Decentralization Myth: Analyzing Lido's Reality, Beliefs, and Pursuits in the Crypto Space (Part 1)

Author: Jake, Jay, Antalpha Ventures

Ethereum History: From Ethereum 1.0's PoW Upgrade to Ethereum 2.0's PoS

Since the release of the Ethereum white paper, Ethereum has accomplished a lot, such as developing a general-purpose smart contract platform and expanding its community and ecosystem. However, Ethereum's development cannot be achieved overnight, so a multi-step development roadmap was established. According to the Ethereum development roadmap, Ethereum has four strategic phases: Frontier, Homestead, Metropolis, and Serenity.

• Frontier: The initial state of Ethereum, which had poor usability but provided centralized protection measures, ensuring good network security. With mining rewards in place, Ethereum incentivized the miner community in its early days and improved its ability to resist hacking attacks.
• Homestead: The first hard fork plan for Ethereum, during which Ethereum removed the canary contract, somewhat enhancing the decentralization mechanism and introduced the Mist wallet, allowing users to trade and hold ETH. At this stage, Ethereum became a tool not just for technicians and developers but also for ordinary users to participate in the ecosystem's construction.
• Metropolis: Metropolis was upgraded through two hard forks, mainly divided into Byzantium and Constantinople. In the Byzantium plan, Ethereum adjusted the consensus for block difficulty assessment, increased mining difficulty, and reduced mining rewards. Additionally, to smoothly transition Ethereum from the "PoW" mechanism to the "PoS" mechanism, the difficulty bomb was delayed. In the Constantinople plan, Ethereum mainly reduced Gas fees, decreased block rewards, and allowed smart contracts to verify the hash values of other smart contracts, improving the efficiency of smart contract verification.
• Serenity: The Istanbul hard fork reduced various development costs such as pre-coding, code pricing, and Gas fees, increasing Ethereum's TPS to 3,000. The Berlin upgrade mainly optimized the performance of Ethereum's mainnet, enhancing contracts, covering Gas efficiency, updating the way the Ethereum Virtual Machine (EVM) reads code, and preventing denial-of-service (DDoS) attacks.

After the merger of the Ethereum beacon chain with the original Ethereum proof-of-work chain, the most important update was the transition from the "PoW" mechanism to the "PoS" mechanism.

• Proof of Stake: A method for validating and confirming cryptocurrency transactions, different from the proof of work used by Bitcoin and others. The PoS mechanism is based on the amount of cryptocurrency held (i.e., "stake") rather than relying on computational power.
• In a PoS system, the security and consensus of the network are guaranteed through the staking of holders. Holders stake a certain amount of tokens to become block validators and producers. By selecting effective validating nodes, they qualify for token rewards as incentives. If validators act maliciously, they will lose a portion or all of their staked tokens as punishment.

Ethereum's Staking Mechanism (Proof of Stake)

In the Ethereum network, staking involves depositing 32 ETH to activate validator software. Validators are responsible for storing data, processing transactions, and adding new blocks to the blockchain. This process secures Ethereum and allows validators to earn new ETH rewards. The beacon chain introduced proof of stake to the Ethereum ecosystem. The beacon chain merged with the original Ethereum proof-of-work chain in September 2022. The consensus logic and block broadcasting protocol introduced by the beacon chain currently protect Ethereum.

By staking Ethereum, stakers can protect the network's security from a validating perspective. The Ethereum network also rewards stakers with corresponding staking rewards. Ethereum's staking rewards follow a diminishing returns principle. When the amount of staked Ethereum is low, the staking returns are higher. As the amount of staked Ethereum gradually increases, the staking returns will gradually decrease. For example, when the total staked Ethereum reaches 12 million, the annual yield will drop to 4.5%. More broadly, staking is a crypto-economic model that incentivizes correct behavior among network participants through penalties and rewards to enhance underlying security.

Source: Public Market Information

In the Ethereum network, different types of entities can gain various benefits when staking Ethereum:

• For the Ethereum network, as more ETH is staked, the network becomes stronger. To attack the network, an attacker would need to control the majority of validators, meaning hackers would need to control a significant portion of Ethereum in the system. Therefore, decentralized Ethereum staking helps improve the security level of the Ethereum network.
• For institutions and users, there is an opportunity to earn staking rewards. In the Ethereum network, consensus actions are rewarded. As long as the software correctly packages transactions into new blocks and checks the work of other validators, rewards will be earned.

At the same time, it is important to note that staking Ethereum is not 100% safe and risk-free. During the staking process, there are still several risks:

• After becoming a validator, running your own validating node requires ensuring long-term online presence and maintaining a healthy network status. If the validator goes offline, there is a risk of penalties, leading to potential financial losses.
• In different staking solutions, there are also code risks. Clients, like all new software, may encounter various bugs. Users or institutions need to bear the issues caused by bugs, such as going offline or reduced earnings.

Overall, staking is a method to help protect proof-of-stake blockchain networks (like Ethereum). Network participants can run validator nodes by "putting their tokens at risk," and if the node commits any malicious acts or is unreliable, tokens can be "slashed" (taken away as punishment). It is important to note that penalties are directly deducted from the staked 32 ETH, and validators cannot reset the entire validating node by replacing or supplementing the originally staked ETH. If the staked 32 ETH is reduced to below 16 ETH, the validating node will be automatically kicked out.

Looking at the circulation of ETH under the PoS mechanism, as of September 2023, the proportion of staked Ethereum is nearly 30%, significantly higher than the proportion in Layer 2 (less than 2%); among all staking solutions, users or institutions favor Lido, with Lido's share of ETH staking accounting for 7.2551% of all circulating Ethereum, surpassing other circulating staking service providers such as Rocket Pool, Frax, and StakeWise. Additionally, according to the Ethereum circulation chart below, from the perspective of users and institutions, the demand for liquid staking is higher than other staking demands, such as centralized exchange staking and staking pool staking. For details, please refer to the chart below.

Source: Eth Wave (Twitter: @TrueWaveBreak)

Comparison of Ethereum Staking Solutions

Each Ethereum staking solution has its own characteristics, allowing institutions or users to choose a suitable staking solution. Some users opt for centralized exchange staking solutions to stake Ethereum, while some institutional users choose other solutions, such as solo staking or pooled staking. Staking can be reverted, allowing institutions or users to earn returns from their Ethereum holdings with minimal time and effort. The principle of centralized exchange Ethereum staking solutions is to pool large amounts of Ethereum to run numerous validators. The following diagram compares solo staking/staking as a service (SaaS)/pooled staking solutions.

Source: Public Market Information

For the above three staking solutions, the table below lists the characteristics, requirements, rewards, and risks of solo staking/staking as a service (SaaS)/pooled staking solutions.

Source: Public Market Information

Liquid Staking

Liquid staking providers absorb user deposits, stake tokens on behalf of users, and provide users with receipts in the form of new tokens, which can be exchanged for the staked tokens (plus or minus some rewards and penalties). These new tokens can also be traded in DeFi protocols or used as collateral, thereby releasing the liquidity of staked assets. Liquid staking service providers solve this liquidity issue by minting new tokens (representing claims to the underlying staked assets), which can then be traded in DeFi protocols. For example, users can deposit ETH into the Lido staking pool and receive stETH (staked ETH) tokens as proof of their assets, which can then be deposited into Aave as collateral. Essentially, liquid staking builds on the existing staking system by releasing the liquidity of staked tokens.

Benefits of Liquid Staking

• Liquidity Release: Tokens staked in networks like Ethereum are locked and cannot be traded or used as collateral. Liquid staking tokens release the inherent value held by staked tokens and can be traded and used as collateral in DeFi protocols.
• Composability in DeFi: By representing receipts for staked assets as tokens, they can be used across various protocols in the DeFi ecosystem, such as lending protocols and decentralized exchanges.
• Reward Opportunities: Traditional staking provides users with the opportunity to earn rewards by validating transactions. Liquid staking allows users to continue earning these rewards while also gaining additional returns through various DeFi protocols.
• Outsourcing Infrastructure Requirements: Liquid staking providers enable anyone to share in staking rewards without maintaining complex staking infrastructure. For example, even if users do not have the minimum 32 ETH required to become independent validators in the Ethereum network, liquid staking still allows users to share in block rewards.

Risks and Limitations of Liquid Staking

• Slashing Risk: Users of liquid staking services essentially outsource the maintenance of validator nodes. If the service provider acts maliciously or unreliably, funds will be fully at risk of being slashed.
• Private Key Leakage: If the private keys of node operators are leaked or if there are any vulnerabilities in the protocol that can be exploited, depositing tokens into a liquid staking service provider will put those funds at risk.
• Secondary Market Volatility: The prices of liquid staking tokens are not pegged to the underlying assets they represent. While they may trade at the same price or a very slight discount most of the time, they can fall below the price of the underlying asset during liquidity crunches or unexpected events. Since the trading volume of staking tokens is usually lower than that of the underlying assets, market shocks can significantly impact the volatility of staking tokens.

Staking Ecosystem and Current Status

Ecosystem Participants: The staking ecosystem around the Ethereum protocol can be subdivided into multiple roles, including the Ethereum protocol, client software, MEV, staking service providers, and custodial staking. Each role and identity plays a part in Ethereum's staking ecosystem, but the roles vary. The table below briefly outlines the roles in the Ethereum staking ecosystem:

Source: Public Market Information

According to data from DefiLlama, a total of $21.788 billion (11.52 million ETH) is staked, with the top three liquid staking service providers by TVL being Lido, Rocket Pool, and Binance. Among them, over 8.9 million ETH is staked in Lido, accounting for a market share of 77.28%, far exceeding other competitors. In the past 30 days, Stader and Liquid Collective have seen the fastest growth, increasing by 85.31% and 43.17%, respectively. In the past 30 days, only two liquid staking service providers, Coinbase and Ankr, experienced slight declines in TVL, down by 1.8% and 2.17%, respectively. However, overall, the ETH liquid staking segment has remained on an upward trend over the past month.

Source: DefiLlama

Moreover, overall, the short-term net inflow of ETH liquid staking funds is heavily influenced by sentiment factors. For example, in June 2022, affected by factors like Terra, sentiment in the crypto industry hit a near-term low, leading to the lowest level of incremental funds in ETH liquid staking. Over the past two years, due to sudden events, the inflow of funds into ETH liquid staking has rapidly declined but has still maintained positive inflows. After the short-term pessimistic sentiment is released, the inflow of ETH liquid staking will rebound sharply. This reflects that long-term holders will continue to increase their positions in ETH liquid staking, while short-term holders, although significantly influenced by sentiment, remain highly interested in the crypto industry and will allocate a certain level of positions in ETH liquid staking.

Source: DefiLlama

In the ETH Staking ecosystem, various roles cooperate to jointly build the prosperous development of the ETH Staking ecosystem. Related subfields include lending protocols, decentralized exchanges, stablecoin protocols, and restaking, among many others. Based on TVL, liquid staking protocols have become one of the largest DeFi categories, with a total issuance exceeding $20 billion. The associated assets and DeFi products have a profound impact on the entire DeFi space, with their status as collateral becoming increasingly prominent, affecting the existing asset pools of lending protocols, stablecoin issuers, and decentralized exchanges. Below is a brief analysis of the ecosystem in the ETH Staking field:

• Staking Liquid Staking Protocols: The process by which investors stake their assets to exchange for liquidity. In return, investors receive equity tokens used to claim the staked assets at a 1:1 ratio, similar to liquidity provider (LP) tokens in decentralized exchanges. Liquid staking tokens can be redeemed at any time, allowing investors to retrieve their original tokens without waiting for a lock-up period. Representative projects: Lido, Rocket Pool, Frax, etc.;
• Restaking: EigenLayer is a restaking protocol that allows ETH stakers and validators to use their staked ETH to secure other networks. This network can access the vast staked capital and validator pool of ETH, paying additional service rewards to ETH stakers in return. The external rewards brought by EigenLayer can significantly increase the optimal staking ETH amount from 33% to over 60%. It currently supports liquid staking tokens stETH, RETH, and cbETH;
• Lending Protocols: Staked tokens related to ETH are one of the important assets in the Ethereum DeFi ecosystem. At the same time, LST-type assets can increase loan interest rates or subsidize borrowing rates. However, it should be noted that LST-type assets carry certain decoupling risks. Representative projects: MakerDao, Spark, AAVE, Compound, etc.;
• DEX: LSTs, as collateral, need to be pegged to ETH. Liquid staking protocols require deep liquidity pools on DEXs to allow for quick exchanges between LSTs and ETH. Representative projects: Uniswap, Curve, Balancer, etc.;
• Structured LST Products: Due to the high correlation and potential higher volatility between LST products and ETH products, various structured products have been developed. For example, in the direction of interest rate swaps, interest rate swaps can convert floating rates to fixed rates and vice versa. Interest rate derivatives help hedge against interest rate fluctuations for different financial institutions; additionally, aggregators distribute equity across multiple protocols, diversifying protocol risks and further spreading network risks; moreover, structured products such as index-type products and stablecoin protocols are gradually attracting the attention of users and institutions in the market. Representative projects: Pendle, IndexCoop, Lybra, Prisma, Asymetrix, etc.

Source: Public Market Information

Among all projects related to ETH staking, Lido is currently the largest liquid staking protocol. Users and institutions can stake tokens and receive daily rewards without locking up tokens or maintaining related infrastructure. Users can stake ETH and receive stETH as proof of their stake. The following will provide a detailed analysis of the representative project Lido.