The upcoming transition on the Ethereum network to a Proof of Stake (PoS) consensus mechanism creates a novel set of incentives, particularly for those wishing to stake their ether in order to generate a yield. In what follows I will briefly highlight why the market for staking ether can be expected to expand significantly in the future, along with the key challenges that must be overcome for a staking service to be successful. Following this, three kinds of staking services are introduced and it is argued that liquid staking will outcompete rival services given the constraints highlighted. Finally, it is argued that the market leading Lido Finance, specifically, is very well positioned to capture a large portion of the growing demand for staking moving forward.
Incentives Under PoS
To begin with, following the Merge and the attendant implementation of PoS on Ethereum, all market participants will have an incentive to stake a large portion of their ether in order to generate a yield. While estimates vary as to the expected annual rate of return for staking, any positive and non-trivial rate will create this incentive structure. Instrumentally, one could view staking on Ethereum 2.0 as the adoption of a global “risk-free” (although of course it’s not truly risk-free — nothing is) rate of return for the Ethereum ecosystem. Under this analogy, prudent market participants will need to be mindful of the opportunity costs associated with not staking when making alternative capital investments with their ether. The full implications of this transition, particularly for other yield generating services in the Ethereum ecosystem, are well beyond the scope of this essay. I raise this notion merely to highlight the strong incentive that individuals will have to stake their ether following the Merge. Of course, ether will still be required in order to buy block space and make transactions; meaning that market participants will have an incentive to stake a large portion of their ether while keeping a small percentage in reserve so as to facilitate everyday operations.
There are, however, several costs, risks, and challenges associated with staking ether as an independent validator. First and foremost, the 32 ether minimum that is required represents a significant barrier to entry for almost all participants. Secondly, even for those who view 32 ether as an insignificant sum, the technical knowledge required to operate a validating node successfully is significant. There are also operational risks associated with the potential loss of one’s funds, via slashing or otherwise. Finally, and perhaps most importantly, the ether staked on the Beacon chain is unusable for other purposes while it is staked. This dynamic creates both a period of illiquidity and an opportunity cost for those who might otherwise employ that ether as collateral or liquidity in other domains. While the illiquidity of Beacon chain deposits prior to the Merge is a well-known issue, this challenge, to a lesser extent, persists after the Merge due to the simple fact that one may not stake their ether while also using it elsewhere.
To summarise, there are four key challenges involved in staking ether as an independent validator. These are:
1. High barrier to entry — The 32 minimum ether required.
2. Expertise — The hardware and technical knowledge required.
3. Downside risk — The risk of slashing, or other unforeseen loss of funds.
4. Illiquidity — The opportunity costs of, and period of illiquidity entailed with, staking.
With all of this in mind, the market demand for staking services following the Merge can be expected to increase substantially. Even prior to the Merge, deposits to the Beacon chain have been increasing steadily.
Three Market Solutions
Those incentives that are created under a PoS system, when paired with the challenges of independent staking just highlighted, creates an opportunity for entities to offer solutions in the form of Ethereum 2.0 staking services. Broadly speaking, there are three kinds of staking services that are either being developed, or are presently available for use. These services being exchange staking, decentralised staking pools via an intermediary service, and liquid staking. Addressing each of these in light of the four challenges highlighted above will elucidate the long-term value proposition associated with each for the typical user. Additionally, each of these solutions will be evaluated in terms of profitability for users and the ability to scale given demand.
Beginning with the exchange staking solutions, such as those offered by the centralised exchanges of Coinbase and Kraken. These services offer a convenient means of staking for those who already have an associated exchange account. Users simply allocate any amount of ether to be staked in exchange for a percentage of the yield generated. The exchanges, in turn, combine the ether provided to them and operate validating nodes on behalf of their users. This approach neatly addresses three of the four challenges highlighted above, which include the high barrier to entry (small amounts of ether can be staked), the expertise (validating is abstracted away from the user), and the downside risk of staking (any losses incurred are socialised). Moreover, one of the benefits of centralisation in this domain is the ability for these exchanges to scale rapidly given the influx of a large amount of ether for staking. With that being said, the yield received by users is likely to be significantly lower than what would be available from an independent validator; as an example, Coinbase keeps 25% of the revenue generated. Additionally, any capital invested in such services is unavailable for other uses, meaning that the final constraint remains unaddressed.
It should also be recognised that many market participants may also be ideologically opposed to centralised custodial staking such as those offered by exchanges. For these individuals, decentralised staking via a service such as Rocket Pool, may be a preferable alternative. Very briefly, Rocket Pool connects technically capable validating node operators with those looking to stake ether (for a more detailed explanation please consult this documentation). On the one hand, depositors can stake as little as 0.01 ETH in exchange for an amount of rETH, a tokenised representation of their deposit that can be used in other areas of the Ethereum ecosystem. Conversely, validating node operators will receive rewards in the form of nETH tokens (at least prior to the Merge) for their services in addition to RPL tokens, which are used for governance and an increased revenue for validators. For validators the barrier to entry of 32 ether is halved to 16 ether, which, while an improvement, is still significant. As was the case with centralised exchange staking, any losses from individual validators are socialised and represented in a reduced exchange rate between rETH and ETH. Thus, for depositors, all of the key challenges associated with staking ether are solved. However, technically capable and well-capitalised validators are still required under this model. Unfortunately, this creates a bottleneck of growth for this kind of decentralised service, which will likely struggle to accommodate the influx of a large amount of capital in a short period of time. Simply put, Rocket Pool may only scale as quickly as validating node operators can join and contribute to the network. In fairness, the tokenomics of the nETH, rETH, and RPL tokens may help to alleviate this concern by incentivising new validators to join the network, however, it seems clear that scalability will be Rocket Pool’s biggest impediment to long-term growth and success as a widespread staking solution.
Finally, striking somewhat of a middle ground between the centralised and decentralised staking services are the liquid staking providers such as Lido Finance or StakeHound. Lido Finance, in particular, allows users to deposit any amount of ether in exchange for stETH, which is a daily rebasing token that increases in supply in accordance with the ether generated via staking. Users holding stETH will witness the nominal amount of stETH increase in their wallets while the value of stETH is pegged to ETH, thereby allowing users to access a yield from staking without locking up their capital. stETH can then, in turn, be employed throughout the Ethereum ecosystem. Importantly, Lido Finance employs nine independent validating staking services such as Chorus One, Staking Facilities, and P2P in order to generate the ether backing stETH. This division of labour allows for a degree of decentralisation over the staking process. Admittedly, this is a lower level of decentralisation than what is provided by Rocket Pool, although it is certainly more than what is offered by exchanges. Moreover, this structure allows Lido Finance to scale rapidly in a way that Rocket Pool is unable to. Thus, a liquid staking service such as Lido Finance not only addresses each of the four challenges of staking for the typical user, but as an entity it can scale rapidly, thereby allowing it to gain dominance in this very competitive and expanding market.
Below is a table summarising each means of staking against the four challenges listed above, in addition to the yield generated for users and the scalability of the enterprise.
With all of this in mind, it seems clear that liquid staking services will represent a significant portion of the Ethereum staking market following the Merge. This is not to say that independent validators, exchange staking, and decentralised staking pools will not gain traction; it is just to say that liquid staking will likely be the dominant means through which people stake their ether.
Before finalising this piece, it is worth briefly addressing both the positive and negative factors influencing Lido Finance’s success in the future. Lido Finance, in particular, will be the focus of this final section because it is, by far, the market leading liquid staking service. Moreover, as Georgios Konstantopoulos and Hasu from Paradigm Research write, ‘ETH staking derivatives [(i.e. stETH)] could follow a power-law or winner-take-all distribution due to the liquidity moat and network effects associated with them’. In line with this, and as of the time of writing, there is 685,364 ETH staked with Lido Finance, which represents 78.1% share of the current liquid staking market.
The other positive factors supporting Lido Finance’s success in the future include:
1. Multi-Chain staking — In addition to providing liquid staking on Ethereum, Lido Finance offers liquid staking on the Terra blockchain, and has plans to expand to other PoS blockchains such as Solana.
2. Strong ecosystem integration — Lido Finance has relationships with entities such as 1inch, Yearn, and AAVE among several others. Increased adoption and integration of stETH in the Ethereum ecosystem contributes to the moat-like network effects that Lido Finance is fostering.
3. MEV extraction — In addition to the staking rewards, Lido Finance will be in a unique position to capitalise on MEV extraction into the future, further boosting profitability.
6. Push towards decentralisation of deposit contracts — It has recently been announced that Lido Finance is moving towards a trustless model of liquid staking that would remove the necessity to trust the staking providers employed by Lido Finance.
7. Capital structure — The rewards generated via staking are divided into three buckets. 90% of the staking rewards are distributed to those holding stETH, 5% are paid to the staking services that Lido Finance employs, and the remaining 5% is allocated to the treasury to cover expenses and as an insurance fund in the event that ether is slashed or lost (this has not occurred yet). This is a conservative approach that can accommodate the vicissitudes of the crypto ecosystem.
Conversely, the factors that may detract from Lido Finance’s future success include:
1. Lido Finance governance token — Lido Finance operates as a DAO using LDO tokens. Presently, approximately 3% of LDO tokens are circulating freely on the market, with a large percentage having been allocated to developers and investors that are vested for at least one year. This will create a large degree of volatility for those exposed to LDO (especially in the event that something goes wrong!). While not negatively impacting Lido Finance as an operation, it is something to consider if one is looking to invest.
2. stETH to ETH peg — Prior to the Merge there exists a risk that the peg between stETH and ETH will break given that any ether staked in the beacon chain may not be extracted in order to arbitrage any divergence away. This is a short-term risk that is removed following the transition to PoS.
3. Protocol changes to Ethereum staking — In the event that significant protocol changes are made to how staking ether will operate prior to the Merge, this could negatively impact Lido Finance’s business model.
Despite the risks just highlighted, the core thesis outlined in this essay provides strong reasons to believe in the continued adoption and growth of liquid staking services leading up to, and beyond, the transition to PoS on Ethereum. Liquid staking services are able to scale rapidly while also addressing all of the challenges attendant with staking ether that would otherwise exist. Lido Finance, in particular, has been highlighted as the market leading liquid staking service, and it appears to be well poised to capture a large portion of the growing market for staking ether, and other PoS assets, when moving forward.
Thank you for your time!
Disclosure: I own LDO tokens at the time of writing.