Liquid Staking Tokens Primer

Published in

Carbonocom

15 min readMar 17, 2023

The combined fork of Shanghai and Capella will unlock the full potential of liquid staking on Ethereum. Liquid Staking Tokens, which guarantee an LST owner’s claim over staked assets, will allow investors to trade their LSTs across DeFi protocols, while still earning the rewards from the Proof of Stake protocol. A groundbreaking development in Ethereum that will probably be one of the leading trends in 2023.

As the LST competition heats up, the following paper aims to explain what are the main elements to take into consideration when diving into this opportunity.

Download as pdf (ENGLISH version)
Download as pdf (SPANISH version)

Intro

Staking was first introduced to Ethereum in December 2020, with the first deployment of the Beacon Chain. During this time, staked ETH could not leave the blockchain for the lack of a withdrawal mechanism. Today we have an ETA for withdrawals (early April) when the newest upgrade in the Ethereum blockchain happens. The fork, sometimes named Shapella, (a combination of the coordinated upgrades Shanghai and Capella) will bring Etehreum’s staking full circle. After Shapella, we will witness the full potential of Ethereum’s staking.

The transition from a Proof of Work to a Proof of Stake consensus mechanism was Ethereum’s most significant upgrade in years. It took place in September 2022 amidst a bear market that eclipsed its importance.

We are now approaching another major related upgrade: Shapella, the name given to the combined forks Shanghai and Capella, will bring staking on the Ethereum network full circle by allowing withdrawals. The Shanghai / Capella upgrade is likely to become a major milestone in the world of crypto, causing ripples across the industry.

It might release capital into the market when staked ETH and associated rewards are unlocked.
It will eliminate uncertainties surrounding Ethereum’s Proof of Stake.
It will speed up the competition between Liquid Staking services providers and create new opportunities for investors and validators.

What is Proof of Stake

Staking is a primary component in Proof of Stake validation. In a PoS blockchain, validator nodes create blocks and validate transactions. They obtain network rewards in exchange for contributing to the system’s security.

In a standard staking system, nodes wanting to participate in validation must “lock” or “freeze” their coins for a specific period. They cannot transfer or spend those coins during the lock period.

Proof of Stake consensus mechanisms also include penalties for bad actors in the form of slashing. If validators act maliciously or fail to follow the rules of the network, they can have a portion of their collateral, or “stake,” slashed as a penalty. This serves as a deterrent to prevent bad actors from disrupting the network.

What is liquid staking

Since the beginning, ETH staking on the Beacon Chain was meant to be performed by dedicated validators. Unlike other blockchains, like Cosmos, where staking is available to any typical blockchain user via protocol-enabled delegation to validators, staking on Ethereum requires technical skills and significant funds (32ETH). Developers implemented these barriers to create an extra layer of security and leave staking in trusted actors’ hands.

Staking pools circumvented this by allowing investors to pool smaller amounts of ETH and hand them to validators. They opened access to PoS rewards to any user, lowered entry and exit barriers, and diminished risks for validators, who now had access to liquidity and could socialize rewards and penalties.

Liquid staking took this trend further: liquid staking providers created secondary tokens called Liquid Staking Tokens. LSTs are derivative tokens that act as the receipt of a staked token. They guarantee the right of redemption of staked ETH to the owner, and they can be used across DeFi protocols.

What are Liquid Staking Tokens

Liquid Staking Tokens are derivative tokens issued by Liquid Staking Providers that guarantee an LST owner’s claim over staked assets. Investors can trade their LSTs on the secondary market or through DeFi protocols, opening the doors to a second layer of rewards. LSTs help investors earn yields in DeFi while still earning the rewards from the Proof of Stake protocol.

For some time, Liquid Staking Tokens have been called Liquid Staking Derivatives, and there are probably more references to LSDs than to LSTs. The acronym has been contested for using the word “derivatives.” The term derivative has some regulatory implications because it assimilates LSDs to securities, and it can be misleading because the use of derivatives is more extended for derivative financial products like options or futures.

What is “Shapella”

Shapella is the name given to the combined upgrades of Shanghai and Capella. Shanghai is the fork on the execution client side, and Capella is the upgrade on the consensus layer client side, but the purpose of both is to enable the withdrawal of funds from the Beacon Chain.

Initially, these forks were going to include some further improvements for the Ethereum network. Still, developers decided to focus all efforts on creating the withdrawal mechanism to close the loop of Ethereum staking and avoid delays.

The Shanghai/Cappella hard fork is expected to happen in early April. All tested deployments to date have been successful.

Opportunities and risks ahead

Staking pools and liquid staking providers have been attracting capital and democratizing access to staking rewards, despite the constant delays and the inherent dangers of upgrades as crucial as The Merge or Shanghai/Capella. To this date, there is over more than 17M ETH staked through Beacon Chain validators (~14% of the total ETH supply).

Source: @hildobby / Ethereum Staking 🥩 (Lido, Coinbase, Kraken, Binance, RocketPool, Frax…)

33% of all the staked ETH in managed by Liquid Staking Providers. This means that 5.7M ETH are simultaneously locked and potentially circulating as LSTs.

Ethereum is one of the Proof of Stake chains with a smaller staking ratio. Other PoS chains like Solana or Cosmos, where staking is readily available from the wallet interface, show more funds staked (70% and 62%, respectively). The margin for growth is potentially massive once Ethereum adds the withdrawal process.

We can expect volatility before the upgrade from investors who mistrust the process, and some unpredictable behavior after withdrawals are on, with some ETH and rewards potentially ending up dumped on the market. Still, it’s also likely that liquid staking will attract more capital, especially as doubts over technology dissipate. Institutional investors have refrained from staking due to these doubts.

At the moment, ~62% of the staked ETH is lower in price than when stakers locked it; the other ~38% owners could choose to realize their gains.

The behavior of validators is also a trend to watch, as some might choose to exit or reallocate with different partners, creating temporary uncertainty.

Liquid staking on the Ethereum blockchain has been singled out as a potential point of conflict for the general Ethereum ecosystem. As liquid staking providers attract more capital, they become a more prominent central point of failure and create new risks for the network. Aside from the counterparty and smart contract risk derived from adding intermediaries with the Beacon Chain, one of the most relevant unwanted consequences is centralization. With such power over staked funds and Proof of Stake validators, Liquid Staking providers can censor many transactions, becoming a de facto single point of failure for censorship resistance.

This debate became mainstream when on-chain sleuths revealed that Lido validators complied with the OFAC’s ban on Tornado Cash. The OFAC (Office of Foreign Assets Control) is the agency in charge of enforcing financial sanctions on behalf of US foreign policy. The OFAC banned US citizens from interacting with the smart contracts of the decentralized protocol Tornado Cash. Lido’s validators reportedly complied with the sanction, extending the OFAC’s censorship over millions of users worldwide and questioning the de facto independence of the Ethereum blockchain.

How to approach the Liquid Staking market

There is no right or wrong way to get exposure to liquid staking on Ethereum. Every choice must be preceded by analyzing the components that make every liquid staking solution different, such as revenue models, token design, validator selection, or governance mechanisms. They all present a variety of options in terms of capital efficiency, and they pose different risks to users and the whole ecosystem. Each investor should decide what their preferred strategy is.

Following, you can find a breakdown of the different components that can take part in evaluating the right way to approach liquid staking.

Service type: the broader categorization for liquid staking service providers is between centralized projects (such as Coinbase) and decentralized protocols (Lido, Rocket Pool, or Frax).
Protocol and token design: every liquid staking provider offers a combination of the following parameters:
Revenue model: revenue distribution among the project, stakers and validators, and the subsequent differences in performance (measured in APR, Annual Percentage Rate).
Token design: how projects design their LST to accrue and distribute revenue
Validator selection: a key concept in the current and potential level of centralization of a protocol
Governance and governance tokens. Decentralized protocols are usually run by token-gated DAOs. Governance tokens have multiple uses and can be a way of getting exposure to liquid staking.
Roadmap. Liquid staking is a very young trend. The most relevant differences between service providers will probably only happen in the future.
DeFi integrations: LSTs’ second life (deployment across DeFi) will probably determine the competition between liquid staking providers.

Types of Liquid Staking service providers

Centralized vs. decentralized

Investors can choose to stake their assets with either centralized or decentralized service providers.

Many centralized exchanges, such as Binance or Kraken, provide access to Ethereum staking. but only a few have moved on to offering liquid staking through LSTs. The most important one, Coinbase, through the launch of their cbETH. Centralized exchanges bring the benefits of easier and safer UXs in exchange for a bigger cut in the staking revenue.

Decentralized liquid staking providers offer the non-custodial, protocol-based version of liquid staking. Investors interact with smart contracts that manage processes automatically and transparently.

Nevertheless, the classification between centralized and decentralized is not as binary as it might look. The degree of centralization in some decentralized protocols has been a matter of debate and concern and a part of the reasons for choosing one provider over another.

Among the top 5 main Liquid staking providers, only Coinbase is a centralized entity. The other four, Lido, Rocket Pool, Frax, and Stakewise (who manage around 97% of the staked ETH), are, to some extent, decentralized. Decentralization is a heated topic of debate, especially since it’s one of Lido’s main weak spots. Lido, with over a 30% market share of all the staked ETH and a 77% market share among LST providers, is a staking behemoth that has become a central point of failure because of its size. Competitors like Rocket Pool have used this to add pressure and build a competing narrative, even though decentralization is a challenge for all providers.

Protocol and token design

Revenue model

Liquid staking providers, first and foremost, offer investors access to validator rewards. They pool funds and distribute them to dedicated validators who share their revenue in exchange for access to funds and lower risks.

Validator nodes have two types of rewards in exchange for participating in the block validation process.

Execution Layer rewards, linked to the order of transactions. Namely, these are priority tips and MEV (Maximum Extractable Value). These rewards were available once The Merge took place. They are liquid rewards, as validators are already receiving the ETH.
Consensus Layer rewards for participating in the PoS process. Ethereum won’t release this newly minted ETH issued to validators until Shapella creates the avenues for it.

MEV is the value validators can extract by reorganizing transactions while validating a block. MEV is created when multiple transactions are trying to be included in the same block, but only a limited number of transactions can fit. In this situation, miners/validators can choose which transactions to include in the block based on maximizing their own benefit.

The revenue distributed through these two types of rewards is variable: execution layer rewards depend on the activity on-chain (more activity means more transaction tips and MEV), and consensus layer rewards depend on the number of validators participating in PoS (more validators means a smaller portion of the Consensus Layer rewards for each validator).

Finally, the different Liquid Staking providers have different ways of redistributing revenue between validators, stakers, and the protocol or company: centralized ones usually take a more significant revenue cut in exchange for the improved UI and security; decentralized options offer higher APRs and different redistribution models with validators. The way protocols reward validators can also take part in the future performance of a protocol, as it might attract more and better node operators.

Ethereum staking is considered a low-yield, low-risk investment (even now that users cannot redeem their staked assets yet). Ethereum distributes a variable yield to validators that have moved in the 5% range.

Liquid Staking Token design

LSTs fall into two categories: rebasing or reward-bearing tokens.

Rebasing tokens adjust their supply to reflect the staking yield. Protocols that issue rebasing tokens re-calculate regularly the total supply of their LST (generally minting new ones) and assign the newly added tokens to stakers based on a weighted average. Rebasing tokens maintain their 1–1 peg to ETH.
Rebasing tokens can add a layer of complexity once they expand to DeFi, as some protocols do not support them. For these cases, liquid staking providers must issue a wrapped derivative compatible with these protocols.
Also, rebasing tokens can generate taxable events that the investors must consider.

Example: Alice stakes 1 ETH in exchange for 1 rbETH (rebased ETH), with a 5% annual yield. After that year, Alice will hold 1.05 rbETH in her wallet, as the protocol has issued more rbETH and assigned the new tokens to Alice proportionately to her stake.

Reward-bearing tokens. Reward-bearing tokens incorporate the yields earned in the price of the liquid staking tokens. Reward-bearing LSTs change in price, as one reward-bearing token represents a portion of an increasing amount of underlying staked ETH.

Example: Alice stakes 1ETH in exchange for 1rwETH (reward-bearing ETH) at a 5% annual yield rate. After a year, Alice will still hold 1rwETH, but the price of that token will have de-pegged from ETH, and she can now trade her 1rwETH for 1.05ETH.

Lido’s stETH, the #1 LST in the market, is the most prominent example of a rebasing token. At the end of every 24h cycle, Lido recalculates the total supply of stETH and distributes it among stakers. This becomes an obstacle in platforms such as Uniswap or 1Inch that don’t allow rebasing tokens to trade; to sort this, Lido also issues wstETH, another tradeable derivative in DeFi protocols.

Tokens like Coinbase’s cbETH or RocketPool’s rETH have chosen reward-bearing tokens, whose value is depegged from ETH.

Frax, on the other hand, uses a dual token design. Investors choose what token they want to obtain in exchange for their stake:

On one hand, frxETH is a simple equivalent of staked ETH that does not accrue value or generate new tokens. Its only purpose is to be used in DeFi protocols, such as Curve, where it is heavily incentivized.
sfrxETH, on the other hand, is a reward-bearing token eligible for Ethereum staking yield, similar to rETH. Since some investors choose to convert their staked ETH into plain frxETH, which doesn’t accrue value, sfrxETH obtains proportionately higher staking rewards.

This allows stakers to choose between earning revenue from either staking or farming: each token is optimized for its strategy.

Validator selection

Validator selection mechanisms are a proxy of the degree of centralization of a project and, therefore, an indicator of regulatory risks: more decentralized protocols are more resistant to law enforcement and regulation, as they are generally off-limits from most jurisdictions. But it is also relevant regarding revenue distribution; a better, more active validator pool will generate and distribute more rewards, improve withdrawal processes, and create a better defense against slashing events.

Different validator selection mechanisms present another critical difference between liquid staking providers:

Permissioned validator selection mechanisms, where validators need to be vetted and approved by the project team or governance body before they are allowed to participate on the network. This provides a higher level of security, as only trusted and reliable validators are allowed to participate. Still, it also centralizes control over the network and limits the number of potential validators.

Permissionless validator selection mechanisms enable anyone to join as a validator on the network without needing approval. This approach provides a more decentralized network with a larger pool of potential validators but also increases the risk of malicious actors participating.

Lido works with a tiny group of 29 validators manually selected by the team. Competitors have highlighted this as a danger for the whole Ethereum ecosystem

Governance, and governance tokens

Decentralized liquid staking providers are generally governed by Decentralized Autonomous Organizations. DAOs can decide on strategies and parameters, such as

Protocol upgrades and deployments in different chains or protocols.
Validator whitelisting and validator selection criteria definition.
Incentive program proposal and approval to increase the market share of a project’s LST.
Protocol roadmap for decisions like the level of commitment to decentralization.

Decentralized liquid staking providers have a governance token separate from the liquid staking token, which is used for community votes but often doubles down as an incentive vehicle. Decentralized protocols can use their governance token to incentivize liquidity in DeFi protocols (lido uses LDO emissions in many DeFi protocols) or to improve revenue models (RocketPool’s validators earn a portion of their rewards in the governance token RPL).

Governance tokens can be used to get exposure to liquid staking solutions and open the door to participation in a project.

DeFi Integrations

The second phase in the lifecycle of LSTs consists of flowing through the DeFi ecosystem. LSTs can be used for lending, trading, or as collateral. This allows ETH stakers to earn extra yield without giving up staking rewards.

The different liquid staking providers compete against each other in DeFi deployment strategies:

Availability on different blockchains.
Availability on different DeFi protocols.
Incentive programs to increase the reach and liquidity of the LST.

Liquid Staking Service Provider Ecosystem

Liquid Staking recently became the second most important DeFi activity by Total Value Locked, surpassing lending.

There are more than a dozen Liquid Staking Token providers. The top 5 leaders are Lido, Coinbase, Rocket Pool, and Frax, representing more than 96% of the LST market share.

Except for Coinbase, the most relevant projects in the LST ecosystem are decentralized. Decentralization has proven to be a strong selling point in the LST ecosystem due to the sensitivity among users to the risks that liquid staking imposes on Ethereum.

Conclusions

Liquid staking will likely become one of the most critical trends in crypto investing in 2023. But uncertainty will reign for the first quarter, maybe the year’s first half. First, the Shapella upgrade needs to finalize successfully before we see staking on Ethereum come full circle. And secondly, we need to see how all the actors (all cohorts of stakers and validators) react to the upgrade in the short term.

Nevertheless, the time is right to consider a strategy to get exposure.

Getting exposure to LSTs should follow a two-phased approach:

First comes identifying the right project for a particular investment strategy, depending on risk tolerance, revenue expectations, operative capacities, or position regarding centralization. Furthermore, evaluating a project’s long-term vision and roadmap in such a changing environment will be equally important since many things will likely happen along the road. Considering how each project may react to a changing environment will be essential.
Second comes devising the second leg of the strategy: where to deploy the LST to increase yield. Again, the strategy must include a combination of current and future perspectives.

But investors can also choose to get exposure to liquid staking by holding utility tokens from these projects, such as FRX, LDO or RPL. Even in the case of Coinbase, liquid staking has the potential to become an alternative source of revenue for the company, in line with their strategy of diversifying from transaction fee collection, and therefore justify exposure to Coinbase stocks.