Why did the ETH staking protocol Lido receive investment from a16z?

Author: Kyle, Hive Tech

Ethereum is undergoing a transition from PoW (Proof of Work) to PoS (Proof of Stake). With the arrival of Ethereum 2.0, stakers will replace current miners and act as validators in the network. For more than a year, users have been able to stake ETH on the Ethereum Beacon Chain to earn rewards. Due to the 32 ETH capital threshold for self-staking and the long-term inability to withdraw ETH, many staking solution providers have emerged.

On March 4, venture capital giant Andreessen Horowitz (a16z) invested $70 million in Ethereum staking solution provider Lido Finance. This is the second round of funding for the solution within a year, following a $73 million raise in May of last year.

From the official website, Lido's functionality is quite simple. After connecting their wallets, users can stake any amount of ETH and subsequently receive daily rewards. In fact, large centralized exchanges like Binance and many DeFi protocols also offer similar services. What makes Lido continuously favored by capital?

According to a16z, "trustlessness" is an important advantage of Lido. This DeFi protocol utilizes the functions of DAO and smart contracts, managing user funds through a DAO while selecting validator nodes via community voting. On the other hand, Lido employs multi-party audited smart contracts to mitigate centralized security risks.

Additionally, after staking ETH on Lido, users receive a staking certificate, stETH, which can be exchanged for ETH and also staked in other DeFi protocols to increase yields. Compared to centralized staking service providers, Lido has advantages in terms of transparency and yield.

As PoS mechanisms gradually become mainstream in the crypto world, decentralized staking protocols are expected to see increased usage. Of course, for these protocols, ensuring the security of the code and user assets will always be a top priority.

Lido Finance Secures $70 Million Investment from a16z

Ethereum is undergoing a 2.0 upgrade, expected to transition from PoW to PoS consensus mechanism this summer. Its biggest feature is the elimination of the "power is king" Proof of Work mechanism, allowing users to temporarily deposit or stake a certain amount of ETH to become validator nodes, verifying transactions on the network and earning rewards.

On November 3, 2020, the Ethereum Foundation announced the staking contract address for the Ethereum PoS layer, the "Beacon Chain," allowing users to deposit at least 32 ETH for staking and earn ETH inflation rewards. However, since the contract does not allow withdrawals, all staked ETH must wait a long time before it can be withdrawn.

In the PoS mechanism, the more ETH staked and the more stakers there are, the more validator nodes exist, making the network's security more reliable. It can be said that staking is a key guarantee for the operation of Ethereum 2.0.

According to data from OKLink, as of March 6, over 9.83 million ETH have been locked in the staking contract on the Ethereum Beacon Chain. However, not everyone has only staked 32 ETH. With the emergence of many centralized and decentralized staking solutions, the capital threshold for stakers has been lowered, with Lido Finance being one of the representatives of decentralized staking solutions.

On March 4, Lido Finance announced it had secured $70 million in funding from venture capital giant Andreessen Horowitz (a16z), marking another round of financing since May 2021. On May 6 of last year, Lido Finance completed a $73 million funding round led by Paradigm, with participation from Coinbase Ventures, Three Arrows Capital, and others.

In less than a year, Lido Finance has completed over $140 million in financing, a figure that stands out in the entire crypto space.

According to Lido's official Twitter, a16z aligns with Lido's community commitment to decentralization and making Ethereum staking as simple and secure as possible. "Moreover, they fully support our roadmap to achieve a completely trustless staking solution." Additionally, a16z has also staked some of its ETH on Lido, "because they recognize that Lido eliminates many operational complexities for institutional investors."

In fact, in the increasingly complex DeFi world, Lido's functionality and operational logic are quite straightforward. Clicking on the staking button on its official website reveals the ETH staking interface, where users can quickly stake ETH by simply connecting their wallets.

Lido Finance ETH Staking Interface

As shown in the image above, the page lists the current annualized yield for staked ETH (4.4%) and the transaction fees incurred (approximately $9.02). After staking, users can receive daily staking rewards. Like most staking solutions, there is no requirement for users to "stake at least 32 ETH" on Lido Finance. After staking, users receive a staking certificate, stETH, on a 1:1 basis with the amount of ETH staked, which is the main vehicle for Lido to solve staking liquidity.

From a functional service perspective, Lido Finance's staking solution is not significantly different from those offered by centralized exchanges like Binance. So why has this seemingly simple DeFi protocol been able to continuously attract large investments from top venture capital firms?

Trustlessness + Yield Expansion as Advantages for Lido

Although the functional services are similar, centralized staking services have varying degrees of limitations compared to decentralized staking services in terms of transparency, yield, and other aspects.

It is well known that any large exchange can easily establish an ETH staking pool. Companies like Binance, Kraken, and Coinbase can easily pool user assets to eliminate the minimum staking requirement of 32 ETH and stake on behalf of users to relieve them of the burden of operating validator nodes. Additionally, these exchanges often provide liquidity services for staked assets, allowing users to withdraw their staked ETH early.

From the process of staking ETH and earning rewards, users do not need to and do not have the authority to participate in the intermediate steps. While this makes staking simple, it also creates a transparency issue; in other words, you do not know whether your ETH has actually been staked and where it has been staked.

In fact, staking ETH on the Ethereum Beacon Chain to earn rewards requires not only a capital threshold but also expertise and complex, expensive infrastructure. This is because acting as a validator node requires professional equipment and ensuring online presence. If a validator node mismanages staking, it may trigger Ethereum 2.0's slashing penalty mechanism, resulting in a loss of the staked principal.

Generally, large exchanges will entrust the ETH staked by users to partnered validator nodes, but exchanges often do not disclose this specific information. Users do not know who their ETH is entrusted to or the qualifications and capabilities of the entrusted validator nodes. These uncertainties bring risks to some extent.

Moreover, centralized staking service providers theoretically have the potential to misappropriate user assets, which is an unavoidable risk compared to decentralized solutions.

In terms of transparency, Lido attempts to leverage DAO and smart contracts to democratize decision-making and use smart contracts to mitigate centralized risks.

In selecting entrusted validator nodes, Lido requires that nodes must be professional staking companies, such as p2p.org, Chorus One, or stakefish. Most importantly, which nodes can be "selected" must be approved by the Lido DAO, and each validator node has a maximum stake they can hold, which is also determined by governance voting. This means that Lido's community users can independently choose validator nodes, and Lido supports users in selecting multiple validators to minimize risks.

In terms of security, Lido has open-sourced all its code and conducts continuous audits. Its smart contracts have been reviewed by security agencies such as Quantstamp and MixBytes. Additionally, it uses non-custodial staking services to eliminate counterparty risks, meaning that users' ETH is not fully entrusted to nodes but is authorized through smart contracts. Since user funds are controlled by the DAO, staking service providers can never directly access users' assets.

"Trustlessness" is clearly an important consideration for a16z's investment in Lido. This venture capital firm stated on its official website that Lido provides the simplest way to stake ETH and other PoS assets while striving for decentralization and democratization of staking through DAO governance. "The Lido community's firm commitment to decentralization has indeed impressed us."

From the perspective of yield, the existence of the on-chain certificate stETH also expands the boundaries of yield that users can capture. stETH can not only be exchanged for ETH on decentralized exchanges but can also be used as collateral to participate in certain DeFi protocols, meaning that users can continue to earn DeFi returns after staking ETH.

Moreover, Lido Finance has been attempting to expand its staking services to more chains. Currently, it has developed dedicated protocols on blockchains such as Terra, Solana, and Kusama, supporting users to stake native assets from different chains to earn rewards.

Lido Offers Staking Services on Multiple Chains

Compared to centralized staking service providers, Lido's advantages in transparency, security, and yield are undoubtedly factors that attract capital. In comparison to other decentralized staking solutions, Lido has also garnered more user votes. According to Staking Rewards, Lido Finance currently has a total staking value exceeding $518 million, significantly ahead of many DeFi protocols like Cream Finance.

As PoS public chains gradually become mainstream in the crypto world, the market's demand for staking solutions will also increase, which may be one of the reasons a16z invested in Lido at this time. For decentralized protocols like Lido and Cream, ensuring code security and user assets will be an ongoing challenge as more funds flow in.