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What Is Ethereum Liquid Staking?
First, we have to understand the “issue” with staking on Ethereum. After the Merge last September, staking on Ethereum now generates real yield as validators stake 32 ETH to secure the network and earn rewards in the process. However, this 32 ETH is locked up, at least for now. As a capital-efficient degen, that doesn’t sound good.
In ELI5 terms: it simply means you get a new token that's worth the same as the staked ETH and can use that to ape into a new yield farm or protocol. Liquid staking does away with the main downside of staking: now you can access your capital and utilize it more efficiently.
The most popular LSD in the market right now is Lido Staked ETH (stETH), with over $7.7B worth of ETH staked, and over 260K stakers.
Why Is Liquid Staking Important?
As a novice DeFi degen, you may wonder about the main benefit of liquid staking: it's called rehypothecation.
In ape terms, rehypothecation is using assets pledged as collateral in several places. For instance, if you use your home to secure a car loan and a loan for another house, that would be rehypothecating your house.
Liquid staking ETH allows staking ETH to secure Ethereum (loan #1). And then you use the same staked ETH as collateral called staked ETH to stake and secure, say, a DeFi loan (loan #2).
But, why would you stake ETH in the first place?
Well, because not doing it means you are losing out on staking yield. Like any proof-of-stake protocol, staking yields are an implicit tax on non-stakers. If you don't want to secure the protocol, fine, but then don't complain when others get paid yield for doing so!
The following chart compares the share of ETH's staking ratio to other blockchains:
Ethereum's staking ratio is lower because:
a) There is more economic utility to ETH.
b) You can't unstake it (yet).
But the latter is about to change.
Blockchain researcher Hasu and Paradigm CTO Georgios Konstantopoulos estimated that 15-30% of ETH may be staked without liquid staking. But with liquid staking, this number may surge to 80% or more!
An added benefit would be increased economic security of Ethereum: the more ETH is staked, the more staked ETH (the derivative) an attacker has to acquire. The more additional steps there are, the more difficult it becomes.
You can think of liquid staking protocols offering this service as banks for staked collateral. Some providers are centralized, while others are decentralized; we'll analyze them in detail below. Even Metamask has jumped on the liquid staking hype train and offers an integration with staking providers from its DApp.
And hype train is definitely not an exaggeration — just look at the token prices of some staking providers over the last month:
Liquid staking is becoming a dominant narrative now because of the upcoming Ethereum Shanghai Upgrade.
What Is the Ethereum Shanghai Upgrade?
The Shanghai Upgrade will allow users to unstake their ETH. Since Ethereum's switch to PoS, staked ETH was "stuck" unless you used a liquid staking provider. This upgrade will finally enable withdrawals from Ethereum and bring down the unstaking time to 27 hours. Here's a timeline for the Shanghai Upgrade:
Because some fear the Shanghai Upgrade could lead to selling pressure. However, a couple of arguments indicate the contrary:
We can't reliably predict what share of the ETH underwater or in the money will prefer to take profits or cut losses.
The upgrade will enable full withdrawals, but only six validators can exit per epoch (an epoch is 6.4 minutes for Ethereum). Consequently, only 1,350 validators can exit daily (43,200 ETH/day). That amounts to only 0.8% of daily ETH trading volume and should be easily absorbed by the market.
Partial withdrawal will be able to withdraw the excess 2 ETH in rewards each validator has staked on average. Multiplied by a bit more than 500K validators, that amounts to roughly 1M ETH hitting the market. That is still only 10% of the ETH's daily trading volume, even before we consider that these stakers are likely to restake much of their balance.
TLDR: sustained selling pressure on ETH might be unlikely.
What to Consider When Choosing a Liquid Staking Provider
So, what about those liquid staking protocols?
You could, of course, stake ETH yourself. The downside is that it will cost you 32 ETH (the minimum amount to run a node), and you won't be able to rehypothecate your staked ETH even after the Shanghai Upgrade.
Lucky for you, there are a plethora of centralized and decentralized staking providers!
Data from Dune indicates that 33% of all ETH is staked with decentralized providers, compared to 28% at CEXes. Lido has a controlling 87.5% market share among those decentralized providers. On the other hand, Coinbase, Kraken, and Binance hold significant shares of all staked ETH:
@bluecollarchain put together an excellent list of important factors to consider for liquid staking providers:
Tokenomics: is the yield from your liquid staking provider real yield (in ETH) or inflated with the provider's native token?
Protocol revenue model: does the staking service provide products other than just liquid staking (i.e., greater utility)?
Current and fully diluted market cap: how is the token doing now and how much more inflation is there to come?
Smart contract risk: are there contract audits, bug bounty programs and does the team have a history?
Depeg risk: how much runway (treasury) does the service have?
Frequency and type of taxable events: what type of reward does the service use and are you subject to capital gains or income tax?
Tokens that are useful beyond being purely liquid staking derivatives will probably do better in the long run:
The two-token system keeps the principal the same. You get one staked ETH for one ETH. Your staking rewards are paid out in a separate reward token. The reward token has the same price as ETH, so 1% yield would result in 0.01 reward tokens:
Frax (FXS) is tipped to be one of the hottest protocols to challenge the existing market leaders. Its share of the liquid staking market has been growing rapidly thanks to a cleverly designed incentive mechanism that guarantees a high APR paid out partially in its native token. Frax also earns fees from the Curve Protocol, benefiting FXS holders and stakers.
Risks: astronomical FDV compared to market cap, high outstanding token emissions.
Stader (SD) is about to launch its ETH staking product. It already has a DeFi product suite and multi-chain staking services but suffers from a massive outstanding token inflation. The ETH staking whitepaper can be found here:
Redacted (BTRFLY) is another wild card DeFi protocol about to launch liquid staking. It is tipped to become a strong contender to more established protocols on Ethereum. Staked ETH are to overcollateralize a new stablecoin, DINERO, which will be useable as collateral across the DeFi landscape. MrStiive covered the upcoming plans of Redacted in a comprehensive thread:
There are three essential strategies to compound your yield from ETH liquid staking.
The stablecoin strategy involves swapping the derivative token for stablecoins on a money market protocol and providing liquidity with these stablecoins. This strategy is safe as long as you monitor your collateralization level.
A riskier strategy involves providing the derivative token as liquidity on an applicable protocol. This strategy incurs higher yield but carries the currency risk of remaining in ETH.
The riskiest strategy is providing liquidity to an ETH/protocol token pool. For instance, for Lido this would mean providing liquidity to the wstETH/LDO pool. To do this, you have to acquire the native protocol token, which will always be more volatile than ETH.
@bluecollarblockchain covered different protocol-specific strategies in this thread:
The ETH liquid staking narrative is already going strong but that does not mean you are necessarily late. Ethereum upgrades and scaling will be one of the main narratives in 2023. Another intriguing project on the horizon is Eigenlayer, which allows users to validate and stake their liquid staked ETH in other protocols, thus earning them yield from two sources. We will cover Eigenlayer in a separate deep dive.
Staking tends to result in an oligopoly. But the good news is that decentralized pools are likely to win over centralized pools since they are more aligned with the Ethereum community and can compete with additional yield opportunities.
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