The Ethereum Shanghai upgrade will launch the withdrawal feature. How will validators' ETH be unlocked?

Author: Nancy, PANews

The withdrawal time for staked ETH on the Beacon Chain has finally been confirmed. On December 8, Ethereum core developers set the Ethereum Shanghai upgrade date for March 2023 during the All Core Developers meeting and confirmed the release of staked ETH withdrawals from the Beacon Chain. So, after the redemption path is opened, can validators exit immediately? Will the liquidity pressure of staked ETH be relieved?

Withdrawal initiation will limit validator unlocking efficiency and amounts

According to statistics from Dune Analytics, the amount of staked ETH on the Ethereum Beacon Chain has been on a continuous upward trend, surpassing 15.6 million ETH as of December 12, accounting for 12.9% of the current total circulating supply of Ethereum, with a total of 488,000 validators. Based on current market calculations, the total value of staked ETH on the Beacon Chain has exceeded $19.4 billion. Among this, liquid staking accounts for 33%, centralized exchanges for 29%, whales for 23%, and staking pools for 10.2%, indicating that most ETH staking is conducted through third-party platforms.

Meanwhile, according to the OKLink multi-chain explorer from OKEx, although the annualized staking yield for Ethereum has been on a downward trend since early November, currently (as of December 12) the annualized yield is 4.07%, but the Ethereum staking rate has reached 13.05%. This also means that Ethereum is entering a deflationary state, and its staking economic incentives remain attractive. Of course, looking at the long-term staking rates of other PoS main chains, which range from 40% to 70%, there is still significant room for growth in Ethereum's staking rate, and many may be waiting to participate after the staking withdrawal becomes effective.

Unlike ordinary users who can participate in staking through flexible third-party platforms, validators can only withdraw after the Shanghai upgrade initiates the staking withdrawal plan. According to community proposals, validators' withdrawals will temporarily consist of two types: partial withdrawals and full withdrawals, and for security reasons, the withdrawal amounts and the rate at which validators can exit will be limited.

For partial withdrawals, the maximum amount that can be extracted per Epoch is set at 256 transactions. Based on the current number of validators, they can extract rewards once every 8 days (total number of validators / (256 * 225)). Based on the current average balance of nearly 33.9 ETH per validator, the average selling pressure that the Ethereum market may face daily is 109,000 ETH, with a cumulative amount of 875,000 ETH over 8 days.

The exit rate for full withdrawals will also be limited, introducing a "Churn Limit Quotient" into the exit mechanism. The limit for ETH withdrawals is set at X/ETH per day, where X is the total number of validators / 65536. Currently, only 7 validators can be activated to exit per Epoch, which means 1,575 validators can exit daily (over 225 Epochs). If each validator holds 32 ETH, then over 50,000 ETH will flow out daily. Of course, the withdrawal rate will also be adjusted based on the total amount of staked ETH to prevent large outflows of funds and attacks by malicious actors.

It is important to note that a validator's effective staked balance must be above 32 ETH; if it falls below this amount, they will not be able to receive the full staking rewards, and if the balance drops below 16 ETH, they will be expelled from the validator ranks. Currently, the pending withdrawal options for validators are divided into partial and full withdrawals, where partial withdrawals allow validators to extract amounts exceeding 32 ETH, while full withdrawals extract all staked amounts before exiting the staking ranks.

However, recently developer Potuz proposed a new plan that claims to cancel the processing of the withdrawal queue, meaning to eliminate the logic of the full and partial withdrawal queues within blocks, suggesting the use of validator indexes to address this issue. The reason is that each validator on Ethereum is assigned a number when activated on the Beacon Chain, and without using the aforementioned queued exits, the Beacon Chain can scan validators based on the maximum number of withdrawals that can be processed per block, then process each validator's withdrawal request in ascending order of their index number. Currently, developers are researching this proposal.

Difficulty in overcoming liquidity shortages, potential regulatory risks

In Ethereum staking, besides Lido's stETH, there are several platforms that can issue liquid staking derivatives for stakers, such as Coinbase's cbETH, Kraken's ETH2.S, Binance's BETH, and other staking derivatives.

According to statistics from Dune Analytics, as of December 12, Lido holds a 29.3% share of all Ethereum staking, followed by Coinbase with 13.2%, and Kraken ranking third with 7.6%.

The discount ratio between Ethereum staking derivatives and ETH represents the holders' demand for liquidity and the demand for discounted purchases of staked ETH derivatives. However, currently, most derivatives are experiencing varying degrees of negative premiums due to insufficient liquidity. For example, the leading stETH/ETH is at 0.98, and cbETH/ETH is at 0.97.

Although these staking derivatives will no longer face liquidity discounts due to the lack of redemption paths once ETH withdrawals are opened, the current lack of liquidity is an undeniable fact, and the limitations on withdrawals will not significantly improve this predicament. The insufficient liquidity of staking derivatives has become a pressing issue that Ethereum needs to address. However, with the launch of the withdrawal function, investors' arbitrage demand may enhance liquidity. For instance, when stETH trades at 0.9 ETH, investors can buy 1 stETH with 0.9 ETH and then redeem it for 1 ETH, gaining a profit of 0.1 ETH in the process, which is a relatively lucrative method, especially for institutional or whale investors.

In fact, many traditional institutions have considered participating in the economic incentives of Ethereum staking. For example, Sandy Kaul, Senior Vice President of Franklin Templeton, the world's largest publicly traded fund management company with approximately $15 trillion in assets under management, stated that Ethereum staking provides a tremendous opportunity for institutions focusing on the crypto market and believes it will fully meet the needs of institutional investors. Swiss crypto bank SEBA Bank also announced in September this year that it would launch Ethereum staking services for its institutional clients, allowing users to receive ETH staking rewards monthly, with different lock-up periods available after merging.

Moreover, regulatory risks cannot be ignored. Gary Gensler, Chairman of the U.S. Securities and Exchange Commission (SEC), stated after Ethereum's merger that cryptocurrencies and intermediaries allowing holders to "stake" their tokens may need to undergo the Howey test to determine whether their assets are securities, which means PoS cryptocurrencies may be subject to federal securities regulations.

According to a recent blockchain report released by CV VC Labs, the U.S. holds 45.3% of Ethereum nodes, ranking first globally. Coinbase CEO Brian Armstrong has revealed that if regulations tighten, they would stop offering Ethereum staking services.

Once regulation arrives, will it lead to a collective exit of the main staking forces in the U.S.? Ethereum founder Vitalik Buterin once pointed out that if regulators conduct protocol-level scrutiny of Ethereum through validators from certain protocols (such as Lido, Coinbase, etc.), the question of "how the Ethereum community will respond" would be viewed as an attack on Ethereum, and they would choose to destroy these nodes through broader consensus.