The Evolution of LSDfi: Unveiling a New Chapter in DeFi

Written by: ValHolla

Compiled by: Block unicorn

Everyone knows that the Ethereum merge will have a positive impact on DeFi, but in less than a year, it has surpassed even the most optimistic bullish expectations. The most evident place we can see this is in LSDfi— the DeFi world based on liquid staking derivatives is continuously evolving. This narrative has existed for some time now, so it is worth exploring where it came from and, more importantly, where it is headed.

In this article, I will divide the evolution of LSDfi into three stages and then take a look at some projects at the forefront of potential LSD applications. One thing is for sure, there is a lot on our horizon, and what we see is just the beginning.

Stage One: Liquid Staking Protocols

Entering 2023, one of the hot areas in cryptocurrency is LSD providers like Lido and Rocket Pool. As you may know, these protocols allow users to stake their ETH on smart contracts and then stake ETH to help secure the network. In return, users receive liquidity tokens like stETH or rETH—representing the liquidity of the ETH they have staked. The result is a liquidity token that can be traded and lent, while still accruing staking rewards from ETH itself.

Earlier this year, many believed these protocols would benefit from increased staking demand, especially after the Ethereum network opened staking withdrawals. I think it is safe to say that this trend has developed in an extremely bullish manner. Just look at the increase in the number of validators:

Similarly, the amount of staked ETH is also rapidly increasing:

By maintaining the liquidity of staking tokens, LSD providers have played an important role in encouraging users to feel comfortable staking their Ethereum. That said, the protocols that issued this first wave of LSDs are not the only ones benefiting from it. If you think these staking protocols are the primary beneficiaries of LSDfi, we can delve deeper into the truth.

Once LSDs are released, it logically becomes necessary to find a way to maintain their peg to their underlying assets. What we least want is a repeat of last summer's situation when the largest ETH LSD, stETH, decoupled due to forced selling by entities like 3AC. Therefore, protocols like Curve and Balancer saw significant inflows into ETH LSD-related pools, amplifying their TVL.

Currently, Curve's stETH/ETH pool is the most prominent LSD pool in DeFi, with a TVL of about $740 million. They also have over $164 million in the frxETH/ETH pool, which is their fifth largest pool on the mainnet.

Balancer—three of their top four pools on the mainnet are related to LSDs, with a TVL exceeding $136 million, accounting for over 13% of their total TVL.

Looking around, we can see that LSDs have actually become the largest source of total TVL in DeFi:

When you put this in context, it is even more impressive: currently, about 10 million ETH is deposited in liquid staking protocols. This number has grown more than fivefold since the beginning of 2022!

During the same period, almost everything else in DeFi and the broader cryptocurrency universe has collapsed, so if LSDfi has experienced this growth, it clearly must offer some real innovation. With this in mind, let's move on to the second stage.

Stage Two: LSD as Collateral

The second stage of LSDfi consists of a series of projects with similar underlying concepts: users lock LSDs in CDPs (Collateralized Debt Positions, where collateral is liquidated if the price drops) and then mint and borrow stablecoins.

You may be tired of seeing new LSD-backed stablecoin products, but don't let the sheer number of protocols using this model diminish its importance. Personally, I believe that so many protocols are doing this because it is a product that can have a tremendous impact.

It not only further expands the utility of LSDs but also contributes a much-needed level of decentralization to the existing stablecoin market. Additionally, LSDs earn yields from their underlying assets by performing certain tasks (such as securing PoS blockchains). The staking APR is often higher than the rates most money markets pay for deposits (unless there are high incentives), so you already have an advantage there. Essentially, using yield-generating tokens as collateral turns each CDP position into a self-repaying loan.

So far, Lybra, Curve, and Raft are the biggest beneficiaries of the second stage.

Lybra

Lybra has been making waves in the crypto community for a few months now, and for good reason. Its eUSD stablecoin, backed by ETH and stETH, has reached a market cap of $177 million. Among decentralized stablecoins, only DAI, FRAX, and LUSD have higher market caps.

Moreover, in less than three months, according to defillama data, Lybra has accumulated a TVL of $345 million, making it the third largest CDP protocol on Ethereum, only behind MakerDAO and Liquity—this is an impressive LSD protocol!

Curve

Curve's CRVUSD stablecoin is backed by wstETH, WBTC, sfrxETH, and ETH.

Overall, these assets have over $120 million deposited as collateral, with over 80% coming from the two LSDs on the list (wstETH and sfrxETH).

As a result, nearly $80 million of crvUSD is now in circulation, having grown more than sevenfold since June 7.

Raft

Compared to the previous two protocols, Raft and its stablecoin R have not been widely discussed or focused on, but so far, they have still made impressive progress. Within weeks, Raft's TVL increased from $1 million to $55-60 million, with current data showing $57.7 million.

So far, over 99% of the R stablecoin's backing comes from stETH collateral. However, they also accept rETH from Rocket Pool as collateral, and more forms of collateral may be accepted in the future.

Currently, Lido's stETH accounts for the vast majority of collateral in these second-stage protocols. I believe there are two ways this situation could change: one way is that smaller LSDs will capture more of the collateral market share.

This will manifest in the form of CDP protocols offering different collateral options, as well as DeFi users being more willing to purchase smaller LSDs and use them as collateral. We have recently seen some projects gaining attention in this space (besides crvUSD), such as Gravita, which accepts both stETH and rETH. So far, Gravita is an exception, as a significant portion of their stablecoin (GRAI) has been minted using rETH compared to stETH.

The other way is the most common path for LSD providers. So far, Lido's stETH has captured nearly 75% of the market.

I believe that as LSDfi evolves, more LSD options will gain market share. In fact, by the end of 2024, I would not be surprised to see stETH's market share drop below 50%. After all, so far, only 17% of the ETH supply has been staked, and less than half of that is through LSD providers. So, this game is far from over.

Stage Three: Diversification of Collateral

So, if stage one is LSD and stage two is LSD-based lending, what does stage three entail?

Given that the underlying trend of this entire process has been the LSD of the second largest asset in cryptocurrency, ETH, the natural direction of development will be to further expand through other composable assets. This can be achieved by using LP tokens, stablecoins, money market deposits (like Aave's aUSDC), etc. Just think: if you could do everything that stage two protocols like Lybra do with ETH, using other types of cryptocurrency tokens you hold, or your investment positions in other projects (i.e., your stake or equity in other projects), how would that work?

A great example of an emerging DeFi project seeking to implement this strategy is Seneca. While their product has not been publicly released yet, they are building a protocol that will be able to unlock credit for various DeFi users.

While you can achieve quite decent yields through LP tokens, LSDs, deposit receipts, etc., there are always ways to seek higher and higher capital efficiency. Seneca will enable these tokens to serve as collateral for their native stablecoin: senUSD loans. This way, liquidity is released while collateral holders can still earn yields on their assets.

Another project pioneering this path is EraLend, a forerunner in the zkSync money market.

EraLend has several features that make it stand out. First, they are already executing stage three by accepting SyncSwap's USDC/WETH LP tokens as collateral. This could be the first of many alternative assets used as collateral on EraLend—the expansion catalyst is their upcoming P2P lending product. Not much is known about this product yet, but I believe anyone could potentially use any type of token (LP tokens, LSDs, debt receipts, NFTs, etc.) as collateral.

EraLend has gained traction in recent weeks, as their TVL has surged from $3.9 million to $24.35 million since June 1 (latest data from their official site, defillama data is delayed):

With the zkSync narrative heating up, this is definitely a project to watch—indeed, it has already ranked third in TVL on zkSync.

Finally, another interesting feature of EraLend is that any token can be used to pay GAS, indicating that this young protocol may achieve account abstraction in the future.

Even if you are confident that Tether and Circle have the assets they claim to have, the ideal scenario is to see a native DeFi stablecoin with traceable on-chain collateral (with minimal exposure to traditional stablecoins) eventually replace them as the leader. At this point, the most obvious approach would be to create a model like Seneca.

Looking ahead, a partially reserved system in DeFi is necessary as it allows for doing more with fewer resources. In fact, I would argue that DeFi can easily optimize for such a system. First, code is law in DeFi, meaning parameters like collateral limits are fixed and cannot be adjusted in special circumstances. Additionally, unlike traditional finance, DeFi is inherently composable, making it easier to integrate new forms of assets and provide use cases for those assets. DeFi is also inherently transparent, making use cases like LSD- and LP-backed stablecoins more attractive compared to traditional stablecoins like USDT and USDC.