The Shapella Effect: the Journey from Merge to Surge
In April 2023, the Ethereum network underwent a consequential upgrade known as Shanghai or Capella. Shanghai is the upgrade to Ethereum’s execution layer while Capella is the upgrade to Ethereum’s consensus layer. Often discussed in conjunction, the upgrade will be referred to as ‘Shapella’, a term that has gained widespread usage within the community. A key feature of the upgrade was the provision for validators to unstake, either partially, where validators could remove their staking rewards while keeping the original ETH staked, or fully, allowing validators to withdraw their 32 ETH along with any rewards accrued, effectively ceasing their contribution to the network’s security. However, due to Ethereum’s processing constraint of 16 partial withdrawal requests per 12-second slot, waiting times were anticipated. Post-upgrade, about 1.1 million ETH from rewards became available for immediate withdrawal, leading to potential sell pressure as stakers might rush to liquidate their tokens. Industry entities like Celsius Network and Kraken, under financial duress and regulation, were also expected to contribute to this selling pressure by liquidating their staked ETH. The upgrade further incorporated four Ethereum Improvement Proposals (EIPs) aimed at enhancing gas fee efficiency for developers which reduced costs and improved user experience in various ways.
High Level Situation Post-Shapella
While there were original apprehensions about a possible sell-off following Ethereum’s Shapellaupgrade, it appears to have drawn an increased number of investors. According to data from the Ethereum Foundation, over a month since the upgrade, around 18.9 million Ether is staked, serviced by about 588,000 validators who are securing an average return of 5.5%. The aggregate value of the staked Ether has seen an upswing, even as the overall supply of ETH has seen a considerable dip. Ethereum transaction costs have reached their zenith in a year, a situation that is driving higher returns for those staking their Ether.
Post the Shapella upgrade, the rate of new participants willing to stake has seen an uptick, evidenced by an about 8% growth in the unique depositors since the upgrade. People now seem more open to staking their funds in return for profits, particularly given the new ability to withdraw their staked Ether. The upgrade did trigger a temporary surge in withdrawal requests, predominantly led by Kraken. The wait times for exit post-Shapella were variable, hinging on the queue of participants, leading to predictions of a 30 to 60 day waiting period for investors to withdraw. However, in a turn of events, a month following the upgrade, the waiting time for Ether withdrawal has plummeted to zero days, while the waiting period to join the staking queue has stretched to 30 days — a complete reversal of the initial projections.
Current Staking Analysis
The present Ethereum staking data indicates there is clear demand for ETH yield and an underwhelming amount of validators looking to exit via the queue. The current ratio of staked ETH is sitting at approximately 18%, according to Dune Analytics. (31st of May) The total net flows since Shapella occurred on April 12th has been heavily weighted toward the deposit side with about 2,263,119 ETH flowing into staked ETH. This number is calculated by the following equation:
Net flows = Amount staked — Total amount withdrawn — Partial withdrawals
The Net Flows of ETH increased by about 33% up to 3,338,055 ETH when excluding rewards that were withdrawn. The majority of reward withdrawals occurred within the first week post-Shapella. Total deposits have trended upward while total withdrawals have done the complete opposite — contrary to many initial projections.
Most of the deposited ETH has been coming from Liquid Staking providers such as Lido, followed by unidentified stakers and CEX deposits. Lido still maintains a large control of the total staking market share at 31.87%.
Looking at the three available categories, the Liquid Staking market is by far most heavily centralized by one protocol while Coinbase and Binance have a clear edge in the CEX market. The staking pools category is the most distributed with Staked.us, Figment, Kiln, stakefish and Bitcoin Suisse making up about 74% of its market share.
The current validator exit and entry queue adds further confluence to the demand for staked ETH. There are 76,349 pending validators in the entry queue compared to 21 validators waiting to exit, at the time of this writing. The wait time to exit is a mere 14 minutes, while new validators have to wait approximately 37.5 days.
One of the most debated and important predictions heading into the second half of this year and 2024 is the ETH staking ratio. This is because users no longer are paying for tech risk from Ethereum switching its consensus mechanism and the illiquidity premium from Shapella. There are predictions this number will converge to the 60% average seen in other major proof-of-stake networks and eventually trend above 90%. This could potentially increase the number of validators from the current amount of 730,000 to well over 2 million. In this scenario, the yield paid to each validator is likely to decrease. This is because of the validator yield composition and how it changes based on specific variables such as the total amount staked. Ethereum validators receive yield from three different sources: block rewards, gas tips and Maximal Extractable Value (MEV) rewards. Block rewards are the new ETH tokens issued on PoS. The annual inflation of the network increases and the yield each staker receives decreases as the staking ratio increases. This can be roughly visualized in the below graphic.
Gas tips are when users can pay extra ETH as “tips” to validators to incentivize their transaction being ordered first in the block. A prime example of why users would want to do this is for a hyped NFT launch where lots of users are trying to purchase the same item. Although there are still reasons to tip validators and this number will fluctuate due to demand catalysts such as memecoin mania, the NFT hype cycle has completely died down, and there are not many sustainable reasons to forecast this type of yield to make up a consistent and substantial amount paid to validators.
The final variable for validator yield is MEV. Although there have been pockets of opportunity where gross MEV profit has skyrocketed, it has consistently tapered down over the past 2 years. As more Ethereum transactions slowly transition to its rollup ecosystem, the amount of MEV that can be extracted on Ethereum will slowly trend downward and become less and less profitable.
After quantifying where ETH yield comes from, in the aforementioned scenario where staked ETH continues to trend upward over the coming years to 60%+, it is unlikely that the yield will sustainably increase. Block rewards make up the primary source of yield and this is likely to trend downward, as well as the other two categories which make up a much smaller percentage of the total yield. Despite evidence Ethereum yield is likely to decrease over time, there is strong evidence indicating a rapid increase in the momentum of Ethereum staking.
Explanation of the Numbers
One of the main reasons for the surge in Ethereum staking post-Shapella could be the removal of tech risk and the illiquidity premium. The Merge and Shapella were both two of the largest events in Ethereum’s history, both of which were highly uncertain events for investors. After a successful completion, the risk of any technical issues due to changing Ethereum’s consensus effectively were removed. Additionally, investors now no longer are paying illiquidity premium with the ability to withdraw their ETH at any time. The illiquidity premium came from the inability to withdraw ETH prior to Shapella, thus users were selling their ETH LSDs at DEXs.
The large discrepancy between the entry and exit queue post-Shapella could be due to the people who were afraid to stake initially and now have full confidence. The concerns around massive withdrawals post-Shapella and the lack thereof could be partially attributed to the queue mechanism. Withdrawals are processed in a dynamic way, meaning it does not allow withdrawals on a fixed time interval. The Shapella Update also made it easier to stake Ethereum. The update removed the requirement for stakers to have a minimum amount of ETH, which made it more accessible to a wider range of people. The recent demand for staked ETH could be coming from more institutional and private clients, as noted by Bitcoin Suiusse’s chief product officer on the demand for staking ETH.
Overall, the user behavior around Ethereum staking in the short term indicates a positive market-wide reaction. Shapella has resulted in a huge growth in staking via Liquid Staking Derivative (LSD) protocols and tokens, such as Lido. Post-Shapella, the growth of staked ETH via LSDs and across the entire sector has seen its largest total deposit month across all categories.
Finally, when looking ahead, DVTs such as SSV and Obol Network are set to launch their mainnets in the near future, of which Lido, Frax Finance, and many new LSD protocols such as Puffer Finance and Swell all will be using to decentralize their validator sets. This could be a driving catalyst for Ethereum staking and the LSD sector in the coming months and years because of the enablement of new LSDs to be built with less overhead. Demand for these new LSDs could be a trend to look out for as newer LSDs can potentially offer better yields than the current ones on the market with the addition of token incentives and initially taking no fees (in the case of Swell). New LSDs will be decentralizing the staking scene, and could potentially take away market share from industry leaders such as Lido or Coinbase, which is fundamental for a striving Ethereum ecosystem.
What’s Next for Ethereum
Overall, the impacts of the Shapella Upgrade were positive for the Ethereum ecosystem and set the necessary foundations for future upgrades. The next steps in the general Ethereum roadmap are now possible due to the fundamental upgrades completed during the Merge and the Shapella update. Improvements to scalability via rollups and data sharding are next, followed by significant improvements to efficiency, decentralization, and censorship resistance.
These upgrades, described well by the Ethereum Foundation’s roadmap, will take years to complete. There are multiple immediate factors outside of this core roadmap that will have an impact on Ethereum overall, namely re-staking and the growing power of liquid staking derivatives. Re-staking tools like Eigenlayer have great potential but also carry significant risk if not properly managed. Combined with the increasing concentration of staked ETH in Lido, Coinbase, and Binance, Ethereum has significant risks to mitigate as it progresses through the roadmap. If the threats of synthetic staked asset leverage and increasing centralization of staking services is not addressed, the overall decentralization of the Ethereum network will be threatened. We are confident that the slate of planned upgrades and the talents and technologies emerging from the staked asset sector will successfully address these emerging risk vectors.
What’s Next for the Industry
As a fundamental asset of the industry, the Shapella upgrade has impacts that are far reaching. As staking has become even safer due to the ability to withdraw, ETH Supply in CEXs is currently draining. Glassnode data reveals that as of Wednesday 31st of May, centralized exchanges held 14.85% of the total ether supply. Such a low level has not been observed in the market since the early days of ETH in the summer of 2016, clearly putting the pressure on the price to increase. In addition, due to the aforementioned staking queue, the demand for stETH as well as other Liquid Staking Derivatives of ETH is likely to increase, resulting in an even higher premium. We are already observing a situation where users want to get into staking generating those rewards asap despite the premium for Lido/Rocketpool/Frax ETH. The resulting situation is likely to strengthen the market share of leading staking players further. At the same time, the use of DVT or improvised liquidity flywheels & tokenomics is likely to lead to market share distribution in the liquid staking space. Newcomers could incentivize users to migrate their staked ETH from the big players to the new platforms by offering substantial lucrative rewards and higher APY. The recent launch of Swell’s Voyage programme comes to mind. Incumbents such as Lido can defend against these attacks by continuously improving their offerings and maintaining strong security measures. This competition is likely to improve the overall state of the space and push the fees to the minimum, thus benefiting the users in the long run.
Lastly, the Shapella upgrade represents a significant advancement in attracting institutional investors, as discussed previously, but it is not the end of the journey. The current landscape of disincentives, primarily in the form of regulatory uncertainties, particularly hinders Western institutional investors — pension funds and insurance companies from making substantial investments in the Ethereum ecosystem. However, the Shapella upgrade could potentially stimulate favorable outcomes in regulatory discussions across the sector, particularly with the emergence of security-related debates. This potential is further enhanced by the licensing of cryptocurrency exchanges in Hong Kong on June 1st. The convergence of these factors — an anticipated capital influx from the Eastern World and the Shapella upgrade — cultivates optimism for a more transparent and regulated future in the industry.
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