Proof-of-stake (PoS) is a consensus technique in blockchains that is used to process transactions, produce new blocks, and keep the chain secure. In PoS, tokens are staked in order to guarantee security for the network. Users are rewarded for staking their tokens using network block rewards and fees paid by users. Users must run validator nodes in order to stake tokens. Because of the difficulties involved, validation is often performed by professional node runners.

Liquid staking protocols such as Lido and Rocket Pool were created to expand access to staking and liquidity. Users may stake their tokens with validators in return for a percentage of the interest yield obtained. Furthermore, these liquid staked tokens may be sold easily on decentralized exchanges, enabling users to convert them back to unstaked tokens (e.g., from stETH to ETH).

We examine the ETH staking industry from a commercial and financial standpoint in this article. The ultimate purpose of this exercise is to determine the value-creation potential of these treatments.

These liquid staking derivatives (LSDs) may look identical at first sight, yet they vary significantly. Each protocol has its own derivative token that accumulates or processes rewards in a distinct way. They also have varying fee and commission regimes, which affect holders' net returns.

Fundamentals explained

Rebasing Tokens

The total supply of rebasing tokens is elastic and may rise or decrease; the change in supply is distributed proportionately among token holders. Lido's stETH is a rebasing token, which means that any yields made are immediately reflected in the quantity of stETH possessed. While this is straightforward for consumers, it becomes more difficult when employed in DEXs since stETH in liquidity pools must also rebase.

Reward-bearing token

Reward-bearing tokens are tokens whose underlying worth rises over time as rewards accumulate. These tokens, unlike rebasing tokens, do not have an elastic supply that varies often. This token system is used by Coinbase, Rocket Pool, and Frax (sfrxETH).

Base Token + Reward Token

StakeWise segments a user's yield and rewards using a unique model of base (sETH2) + reward token (rETH2), both of which are valued 1:1 with ETH staked and earned on the beacon chain. This is done primarily to assist in offsetting temporary loss while providing liquidity in DEXs. However, since two liquidity pools are necessary, this results in fragmented liquidity and possibly increased slippage.

Base Token + Reward-Bearing Token

Frax employs a novel paradigm that lets users select between two tokens, frxETH and sfrxETH, to accomplish distinct goals. FrxETH does not get beacon chain yields from staked ETH; however, sfrxETH receives full staking yields. This implies that sfrxETH receives yields from every frxETH that is not staked, increasing its yields. This approach has two major advantages:

frxETH is meant to maintain parity with ETH, making it appealing to liquidity providers that can provide frxETH-ETH liquidity pools. Furthermore, Frax has the most protocol-owned CVX, which it may utilize to steer emissions and attract additional liquidity. Liquidity providers do not receive beacon chain returns on staked ETH while utilizing frxETH to offer liquidity.

These yields are instead focused toward sfrxETH, resulting in larger sfrxETH yields than other liquid staking derivatives. This enables sfrxETH to reach a "levered" yield since the yield on 1 sfrxETH is larger than the yield on one staked ETH.

It should be noted that not every ETH staked in frxETH gets deposited with validators. frxETH features an Algorithmic Market Operations (AMO) function that uses part of the ETH transferred into frxETH to assist in keeping the frxETH-ETH peg stable. This may be seen as Frax using their CVX voting power to raise the yields generated on staked ETH indirectly at the price of beacon chain incentives. However, sfrxETH stakers may still earn more than the return received on one staked ETH; therefore, it's a win-win situation.

Commissions

When it comes to fees, Lido, StakeWise, and Frax have the lowest at 10%. Coinbase charges the most, at 25%, followed by Rocket Pool. Low commissions help liquid investors the most since they may keep more of their earned rewards. Despite its somewhat high costs, Coinbase is the second-largest liquid staking derivative, partly due to its reputation as a trustworthy centralized exchange.

Operators of Nodes

Node operators are in charge of staking ETH and operating validators on depositors' behalf.

With 1,906 unique operators, Rocket Pool is the most broadly dispersed operator pool. They let anybody put up a mini-pool validator for a minimum of 16 ETH from the operator and another 16 ETH from Rocket Pool depositors.

With 27 node operators, Lido has the second biggest operator pool. They do, however, control a significant amount of the ETH staked, raising worries about centralization issues on the Ethereum network.

StakeWise is moving towards decentralization with the introduction of StakeWise v3, which will enable permissionless node operators. StakeWise v3 was supposed to be released in late 2022; however, it has already been pushed back until early 2023.

Frax Finance is developing frxETH v2, which will aid in the decentralization of frxETH. It is scheduled to deploy closer to the March 2023 upgrade of ETH Shanghai.

The current state

The ETH liquid staking market has expanded dramatically, currently accounting for around 40% of all ETH staked. Lido is the obvious frontrunner, with almost 30% of all ETH staked. Since the Merge, staked ETH has risen in tandem with yields. Since yields have grown, so has competition, as a major section of the market remains untapped.

While Lido is the industry leader, rivals are gradually eroding its market share. Rocket Pool, StakeWise, and Frax are three protocols that are progressively eroding Lido's market dominance. Coinbase has also joined the fray, accounting for 16% of the liquid staking market. Coinbase has great branding as one of the main centralized exchanges, and its ability to onboard customers to staked ETH puts them in a perfect position to develop.

Source: Dune Analytics

Given their rapid development rates, Coinbase and Frax are key players to watch.

Most LSDs trade at a discount to their underlying value on a consistent basis. Prices for all LSDs fell in June owing to the collapse of 3AC and worries about cascade liquidations. Most have now rebounded to within a few points of the peg. Because LSDs cannot be unstaked until the Ethereum Shanghai upgrade is done, the present discount reflects the expense of keeping them.

Interestingly, cbETH trades at a 5% discount to the other LSDs, while rETH trades at a 1.7% premium. Given recent occurrences, the discount on cbETH might be attributable to CEX fears. However, assuming all other circumstances stay constant and you trust in Coinbase's long-term viability as a CEX, cbETH might be a less expensive way to get exposure to staked ETH.

Despite the fact that Rocket Pool has a diverse range of node operators, there is presently a shortage of demand for them to operate mini-pool nodes, with 5,000 ETH in the deposit pool waiting to be matched with mini-pool validators. Because there aren't enough mini-pool validators to meet the demand for deposits, rETH is trading at a 1.7% premium. To arbitrage the premium, node operators may start mini-pools, but they must also deposit at least 10% of the value of the staked ETH in RPL, which reduces the profitability of this approach. Arbitrage earnings may be seen by node operators as a "discount" for the RPL staked.

The Prospects for ETH's Liquid Staking Protocols

Before delving into forecasts, examine the probable status of ETH staking over the next three years. In 2019, Ethereum developer Justin Drake said that a stake of roughly 33.5M ETH (approximately 27% of the entire ETH supply) "feels about reasonable for solid security." According to a public Twitter survey conducted in 2019, the majority of respondents thought that 30% of ETH would ultimately be staked.

Using Justin Drake's staked ETH aim, as well as the average daily ETH burnt and expected daily ETH emissions, it is estimated that roughly 33.5M ETH will be staked by April 2024.

Of course, there are worries regarding the possible unstaking of ETH as a result of the Shanghai upgrade. Our model, however, continues to forecast a rise in staked ETH for the following reasons:

There will still be a line for unstaking after the Shanghai upgrade, and not all staked ETH will become liquid instantly. This minimizes uncertainty for ETH holders thinking about staking since it addresses current worries regarding the length of unstaking, which may lead to ETH LSD mispricing.

As ETH redemptions allow actual arbitrage, ETH LSDs will be priced more correctly once the period of unstaking is known. Any premium/discount will be arbitraged and will converge to approximately 1:1 market price with ETH.

With more stable prices, liquidity will expand as more liquidity sources feel comfortable with lesser risks of a depeg.

With more liquidity, ETH holders will be more willing to stake since they will know they can sell their LSD back to ETH if they do not want to wait for unstaking.

Furthermore, lending protocols will begin to see ETH borrowed for staking as arbitrageurs exploited the differential between borrowing rates and staked ETH returns. This might lead to more leveraged staked ETH holdings to optimize profits, which is also good news for ETH lenders. We anticipate that the spread between ETH loan rates and staking rates will reduce.

Next, consider how an increase in staked ETH affects yields.

eth consensus yield vs emission

Source: Delphi Digital

The consensus layer and the execution layer both provide rewards for staked ETH. The consensus layer compensates validators for submitting or validating blocks, attesting to their perspective of the chain, and participating in sync committees. The consensus-layer payouts are set and distributed in proportion to the quantity of ETH staked. The formula for determining consensus layer rewards is as follows:

(c*F) / sqrt yields (Total Staked ETH)

The variables are as follows:

c is the 2.6 constant factor depending on the number of epochs in one year.
F is the developers' basic reward factor of 64, which influences emissions.

The figure above demonstrates that we are presently at roughly 15M staked ETH, resulting in validators being compensated with a return of around 4%. As the estimated quantity of ETH staked exceeds 33.5M, yields will progressively fall to about 2.76%.

Actual rewards have been somewhat lower than advertised, based on accessible data since the Merge, with the median and average c factors being 2.506 and 2.4997, respectively. Because the average c factor deviates less from the actual issuance amount, the model will use this figure to determine future yields.

The execution layer's rewards are flexible and based on the degree of activity on the blockchain. These incentives include MEV tips and transaction priority tips. More transactions occur in a bullish market, resulting in greater levels of MEV and priority tips. A bearish market, on the other hand, results in reduced levels of these benefits. The execution layer's daily incentives now vary between 1-2% APR, with an average of 1.84% APR since the Merge.

A prediction of LSD protocols

We constructed a model of the future ETH supply, LSD dominance, and staked ETH returns by making use of the data points that were discussed earlier in this paragraph. To have a better grasp of the variables, let's go through the most important assumptions first.

ETH Supply: This is the net supply change based on ETH issuance (which varies dependent on ETH staked, as was indicated above), as well as the average daily amount of ETH that has been burnt since the Merge.

ETH Staked: This was calculated by extrapolating the growth rate that has been typical since the Merge.

Staked ETH as % of Total ETH: The projected % of ETH supply staked.

% of Staked ETH in Liquid Staking: This indicates the whole market share of LSDs, which has quickly expanded from 21% in 2021 to 39.5% in 2022. In our model, we decided to take the cautious approach of lowering the growth to a rate of less than 5% each year.

Rewards for the Consensus Layer: As was stated before, the returns decrease as more ETH is pledged.

The present situation in ETH suggests a cautious scenario for extended negative or sluggish market conditions. Execution-Layer Rewards The incentives are determined by taking the typical daily payment from the execution layer and diluting it by the amount of ETH that has been staked.

The sum of the rewards for both the consensus layer and the execution layer is referred to as the Total Staked ETH Rewards.

The model provides a more in-depth breakdown of the essential ETH LSD protocols and firms. We anticipate that Lido will continue its rapid expansion, but we also anticipate that Coinbase and other smaller protocols will eventually join the market and begin to eat away at Lido's overall market share. Despite this fact, it is probable that Lido will continue to hold the position of market leader when it comes to liquid stakes. The expansion of Coinbase is anticipated given that the company already has a sizable user base thanks to the success of its exchange operation. They quickly seized a major 16% of the market immediately after its introduction in June of 2022, which demonstrates unusually robust growth on their part. At least in the short future, it is more probable that institutions, in particular, would have greater comfort staking their cryptocurrency with Coinbase as opposed to decentralized protocols.

There is a good chance that Rocket Pool will maintain its position as the second-leading ETH LSD protocol. To successfully arbitrage the rETH premium, it is necessary for it to continue recruiting mini-pool stakers beyond its node operators.

Over the course of the last year, StakeWise has had a difficult time growing its share of the market. Because of its modest development, its market share will almost certainly decrease over the course of time. This forecast does not take into account the future launches of their v3 and osETH platforms since there is not enough information available to assess whether or not these initiatives will be successful.

Since its inception, Frax's frxETH has seen remarkable growth. In comparison to other LSD protocols, Frax has a significant amount of CVX voting power, which encourages deep liquidity and an AMO mechanism that assists in maintaining the frxETH peg. Both of these features give Frax an edge. In addition, sfrxETH is among the most yielding ETH-staking derivatives, if not the highest yielding. This fact serves as a natural incentive for users to consider Frax as an investment option.

Other methods have not shown any signs of an increase, and the forecasts suggest that this trend will continue for the foreseeable future.

Let's take a look at Lido, StakeWise, and Frax's income and P/S multiples since these are the three protocols that charge fees on the rewards gained from ETH staked and put into their respective DAOs.

Source: Coingecko

The fees that are earned here on incentives are subsequently contributed to the protocols' respective DAOs. The following are the costs that they require:

Lido: 5%
Frax: 8%

For StakeWise, the fee is 5% if the node operators are not affiliated with StakeWise Labs and 10% otherwise. As a consequence, the weighted average for StakeWise comes out to be -8.5%.

The table that can be seen above illustrates the potential earnings for each protocol at a variety of different ETH prices. The cells that have been highlighted in green show the current income generated by each protocol. This revenue is calculated based on each protocol's current ETH LSD market share. The preceding two models of the quantity of staked ETH, the percentage of staked ETH that is in liquid staking, and the respective market share of each protocol have served as the basis for our estimates for the years 2023-2025. In order to highlight the possible influence that varying ETH pricing scenarios may have on the money generated by various protocols, many price levels have been included in the model. Please be aware that these estimates are based only on the ETH liquid staking products offered by the protocols; they do not take into account any additional offers.

At this time, the annual run rates for Lido, Frax, and StakeWise are, respectively, $18.41 Million, $0.3 Million, and $0.48 Million. Because the income of LSDs is dependent on the price of ETH, small changes in that price may have a big impact on both the good and negative aspects of these measures.

Source: Coingecko

The fully diluted price-to-sales (P/S) ratios of the protocols are based on the price of ETH and are shown in the table that can be seen above. Lido's strong market share position has made it a very lucrative firm, which has resulted in it having the most attractive price-to-sales multiple. This is despite the fact that Lido has the greatest fully diluted value (FDV). The P/S ratio of Lido was 610x in 2021; however, it has substantially decreased to 76x over the course of the last year.

As a result of their lesser market share and the lower revenue that comes along with it, Frax and StakeWise have higher P/S ratios even though their FDVs are lower.

Conclusion

Staking futures based on ETH is a straightforward business strategy that has helped protocols like Lido make millions of dollars in income. ETH LSDs, on the other hand, are seeing increased levels of competition as Coinbase and other emerging protocols, like Frax, chip away at Lido's market dominance. The amount of ETH that is staked is expected to increase over the course of the next two years, which indicates that the entire addressable market for ETH LSDs has not yet been completely tapped. The liquidity concerns that make it difficult for stakers to quit pre-unstaking might pose a difficulty for less liquid staking protocols, which could lead to complications. Due to the fact that they have a stranglehold on CVX, Frax is in a very special position, and this already makes frxETH the LSD with the second deepest liquidity.

In addition, there is also a lack of clarity on the yields of the execution layer that are the result of roll-ups. This may have a dampening effect on MEV as well as transaction priority tips, which in turn impacts execution-layer yields and, as a result, reduces income to liquid staking procedures.

Since income is directly proportional to ETH prices, liquid staking protocols may be seen as a leveraged bet on ETH as they achieve a higher market share than staked ETH. This is because revenue is directly proportional to ETH prices. The unstaking that is almost expected to take place should not be seen as a bad development for ETH but rather as a good development for liquid staking protocols since it will lower the level of uncertainty that now surrounds LSDs.

Even though there is a lot of unpredictability, the market for ETH liquid staking is doing quite well. ETH liquid staking techniques are analogous to placing a leveraged bet on the Ethereum network itself, and it is anticipated that they will further solidify their position as PMF in the years to come.

Disclaimer:
This article is intended for and only to be used for reference purposes only. No such information provided constitutes advice or a recommendation that any investment or trading strategy is suitable for any specific name.

A deep dive into ETH liquid staking