Another look at the liquid staking track: Is Lido still popular now?

Original author: Tanay Ved

Original compilation: Deep Chao TechFlow

introduce

The evolution of the Ethereum network to a PoS blockchain has brought significant changes to its key participants and underlying economy, now positioning PoS as the backbone of the Ethereum consensus. After the successful completion of the “merger,” the “Shapella” upgrade followed, allowing an entire industry to arise around PoS. With approximately $40 billion in assets pledged and a growing ecosystem of stakeholders, it’s important to understand the current state of the space and gain insight into the key players with significant influence on the industry.

Lido, the largest player in the PoS economy, has taken a look at the status of its liquidity staking token (stETH), governance token (LDO), and underlying node operators. Through this article, we seek to explore Lido’s prominence in the liquidity staking space, which has become an increasingly contentious topic for the Ethereum community.

The current status of Ethereum PoS

However, before we delve into the depths of Lido and stETH (staking ETH), it will be very helpful to understand the current situation of Ethereum PoS, especially in the macroeconomic context of monetary tightening and rising interest rate rates.

As of October, approximately 27.9 million ETH (23% of the current supply) or approximately $40 billion worth of assets have been staked on the Beacon Chain, highlighting the rapid growth in staking since the Shapella hard fork. Currently, however, this accelerated adoption appears to have slowed. This slowdown can also be attributed to the drop in Ether staking APR since the merger from over 5.5% to 3.5% in October due to a large number of validators entering the network and lower transaction fees. By comparison, the U.S. 10-year Treasury yield currently stands at 4.67%, incurring significant opportunity costs in timing the search for safer and higher yields. However, changes in these conditions could cause this outlook to change, making on-chain gains attractive again.

Learn more about Lido dominance

Lido plays an important role in the PoS economy, making staking more democratic. At its core, the protocol brings together capital providers (i.e. ETH stakers/delegators) and infrastructure providers (i.e. node operators), allowing users to deposit any amount of ETH rather than just being a validator. 32 ETH required. When users deposit ETH into Lido’s smart contracts, the funds are pooled and outsourced to a select group of node operators who run the required software and hardware. As a result, the delegator receives stETH - a fungible claim on the ETH deposit minted at a 1:1 ratio.

Of the total 27.6 million ETH, 8.9 million ETH are staked through Lido, with a total value of $16.8 billion, making it the largest liquidity staking and decentralized finance (DeFi) protocol. In percentage terms, this equates to about 32% of all ETH staking, a metric that has been of concern as Lido’s market share accounts for roughly a third of all ETH staking, raising concerns about centralization.

These concerns stem from the idea that if a liquidity staking protocol or the node operators underlying it exceed a threshold of total ETH staking, it could increase the likelihood of adverse outcomes for the Ethereum network, including increased centralization , coordinated maximum extractable value (MEV) withdrawals, unfair reductions (penalties), and other forms of manipulation, such as time-stealing attacks for personal gain. However, it is worth noting that Lido does not operate as a single entity, but rather consists of 38 node operators, subject to a staking cap, with servers geographically distributed to maintain judicial decentralization of the validator set.

Arguably, the governance process overseen by the Lido DAO (Decentralized Autonomous Organization) poses greater (potential) risks to the protocol than its staked share of ETH.

The debate over Lido’s dominance has intensified recently, with supporters arguing that Lido increases the accessibility of staking and attributing its success to stETH’s free market dynamics and strong network effects. Instead, critics, concerned about the potential for centralization due to its growing influence, have urged Lido to limit its growth and explore alternatives such as embedding staking more directly into the Ethereum network itself. While the reality of this situation is more complex, it’s clear that finding a balance between accessibility and decentralization is critical to maintaining Ethereum’s core principles and long-term health.

stETH’s network effects

Lido’s first-mover advantage and the introduction of native revenue through stETH have allowed the protocol to accumulate a large number of network effects. These characteristics lead to a winner-take-all dynamic, creating an oligopolistic market structure around liquid staking. stETH is one of the most important parts of the Lido ecosystem, allowing users/stakers to “delegate” their ether to secure the network (participate in consensus) in exchange for tokenized representations, derivatives of their underlying stake. Not only does this token provide a native form of income, it also has additional utility as it can be traded, exchanged, loaned, or used to provide liquidity while earning staking returns, a key value proposition for liquidity staking. .

stETH as collateral

stETH and its wrapped version (wstETH) have become the largest form of collateral for lending supported by several decentralized finance (DeFi) platforms including Aave, Maker, and Compound. As shown above, the total share of deposits on Aave v2 consists of 33% of stETH, growing rapidly since its introduction. Meanwhile, the share of encapsulated ETH (WETH) has dropped from a high of 39% to currently 21%. The growth of stETH is driven by its yield and capital efficiency, which provides an opportunity cost compared to holding or using pure ETH.

These characteristics have also led to the emergence of a range of emerging products that utilize stETH as over-collateral or primary collateral for synthetic stablecoins. These products are complementary to other products such as sDai, sFrax and USDM, which bring yields from public securities such as US Treasuries onto the chain.

The situation of stETH on the exchange

stETH also has a presence on decentralized and centralized exchanges, allowing users to gain exposure to the token and its staking rewards. Additionally, having significant liquidity in automated market makers (AMMs) such as Curve Finance and Uniswap helps facilitate liquid trading of assets. As the chart above shows, stETH has historically benefited from its significant presence on Curve, with monthly trading volume reaching approximately $35 billion in May 2022. Recently, however, this trend seems to have diminished as Uniswap has started to gain more liquidity and trading volume. In contrast, liquidity on centralized exchanges is generally lower, although exchanges like OKX and Huobi appear to be picking up.

stETH token – rebase mechanism

The stETH token uses a “Rebase” mechanism. This has important implications for users of Lido and applications that feature stETH tokens. Fundamentally, rebase tokens like stETH are designed so that when the supply of the token or a users staked ETH balance increases proportionally to the underlying asset, the supply of the token increases accordingly. In this case, when users provide ETH (the base asset) to Lido, stETH (the derivative asset) will increase along with the staking rewards. Therefore, users can see changes in their staked balance without making any side transactions.

Rebase function:

balanceOf(account) = shares[account] * totalPooledEther / totalShares

As shown above, stETH’s Rebase function can be visualized at the following high level. For example, we can consider 3 hypothetical accounts with initial staking amounts of 50, 30, and 20 ETH. The oracle reports daily statistics from the Beacon Chain on the total amount of ether pooled between validators. Increases or decreases in this pooled total (in the case of validators being slashed) and the rewards earned will be reflected in the users account balance at the end of the daily rebase, just like a balance increase in a traditional savings account.

While this results in a user-friendly experience, it means that applications that cannot support Rebase tokens will need to bring in non-Rebase versions for compatibility. This has led to the introduction of the Wrapped Staked ETH Token (wstETH), which is available on multiple protocols including Maker, Aave v3, Compound v3 and Uniswap V3.

Lido DAO Governance and LDO Tokens

As mentioned earlier, governance is an important part of the Lido protocol. The Lido DAO, governed by LDO token holders, has “root” access to certain key aspects of the protocol. This includes the ability to conduct smart contract upgrades, manage the node and oracle operator registries, their associated withdrawal keys, and oversee the Lido treasury. These privileges, along with the high concentration of LDO token holders, raise concerns about Lido’s governance layer as a potential attack vector. Therefore, a proposal was made for dual governance, allowing stETH holders to veto the decisions of LDO holders, aiming to create a balance in the current power dynamics.

The chart above shows the Herfindahl Hirschman Index (HHI) for LDO token holders. HHI measures the concentration of market participants in an industry, in this case the concentration of accounts holding LDO tokens. An HHI around 0 indicates a uniform distribution, while an HHI value close to 1 shows an extremely concentrated allocation, with a small number of holders controlling a disproportionate amount of the supply. It is clear that concentration changes significantly with day-to-day fluctuations in the holder base. The spike in HHI above 1 is likely due to a temporary increase in concentration due to the initial token distribution in December 2020 and the sharp drop in LDO price. However, there appears to be a downward trend in LDO token holder concentration over the longer term, as shown in the chart, falling from 0.6 at the beginning of 2021 to 0.3 in October 2023.

in conclusion

Lido is a key component of Ethereum and therefore closely tied to the health of the Ethereum network. Therefore, there is a strong incentive to protect the Lido. The current discussion about Lido and its prominence represents a welcome path forward for Ethereum as a PoS blockchain. While the path forward may be nuanced and not entirely clear, it shows that stakeholders on both sides of the debate have Ethereum’s best interests in mind – in line with its principles of accessibility and decentralization.