October 13, 2023

Q3 State of the Union: Ethereum Liquid Staking

Intro to Liquid Staking

Crypto staking has been around since the creation of the first Proof-of-Stake (PoS) blockchain. Bitcoin and other Proof-of-Work (PoW) blockchains rely on significant computational power (and electricity) to verify and write new blocks to the chain. PoS blockchains, on the other hand, enable users to “stake” their crypto to the blockchain in return for rewards, governance rights, and the chance to act as “validators” who confirm the transactions to be written into new blocks. PoS was created as a much more energy efficient alternative to PoW.

Staking is simply purchasing and pledging or locking up crypto on a particular chain. In a sense, it’s like buying a CD—you lock up your coins for a specified period of time to receive a specified rate of return (along with the other rights). Staking is popular in the crypto investment community because it’s a way to earn a decent rate of passive income, particularly attractive when IRL interest rates are very low. In fact, some staking Annual Percentage Yields (APYs) are very high.

However, many investors didn’t love the idea of not being able to access their crypto so, in 2020, the first liquid staking protocol, Lido, was launched. Liquid staking was quickly adopted by crypto investors, but its big boost came in late 2022, when the Ethereum blockchain converted from PoW to PoS and later, in April 2023, when its Shanghai upgrade enabled ETH stakers to unlock their locked ETH, significantly increasing the pool of ETH available for liquid staking.

The current liquid staking TVL is roughly $21 billion, making it the largest DeFi protocol type. The three largest liquid staking providers are Lido, Coinbase, and Rocket Pool, and they account for approximately 90 percent of all liquid staking TVL. The overwhelming majority of all that TVL is from the liquid staking of ETH. Currently, Lido has an ETH liquid staking TVL of $14 billion; Coinbase Wrapped, $2.1 billion; and Rocket Pool, $1.7 billion.

How does Ethereum liquid staking work?

Liquid staking works via the creation of a derivative token (a Liquid Staking Token or “LST”) that represents the underlying asset. When an ETH holder stakes their ETH on a staking platform like Lido, they receives a derivative token – stETH on Lido – that represents their ETH that’s staked on the platform. The ETH stays on the platform earning rewards, but the stETH can be traded or lent. The staking platform typically takes a cut of the staking rewards that are generated. Many of the top crypto lending platforms, such as Aave, MakerDAO, and Curve, support LST lending.

Importance of liquid staking in Ethereum ecosystem

Liquid staking plays an increasingly important role in the Ethereum ecosystem. For starters, it's created $billions of additional liquidity that can be borrowed or lent to new protocols, and provides investors with increased flexibility when devising overall investment strategies. This flexibility increases the utility of staked tokens, allowing them to be used for governance and participation in decentralized applications and protocols while still earning staking rewards.

Liquid staking risks

Despite its benefits, liquid staking also comes with risks. As always, when dealing with blockchains, poorly written or otherwise vulnerable smart contracts can lead to a loss of funds. With lending of any type, there's a counterparty risk of bankruptcy. Given that liquid staking is relatively new, some of the protocols offering it have relatively small numbers of validators; this is never optimal.

Centralized vs decentralized Ethereum liquid staking

Centralized and decentralized Ethereum liquid staking are two different approaches to the liquid staking process. Each has its advantages and disadvantages.

Centralized liquid staking involves a centralized provider, such as Coinbase, holding custody of the assets. You stake your ETH through these centralized exchanges, which provides flexibility and ease of use. However, it also means that you’re placing your trust in a single entity to manage your staked assets. A single entity, which represents a potential single point of failure or breach. The key benefits of centralized ETH liquid staking include ease of use and more straightforward user interfaces.

Decentralized liquid staking, on the other hand, doesn't require custody of tokens. Instead, you deposit your ETH into a protocol's smart contract and receive the liquid token version of their staked tokens in return. Decentralized liquid staking is non-custodial, so you always have control of your assets. However, it may be more vulnerable to smart contract exploits. Also, some users find dealing with a decentralized protocol too complicated for their taste.

Choosing between CEX and DEX depends on individual preferences, risk tolerance, and technical expertise. Centralized ETH liquid staking may be more suitable if you prefer simplicity and convenience, while decentralized is more appealing if you prioritize security and control over your assets.

Future of Ethereum liquid staking

Analysts expect that Ethereum liquid staking will see significant growth owing to: a) the increasing use of liquid staking tokens as a more flexible alternative to ETH, b) increased institutional involvement, and c) the development of new products based on liquid staking.

Hashkey Capital believes Ethereum LST TVL could double in the next two years, and that the amount of staked ETH could make up 31 percent to 45 percent of total ETH supply during that time. Hashkey also predicts that staking yields might decline due to increased investor participation, but believes that the effects of this can be somewhat mitigated because the composability of DeFi protocols could lead to new uses in income-generating strategies.

Others believe that ETH LSTs will completely replace ETH because of their liquidity and flexibility advantages. Their argument is a simple one: Why would anyone willingly sacrifice a 4 percent or more APR? Nonetheless, we're still in the very early days of ETH liquid staking, and the crypto world is always evolving.

Currently, institutional involvement in Ethereum liquid staking is growing as institutions see its value to them. According to a survey from staking integrator Kiln, nearly 70 percent of institutions holding ETH plan to begin liquid staking or increase their liquid staking in the future.

Another big example of institutional activity is, of course, Coinbase Prime’s partnership with Liquid Collective to offer liquid staking to institutions via the LsETH token. And Alluvial, the software developer supporting the Liquid Collective protocol, recently raised over $18 million to create, launch, and build out that protocol from investors such as Coinbase Ventures, Kraken, Figment, Ethereal Ventures, and Variant, among others.

As for new products, in a recent interview, Adam Campbell from Staking Rewards and Dr. Karl-Michael Henneking from Untitled Investment Expertise discussed in depth the future of Ethereum liquid staking, and one of the topics they explored was new product innovation based on ETH liquid staking. Some of the products they mentioned were fixed-rate ETH staking, leveraged ETH staking, Ethereum LST-backed fully decentralized stablecoins, and yield optimizers.

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