A Dive into ETH Liquid Staking, Node Operators, Shanghai, Future Innovations, and DVT

Background 

Ethereum successfully transitioned from Proof-of-Work (PoW) to Proof-of-Stake (PoS) in Sep 2022 

This introduced a new consensus mechanism to the blockchain, where ETH holders can choose to stake (”lock”) their tokens in order to process transactions, create new blocks, and provide security for the network 

In exchange for staking their tokens as collateral, stakers are compensated with block rewards from the network and fees paid by users of the chain 

There are three ways to earn these rewards & fees: 

Run your own validator node — but this is less common due to the technical complexity involved and relatively high minimum capital requirement (32 ETH to run a node) 

Engage in centralised staking pools / staking-as-a-service providers — but this comes with centralisation risks and lack of self-custody of your assets 

Engage in liquid staking protocols — this allows users to stake their tokens with professional validators in exchange for a % fee cut from a portion of the yield earned 

Early days: Centralised / Third-party staking 

The staking of network tokens in PoS blockchains is not a new concept to most people in crypto. The first iteration of regular staking came from notable players like Binance and Coinbase, where they offer centralised ETH staking pools for their customers. Users can stake with as little as 0.01 ETH, lowering the monetary barrier to entry. 

Centralised platforms would aggregate ETH deposits from various users and allocate the tokens to third-party node operators and validators. The staking rewards earned are then shared on a pro-rata basis with depositors, after a certain fee cut from the service provider. 

There are also non-liquid staking-as-service providers like DSRV, Blockdaemon and Figment who tend to service instituational clients with idle assets that do not have the capacity to run their own node operations. 

However, when participating in a centralised staking pool or outsouring to third-party providers, the staked assets cannot be easily moved. 

ETH deposited directly to the staking contract remains locked up until the “Shanghai Upgrade”, which will then allow ETH withdrawals and accrued rewards from the deposit contract. The launch is targeted for April 2023. 

Capital inefficiency is a key concern with staking pools, as assets are locked up in smart contracts and cannot be used for other purposes such as collateral for loans or urgent liquidity when needed. 

Emergence of Liquid Staking 

Liquid staking: A mechanism designed to give stakers a transferrable, yield-bearing representation of their deposited asset. 

The beauty of liquid staking is that it gives users additional composability with their staked tokens (e.g. collateral for loans on a money market or earning yield on fees on liquidity pools) and the option to immediately monetise them in available trading markets if need be. 

The concept of liquid staking derivatives has been around since Dec 2020, when Lido launched its liquid staking feature for the Ethereum blockchain. Since then, multiple other protocols were built to capitalise on this vertical. 

To date, a total of 18,208,633Ξ has been staked on Ethereum’s Beacon Chain Deposit contract. This only makes up ~15% of ETH’s total supply. 

Of that ~18.2M ETH staked, liquid staking protocols capture ~33%. 

This is significant growth and proven traction of liquid staking derivatives, as back in Dec 2020, when Lido first launched, their market share was only 3.4% (75k out of 2.2M ETH staked). 

Current Liquid Staking Derivatives (LSD) landscape 

Most liquid staking protocols have a unique staking derivative to represent the underlying ETH asset, but more importantly a different native token that accrues value and/or controls governance for the protocol. They also have different fee and commission structures which will be discussed below. 

Lido holds a sizeable market share as the dominant decentralised liquid staking protocol, controlling >31% of total staked ETH, while the leading centralised player is Coinbase, controlling >12%. 

Coinbase stakers are subject to centralisation risks and custody on exchanges, but remain popular due to its reputable branding. The next largest LSD player is Rocket Pool, while other protocols like Frax and StakeWise are gradually gaining traction. 

Rebasing 

Rebasing tokens have an elastic total supply that increases or decreases on its own, automatically without any transactions taking place 

In the case of Lido, stETH balances change daily to reflect ETH staking rewards and any changes in Beacon Chain contract deposits 

Reward-bearing 

Reward-bearing tokens increase their underlying value over time as rewards accrue (redemption value in the future is more than its value today) 

For example, Rocket Pool’s rETH represents the tokenised staking deposit and rewards it gains over time, i.e. 1 rETH in the future is worth more than 1 rETH today because of all staking rewards accrued 

Base + Reward-bearing 

This is a model where the protocol has two kinds of staking derivatives — the Base token which represents the underlying ETH on a 1:1 basis and the Reward-bearing token that accrues yield over time 

Frax employs this unique model with frxETH (Base) and sfrxETH (Reward-bearing) 

frxETH does not earn staking yields, whereas sfrxETH earns all yields from staking 

Splitting the base and yield token provides interesting opportunities: 

Because the base frxETH token is designed to maintain parity with ETH, they have a frxETH-ETH liquidity pool on Curve 

If users choose to hold frxETH and provide liquidity to it, they can earn liquidity incentives from the DEX 

This is unique to Frax because they own a large amount of CVX which can be used to direct CRV emissions to their own pool 

For sfrxETH holders, they earn all the remaining yield from frxETH that is not staked, giving sfrxETH higher yields than other LSD token on the market 

Base + Reward 

This is a simple model where users make an ETH deposit, and the protocol issues a Base token that represent their deposited ETH at always a 1:1 ratio 

Any rewards earned are then rewarded in a separate Reward token, net off commissions 

This allows protocols like StakeWise to segment a user’s principal token and associated rewards, both of which are worth 1:1 with ETH staked and earned on the Beacon Chain respectively 

Because there is no rebasing or reward-bearing aspect involved, this mitigates any chance of impermanent loss when providing liquidity in DEXs.