Deep Dive: Ethereum Staking – From Liquid Staking Derivatives to Liquid Restaking Tokens

Since the second-largest blockchain network introduced the PoS Beacon Chain in December 2020, staking has become an important source of revenue for crypto investors. However, this investment option is just as risky as any other crypto investment, meaning it needs to be approached with caution and understanding. 

Therefore, in this deep dive guide, you will discover the state of Ethereum staking since the Merge, the different products that have emerged, and the benefits and risks they pose. 

Ethereum since the Merge 

On September 13, 2023, Ethereum marked one year since transitioning from Proof-of-Work (PoW) to Proof-of-Stake (PoS) through an event known as the Merge. Thanks to the shift, Ethereum now relies on validators rather than miners to safeguard the network and confirm transactions. 

Since the Merge, the validator landscape has changed dramatically as more people have taken up ETH staking. There are now over 800,000 validators, and this number is expected to hit 1 million by the end of 2023. 

To be exact, the number of ETH validators currently stands at 869,310 and 37% of them use liquid staking platforms. That means liquid staking dominates the market, and Lido is the platform with the largest market share. According to data on Dune Analytics, Lido’s market share is 31.72%. 

Today, validators are staking ETH on centralized exchanges (Kraken, Coinbase, etc.), liquid staking platforms (Lido, Rocketpool etc.), staking pools (Stakefish, Everstake, etc.), and individually (Solo staking through Dappnode for example). Here’s a breakdown of these categories. 

Source: Dune Analytics

Liquid staking is popular because it lowers the entry point (you can stake with less than 32 ETH) while giving participants liquidity access as they stake their ETH. How this works is investors stake their ETH and, in return, receive a liquid staking token (LST), which they can trade or lend to produce additional yields. 

Ethereum is the greatest benefactor as more and more stakers join the network. However, individual validator yields are negatively affected as rewards are now shared among more people. That means staking profitability has dropped as the number of validators has increased post-Merge and post-Shapella (an upgrade that enabled the withdrawal of staking rewards and unstaking of ETH). At the same time, staking profits in US dollar are also dependent on Ether’s US dollar price, which as we know is still notoriously volatile. To put this development into perspective, 77% of stakers are underwater, while 23% are in the money. 

Source: Dune Analytics 

Another factor that has changed since the Merge is Ethereum’s supply. For the most part, Ethereum has been deflationary, meaning its supply has declined. Nevertheless, the network has been trending towards inflationary status in the past few months on account of decreasing user activity. 

Below is a graph showing Ethereum’s supply trend since the Merge. 

Source: Ultra Sound Money 

Liquid Staking Derivatives Landscape

Liquid staking derivatives (LSDs) or liquid staking tokens are issued once an investor locks their ETH on a liquid staking platform. These tokens represent the underlying staked ETH and the rewards it attracts. In other words, derivative tokens accrue value based on staking rewards. 

LSDs are essential since they help stakers access liquidity. That means they can participate in DeFi applications through trading, lending, borrowing, or any other preferred activity where they can generate more yields for themselves. 

Most stakers are staking their ETH on Lido, making it the largest staking platform in the market today. Users deposit Ether in smart contracts, which is then pooled between node operators and distributed to a set of validators. 

In return, Lido users receive stETH (staked ETH), a derivative token that is minted on a ratio of 1:1 to the amount of Ether staked. It allows investors to participate in yield-generating opportunities across dApps. The value of stETH tokens is adjusted daily through a mechanism known as rebasing to account for newly earned staking rewards. 

While Lido is a favorite among stakers, its popularity has sparked criticism from people who believe a single entity shouldn’t control such a large number of staked ETH and validators. According to critics, Lido’s popularity makes Ethereum vulnerable to centralization and time bandit attacks. 

A centralization attack occurs when a few nodes control the majority of staked ETH, opening the network to censorship and cartelization. On the other hand, a time bandit attack is a maximal extractable value (MEV) strategy where validators propose a competing block at the expense of users when the reward is great enough. 

As a matter of fact, a centralization attack could already occur if Lido holds more than one-third (33.3%) of the Ethereum staking market share. Currently, Lido’s market share is slightly below one-third (31.7%). 

Although some may view the platform as a single entity controlling more than 30% of staked ETH, Lido is composed of more than ten independent node operators. Lido’s governance caps each node’s stake at a specific maximum. 

The graph below indicates the staking share of each Lido node operator. 

Source: CoinMetrics 

Interestingly, five liquid staking platforms entered into an agreement in September 2023, pledging not to own more than 22% of the Ethereum staking market share. These platforms include Rocket Pool, Diva, StakeWise, Superphiz, Diva Staking, and Stader Labs. Lido was not one of them. 

Going forward, we could see new platforms competing for Lido’s market share. One new market entrant that’s already making some buzz is Diva Staking. The platform supports permissionless nodes, unlike Lido, which is restricted. Additionally, the platform leverages distributed validator technology (DVT), enabling squad staking where small groups of people can stake collaboratively. 

Users can become validators on Diva with just 1 ETH. 

LSDFi – Another layer of financialization 

Liquid staking has grown significantly in 2023, leading to the rise of LSDs. Consequently, a new branch of DeFi known as LSDFi or LSTFi has emerged. LSDFi refers to DeFi protocols that use derivative tokens as the main source of collateral, thereby providing investors with opportunities to earn extra yields with their liquid staking tokens. 

In LSDFi, LSTs are used as collateral, allowing users to mint stablecoins, which they can then use to receive yields. Examples of LST-backed stablecoins include Lybra, Prisma, Ethena, Raft, Gyroscope, Gravita, ZeroLiquid, and PSY. While most LST-backed stablecoins are fully backed by liquid staking tokens, some are partially backed by other stablecoins like Dai and crvUSD. 

Besides LST-backed stablecoins, other LSDFi products include interest rate swaps like Pendle and Flashstake and index products like Asymmetry and Origin Ether. 

According to CoinGecko’s 2023 Ethereum liquid staking report, the total value locked (TVL) on LSDFi has expanded by 5,870% since the beginning of the year to $919 million at the end of August 2023. 

Here are the top LSDFi protocols by TVL: 

Source: CoinGecko 

New narrative: Liquid Restaking Tokens 

As Ethereum staking grows, projects are keen to find new ways to help stakers generate as much earnings as possible. This has led to the emergence of liquid restaking tokens (LRTs), a crypto asset class that enables stakers to earn a higher yield on their Ether. 

Restaking refers to the process of using the same stake used to secure Ethereum to secure other networks. This concept is being pioneered by the EigenLayer protocol, where stakers can repurpose their liquid staking tokens by depositing them in an EigenLayer smart contract. In exchange, stakers receive a liquid restaking token. 

EigenLayer, which is built on Ethereum, connects restakers with protocols where they can provide a service (e.g., security) and earn money. Failure to reliably provide this service leads to a slashing event where a restaker loses a portion of their staked ETH.  

Other than restaking LSTs, EigenLayer also offers native restaking. This option enables stakers to natively restake their ETH by pointing their withdrawal details to EigenLayer smart contracts. 

Restaking with EigenLayer adds an extra step to the withdrawal process of staking. So, instead of funds going directly to your wallet, they are channeled to an EigenLayer smart contract that has the authority to slash your stake or transmit your rewards. Once this step is set up, restakers can seamlessly begin withdrawing their funds. 

Although restaking can boost staking yields, it exposes investors to slashing and smart contract risks. Moreover, the Ethereum developer community has criticizedrestaking as a process that could weaken Ethereum’s security when other protocols slash staked ETH. 

Projects building LRTs on the EigenLayer protocol include Stader Labs, Astrid Finance, Restake Finance, and InceptionLRT. 

Conclusion: Complexity and thus risk will grow, but so will resilience 

Ethereum staking will continue to grow as custody and staking converge and as innovation around the financialization of staking continues to expand. That means LSDs, LRTs, and LSDFi will advance considerably in the coming years as projects seek to create more earning opportunities for stakers. Consequently, this will lead to many complexities that will, in turn, introduce additional risks. Inevitably, failures will be experienced, and money will be lost.  

The hope is that since staking and all related products are based on blockchain technology, the blockchain’s fundamental aspects of permissionlessness and transparency will lead the staking industry to grow more resilient, focusing on what works and abandoning what doesn’t.