broad sense, because they all support LSDfi to a greater or lesser extent (in fact, except for a few stablecoin protocols, most DeFi protocols are already associated with LSD). Obviously, LSD can capture the beta of LSDfi. The popularity of LSDfi will further promote the share of liquid staking in the overall staking track.
Ethereum Foundation’s stance
Regarding issues related to staking, the Ethereum Foundation has expressed the following attitudes:
1. We do not want too much ETH to enter staking. Too much ETH entering staking will, on the one hand, increase the release of ETH rewards at the consensus layer, which is contrary to Ethereum’s long-standing concept of “minimum viable issuance”. On the other hand, it will reduce Ethereum’s economic bandwidth (economic bandwidth, a concept proposed by Bankless, refers to the liquid market value of Layer 1, which is the basis for the operation of all Dapps on it).
2. Negative views on MEV. For every Ethereum staker, MEV is a huge reward that may fall from the sky at any time with a very low probability. If no intervention is made, it is easy to cause forced centralization (such as BTC and ETH in the PoW mining pool), thereby establishing new alliances on top of Ethereum's consensus (such as the current MEV-boost), causing unnecessary and unsafe complexity in the consensus layer. In the medium and long term, the Ethereum Foundation will promote the destruction of MEV, turning MEV from a privilege of a few validators into a common reward for all ETH holders.
3. We do not want to see an overly powerful LSD that can "replace" ETH on the Ethereum mainnet. This will also bring more unnecessary security risks to ETH.
The main idea behind Ethereum's idea is to maintain a decentralized consensus layer without affecting the characteristics of ETH itself as the most important mortgage asset of the Ethereum network, and also without wanting Ethereum's consensus layer to be affected by the protocol built on Ethereum.
Source https://ultrasound.money/
stETH is currently the largest non-native non-stablecoin asset on the Ethereum network. USDT and USDC, which rank higher than stETH, do have very broad use cases, but they are essentially maintained by the credit of Tether and Circle. If they have problems, it may indeed have a great impact on Ethereum, but it will not consume Ethereum's credit.
But the special thing about stETH is that it has been integrated into almost all DeFi protocols as collateral similar to ETH. Let's do a thought experiment. If the contract of Lido Finance is attacked, all the withdrawal private keys of Lido in the beacon chain are controlled by hackers. Then will Ethereum need a hard fork like the DAO incident?
No one wants to see this, so we can understand why the Ethereum Foundation needs to work hard to support solo staking, why the Ethereum community discusses whether to limit the scale of Lido, and why Lido will take decentralization as its next major task. But the problem is that the emergence of a large liquid staking service provider is not the deliberate act of an evil centralized organization, but the natural result of market competition. Even if the Ethereum Foundation/core community can control the scale of Lido in some form, Mido or Nido will appear and become the Schelling point of the pledge.
There are two worlds before us:
1. One is what the Ethereum Foundation hoped to see in its original design: the proportion of ETH pledged is not high, just enough to maintain security, and most ETH is still used as collateral assets on the main network to maintain the normal operation of various Dapps, and the main body of the pledge is the Solo staker;
2. The other is what we are actually likely to see: due to the existence of one (or several) powerful LSDs, more ETH enters liquid staking, this (or these) LSDs become the collateral of various DAPPs, and to a large extent this (or these) LSDs "become" ETH.
From the current perspective, the latter is much more likely to occur.
References:
https://eigenphi.substack.com/p/value-allocation-in-mev-supply-chain
https://www.youtube.com/watch?v=nb7x7n8Ga3U
