crypto strategy

Ethereum’s centralized and decentralized liquid staking providers battle for dominance

What happened

After Ethereum began its transition to proof-of-stake, liquid staking platforms allowed users to earn a return by delegating their ether (ETH) to a validator, while receiving a tradable staking token that represents a claim on the underlying staked ETH.

Liquid staking products have seen significant traction in recent months, with two of the largest liquid staking pools, Lido and Rocket Pool, gaining the largest market share among decentralized staking pools. Decentralized staking pools allow users to delegate their assets while retaining custody of their private keys, while their centralized offerings require users to first move their assets to a centralized platform. Lido and Rocket Pool’s respective native tokens, LDO and RPL, have surged 115% and 80% year-to-date, indicating growing interest in the platforms.

Coinbase, the largest centralized exchange based in the United States, is a new entrant in the liquid staking space and has quickly risen to second place with its staking service and the associated cbETH wrapped staking token. According to Dune Analytics, decentralized staking protocols Lido and Rocket Pool have 76% and 3.5% market share in terms of ETH deposited on their platforms, while Coinbase quickly gained 17% market share.

Broader context

Since the launch of the Ethereum beacon chain in December 2020, initiating the first phase of the network’s transition from a proof-of-work consensus mechanism to a proof-of-stake alternative, individuals could stake their ETH and serve as validators to process transactions and secure the network. Individual players need specialized hardware with high internet availability and a minimum of 32 ETH (~$49,000) to run the nodes themselves. In exchange for this service, punters receive compensation in the form of block rewards (new issuance of ETH), tips and minimum extractable value (MEV), paid in ETH. Staking yield decreases as more validators come online, and the current yield is around 5.5% APR with a total of 15.9 million ETH staked.

Ethereum completed its transition to proof-of-stake when the Merge upgrade took place in September 2022. Even though the network has completely moved away from its energy-intensive proof-of-work consensus mechanism, the stakers are not yet able to withdraw their assets until the Shanghai upgrade is implemented, which is expected to take place in March this year.

Enter liquid staking.

Although the underlying ETH is locked until the Shanghai upgrade is complete, liquid staking providers issue a derivative token individually backed to assets staked on the platform. Lido depositors receive stETH and Rocket Pool depositors receive rETH, which update their balances daily to reflect user token rewards. These tokens provide users with liquidity on their underlying staking positions, allowing them to sell their positions or leverage these tokens to earn yield or access credit through various DeFi strategies. Even though the upgrade will allow withdrawals, the staked ETH should still be locked during the staking process, ensuring that liquid staking protocols will still be in use after the upgrade.

As Lido, Rocket Pool, Stakewise, Coinbase and other liquid staking providers have come online, the amount of ETH staked in pools has soared 2,470%, from 265,000 ETH at the start of 2021 to over of 6.8 million ETH now.

It should be noted that the price of ETH and its derivative liquid staking tokens have consistently diverged, with staking tokens often trading at a slight discount. There are several reasons why staking tokens are trading at a discount to ETH, such as users selling their staking tokens to buy more ETH, effectively leveraging their ETH positions, as well as the inherent risk that the Shanghai upgrade will not be executed as planned, leading to delays in withdrawals.

When withdrawals are activated, the gap should close and the tokens should trade at par with ETH. As shown below, stETH, cbETH, and rETH are currently trading at a ratio to ETH of 0.992, 0.989, and 0.962 respectively.

Key stat

Currently, 42.7% of all staked ETH participates in liquid staking pools, or 6.9 million ETH (~$10.7 billion). The circulating supply of Ethereum is around 120.5 million ETH, so the pooled amount is 5.6% of the network’s total supply.

Prospects and implications

Both centralized and decentralized staking providers have grown in popularity as they remove the technical complexity from the staking process and allow users to stake without minimums, thus lowering the barrier to entry for daily users.

Decentralized liquid staking providers like Lido, Rocket Pool, and Stakewise have also formed Decentralized Autonomous Organizations (DAOs) to manage governance and reward various protocol stakeholders. The native tokens of these platforms are used to compensate node operators, provide oracle pricing data (i.e. provide real-time ETH prices), vote on matters such as fee settings staking rewards and the use of funds for protocol development (i.e. Lido charges a 10% fee on staking rewards which are split between node operators and DAO treasury), adding and removing node operators and other operational issues.

Coinbase recently announced its intention to join Rocket Pool’s Oracle DAO. As a member of the DAO, his responsibilities will include providing real-time ETH pricing data, running Rocket Pool nodes, and voting on protocol upgrades. In exchange for these services, Coinbase will receive RPL tokens as compensation.

Although major centralized exchanges Coinbase, Binance, and Kraken already provide staking services to their retail user bases, the institutional market has been largely untapped. This could change with the launch of Alluvial, which will form a consortium among some of the major centralized staking providers, including Coinbase, Figment, Kraken and others. First announced in September 2022, Alluvial is a liquid collective that aims to provide an enterprise-grade multi-chain liquid staking protocol, initially targeting institutional investors.

The fact that Lido represents such a high percentage of the total set of validators raises its own concerns about the risk of centralization and the possibility of a single platform censoring transactions at the protocol level, since validators have the ability to order or even exclude transactions from a block. . This may be a bigger concern if Coinbase gains more market share, as centralized platforms will face additional pressure to comply with OFAC sanctions and local compliance regulations.

When withdrawals are enabled with the Shanghai upgrade, staked ETH tokens will be unlocked, which could potentially lead to increased market supply and additional selling pressure. On the other hand, opening withdrawals can actually lead to more staked tokens and reduce selling pressure, as it can reassure future stakers that their tokens are freely tradable and no longer locked. for an indefinite period.

Among the top proof-of-stake networks, Ethereum has a relatively low stake ratio at ~14% compared to 71% for Solana, 72% for Cardano, and 97% for BNB. This suggests that there is room for more ETH holders to get involved and lock in a larger percentage of supply through staking.

Decision Points

ETH holders looking to earn yield through staking should be aware of the tradeoffs between centralized and decentralized providers. Centralized providers like Coinbase require users to open accounts and undergo KYC/AML checks. Additionally, users must first send their assets to Coinbase, which takes custody of the assets and poses third-party risk.

Alternatively, decentralized solutions like Lido and Rocket Pool never take custody of users’ private keys and users can stake their assets directly from their non-custodial wallets, such as Metamask or Ledger. However, these platforms come with their own unique risks in the form of smart contract risk, which if exploited could result in the loss of users’ funds.

Staking platforms also provide liquid staking solutions for cryptonets other than Ethereum. For example, Lido supports staking on Solana, Polygon, Polkadot, and Kusama with their respective stSOL, stMATIC, stDOT, and stKSM tokens. These other networks are not subject to the same withdrawal restrictions, and investors can earn returns by backing the networks they are fundamentally bullish on.

More exotic yield farming and DeFi strategies can help users maximize the yield that investors earn, if they manage their staking tokens properly. Users can earn an estimated additional APY of around 3% by mining liquidity on Curve and depositing their stETH and an equivalent amount of ETH into DEX’s stETH-ETH pool. The Uniswap and Sushiswap DEXs offer similar pools for users to deposit their assets to earn additional return. Users can also lend their staking assets or borrow against their staking positions by leveraging DeFi loans such as the Aave or Compound protocols.

Prior to deploying these strategies, users should perform their own due diligence and understand the risks inherent in these DeFi protocols, such as buggy smart contracts, impermanent losses, or substantial token price fluctuations, which may result in the loss of capital from traders. investors.

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