A Dive into ETH Liquid Staking, Node Operators, Shanghai, Future Innovations, and DVT

cpt n3mo
Hashed Team Blog
Published in
11 min readApr 11, 2023

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Disclosure: Hashed has established, maintained, and enforced strict internal policies and procedures designed to identify and effectively manage conflicts of interest related to its investment activities. This content is provided for informational purposes only, and should not be relied upon as legal, business, investment, or tax advice. Furthermore, references to any securities or digital assets are for illustrative purposes only and do not constitute an investment recommendation or offer to provide investment advisory services.

Background

  • Ethereum successfully transitioned from Proof-of-Work (PoW) to Proof-of-Stake (PoS) in Sep 2022
  • This introduced a new consensus mechanism to the blockchain, where ETH holders can choose to stake (”lock”) their tokens in order to process transactions, create new blocks, and provide security for the network
  • In exchange for staking their tokens as collateral, stakers are compensated with block rewards from the network and fees paid by users of the chain

There are three ways to earn these rewards & fees:

  1. Run your own validator node — but this is less common due to the technical complexity involved and relatively high minimum capital requirement (32 ETH to run a node)
  2. Engage in centralised staking pools / staking-as-a-service providers — but this comes with centralisation risks and lack of self-custody of your assets
  3. Engage in liquid staking protocols — this allows users to stake their tokens with professional validators in exchange for a % fee cut from a portion of the yield earned

Early days: Centralised / Third-party staking

The staking of network tokens in PoS blockchains is not a new concept to most people in crypto. The first iteration of regular staking came from notable players like Binance and Coinbase, where they offer centralised ETH staking pools for their customers. Users can stake with as little as 0.01 ETH, lowering the monetary barrier to entry.

Centralised platforms would aggregate ETH deposits from various users and allocate the tokens to third-party node operators and validators. The staking rewards earned are then shared on a pro-rata basis with depositors, after a certain fee cut from the service provider.

There are also non-liquid staking-as-service providers like DSRV, Blockdaemon and Figment who tend to service instituational clients with idle assets that do not have the capacity to run their own node operations.

However, when participating in a centralised staking pool or outsouring to third-party providers, the staked assets cannot be easily moved.

ETH deposited directly to the staking contract remains locked up until the “Shanghai Upgrade”, which will then allow ETH withdrawals and accrued rewards from the deposit contract. The launch is targeted for April 2023.

Capital inefficiency is a key concern with staking pools, as assets are locked up in smart contracts and cannot be used for other purposes such as collateral for loans or urgent liquidity when needed.

Emergence of Liquid Staking

Liquid staking: A mechanism designed to give stakers a transferrable, yield-bearing representation of their deposited asset.

The beauty of liquid staking is that it gives users additional composability with their staked tokens (e.g. collateral for loans on a money market or earning yield on fees on liquidity pools) and the option to immediately monetise them in available trading markets if need be.

The concept of liquid staking derivatives has been around since Dec 2020, when Lido launched its liquid staking feature for the Ethereum blockchain. Since then, multiple other protocols were built to capitalise on this vertical.

To date, a total of 18,208,633Ξ has been staked on Ethereum’s Beacon Chain Deposit contract. This only makes up ~15% of ETH’s total supply.

Of that ~18.2M ETH staked, liquid staking protocols capture ~33%.

This is significant growth and proven traction of liquid staking derivatives, as back in Dec 2020, when Lido first launched, their market share was only 3.4% (75k out of 2.2M ETH staked).

Current Liquid Staking Derivatives (LSD) landscape

Most liquid staking protocols have a unique staking derivative to represent the underlying ETH asset, but more importantly a different native token that accrues value and/or controls governance for the protocol. They also have different fee and commission structures which will be discussed below.

Lido holds a sizeable market share as the dominant decentralised liquid staking protocol, controlling >31% of total staked ETH, while the leading centralised player is Coinbase, controlling >12%.

Coinbase stakers are subject to centralisation risks and custody on exchanges, but remain popular due to its reputable branding. The next largest LSD player is Rocket Pool, while other protocols like Frax and StakeWise are gradually gaining traction.

Source: Dune (@hildobby), Delphi, Protocol Docs

4 types of LSD tokens

Originally categorised by Delphi Research, these four types of LSD tokens are not exhaustive, though they should cover majority of token mechanics in the current market. Refer to the visual aid below for a clearer representation.

Rebasing

  • Rebasing tokens have an elastic total supply that increases or decreases on its own, automatically without any transactions taking place
  • In the case of Lido, stETH balances change daily to reflect ETH staking rewards and any changes in Beacon Chain contract deposits

Reward-bearing

  • Reward-bearing tokens increase their underlying value over time as rewards accrue (redemption value in the future is more than its value today)
  • For example, Rocket Pool’s rETH represents the tokenised staking deposit and rewards it gains over time, i.e. 1 rETH in the future is worth more than 1 rETH today because of all staking rewards accrued

Base + Reward-bearing

  • This is a model where the protocol has two kinds of staking derivatives — the Base token which represents the underlying ETH on a 1:1 basis and the Reward-bearing token that accrues yield over time
  • Frax employs this unique model with frxETH (Base) and sfrxETH (Reward-bearing)
  • frxETH does not earn staking yields, whereas sfrxETH earns all yields from staking
  • Splitting the base and yield token provides interesting opportunities:
  • Because the base frxETH token is designed to maintain parity with ETH, they have a frxETH-ETH liquidity pool on Curve
  • If users choose to hold frxETH and provide liquidity to it, they can earn liquidity incentives from the DEX
  • This is unique to Frax because they own a large amount of CVX which can be used to direct CRV emissions to their own pool
  • For sfrxETH holders, they earn all the remaining yield from frxETH that is not staked, giving sfrxETH higher yields than other LSD token on the market

Base + Reward

  • This is a simple model where users make an ETH deposit, and the protocol issues a Base token that represent their deposited ETH at always a 1:1 ratio
  • Any rewards earned are then rewarded in a separate Reward token, net off commissions
  • This allows protocols like StakeWise to segment a user’s principal token and associated rewards, both of which are worth 1:1 with ETH staked and earned on the Beacon Chain respectively
  • Because there is no rebasing or reward-bearing aspect involved, this mitigates any chance of impermanent loss when providing liquidity in DEXs.

Commission structure and token utility

LSD protocols employ a straightforward business model where they take a commission fee from the staking yield earned when users deposit ETH through them. See the table below for a comparison of fees and where they are directed to.

The most typical commission fee is 10%, which is what Lido, Frax, StakeWise and Ankr charges. Rocketpool charges 15% while Coinbase is the highest at 25%.

Although Coinbase charges a high fee, it still receives a substantial amount of attention (12% of total staked ETH — 2nd largest player) due to its ease of onboarding and reputation as a trusted CEX. Other decentralised players, especially newer players, have to charge the market rate between 10–15%.

The fees collected are then distributed to validators (as they need to be compensated for their expertise in running technical operations) and the protocol’s treasury.

In only Frax’s case, there is fee-sharing with $FXS token holders. ETH staking rewards earned by treasury is converted to frxETH, then distrubted to holders on a pro-rated basis.

For the other protocols’ token holders (e.g. $LDO, $RPL, $SWISE), their main utility is to vote on protocol parameters and treasury governance. These include decisions surrounding:

  • How to grow the protocol’s insurance fund
  • Grants, salaries and operational expenses (e.g. marketing, legal, etc.)
  • Distribution of protocol fees
  • Use of native token for liquidity mining events

Node operators

Context:

  • Ethereum nodes are needed in order for the Ethereum blockchain to work.
  • Since new software versions are often released (new features, bug fixes, security enhancements), node operators must stay up to date with developments to understand the status and requirements of the blockchains they support.
  • Nodes need to have enough RAM, disk space, bandwidth, etc. to stay operational and serve the network.
  • LSD protocols need to onboard node operators to run staking infrastructure on their behalf to help depositors earn yield on their staked ETH. In return, they earn a share of staking rewards.

One big difference between these liquid staking protocols is in the way they select node operators.

Some protocols only allow verified (whitelisted) node operators while others allow independent (permissionless) entry, or a mix of both.

The diagram below shows the landscape of node operator management by the largest LSD protocols. The degree of decentralisation refers to the accessibility of being onboarded as a node operator, not with regards to user interaction from a staker’s perspective.

Rocket Pool is the most decentralised and has the largest number of node operators (>1,900). Instead of relying on the node operator’s reputation, the protocol allows permissionless entry into the validator set and encourages operators to secure their stake through economic incentives.

StakeWise is also similar in that any individual or institution can run nodes through the protocol. However, their V3 is still in testnet stages and so have onboarded fewer operators than Rocket Pool.

This level of decentralisation leads to wider participation in the validation process, although the quality and professionalism per node operator is less verified than a permissioned system.

The onboarding process for Lido, Swell and Ankr are similar. Operator slots are periodically opened and facilitated by an internal committee (e.g. For Lido, they have “LNOSG” — Lido Node Operator Subgovernance Group), and candidates are invited to apply when applications open. These submissions are then evaluated by the committee, and approved for addition to the operator set by the DAO (token holders) through governance snapshot voting.

Frax and Coinbase are the most centralised and all validators are run by a core in-house team.

This comes with inherent centralisation risks, but the advantage of having a structured and permissioned process is that performance is typically of higher quality — robust and resilient downtime to provide underlying asset holders competitive returns against other LSD protocols.

Shanghai upgrade & Innovations to watch out for

Since the Beacon Chain launched in Dec 2020, staking of ETH assets has been a one-way affair where funds get locked in the deposit contract while Ethereum developers build out the POS chain.

The Shanghai upgrade is a major improvement to the Ethereum blockchain, where its major change involves giving stakers the ability to instantaneously withdraw their staked coins and accrued rewards on a 1:1 basis. This is planned for April 2023.

The impact of Shanghai should spur more innovation within the liquid staking scene, and develop certain layers above these protocols.

  1. Yield aggregators — the ability to stake, withdraw and restake ETH rewards with higher frequency and accessibility should encourage a financial layer above these protocols that help users maximise yield.
  2. LSD aggregator — the current LSD space is highly fragmented, with each protocol having a different LSD token type design. The different models prevent adoption of underlying LSD tokens as functional assets in DeFi services (e.g. Aave having to create separate vaults for each LSD token). Aggregating LSD liquidity to simplify liquid staking for retail stakers, institutions and DeFi protocols would be meaningful for the entire ecosystem. (e.g. Ion Protocol)
  1. Underlying LSD token integrations — Whether it be stETH, frxETH or rETH, these staking derivatives are expected to see better utility and composability as LSD protocols compete for ETH liquidity with centralised players and third-party node operators. (E.g. integration with lending markets or DEX pools to incentivise greater usage of the underlying LSD)

Distributed Validator Technology (DVT)

DVT is one of the core components in the official ETH 2.0 roadmap — introduced by the Ethereum Foundation and shared by Vitalik — to improve 3 core principles of the network:

  1. Decentralisation
  2. Fault tolerance
  3. Security

Understanding current staking infrastructure:

  • Multiple validator keys (public & private) allows the controller to sign and earn rewards
  • Put all keys into a software called a validator client, which is connected to a Beacon Node
  • Together, they execute duties to validate the network and earn ETH rewards
Source: SSV Network

Problems:

  • Keys must be online 24/7 all-the-time >> which is expensive and presents cybersecurity risks
  • Each validator client can only run a unique set of keys or they will get slashed >> no backup if one client was to go down
  • Infrastructure is heavily centralised in nature

DVT provides an infrastructure for splitting a validator key into multiple KeyShares stored in a multi-sig construct, and the keys created are securely distributed between independent nodes.

All nodes are non-trusting and independent — different countries, data centers, tech stacks, etc.

Source: SSV Network

On a high-level… How it works:

  • A new duty for a validator comes in, i.e. a responsibility that they must complete within the Beacon Chain
  • One of the nodes initiates the duty and offers the other nodes to “sign”
  • Verify if it is valid? Slashable? >> If no…
  • Each one signs with their own KeyShare, construct a signature altogether and send to the Beacon Chain
Source: SSV Network

Benefits:

  • Fault tolerance — this consensus protocol ensures that if one node gets compromised / goes offline, others continue to work seamlessly and earn rewards (no single point of failure that poses systemic risk to the network)
  • Slashing risks are mitigated — since each node must independently review & sign each duty, malfunctions from a single node are negligible
  • Validator keys are offline — only the multi-sig keys are kept online; main keys in cold storage

DVT decentralises Ethereum’s security layer without compromising validator performance.

Conclusion

If any of the above innovations resonate with you, please reach out to us! We are excited about the future of Ethereum and would love to journey alongside you to further your initiatives.

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cpt n3mo
Hashed Team Blog

VC | Investment | Research @ Hashed; Articles are my personal views and not financial advice. @cptn3mox on Twitter