Liquid Staking Derivatives - Post Shanghai Upgrade
In the complex landscape of decentralized finance (DeFi), the emergence of Liquid Staking Derivatives (LSD) began in earnest following Ethereum’s significant Shanghai upgrade on March 12. This pivotal development set in motion a new LSD trajectory, propelling their path to comprehensive functionality. The recent Shapella upgrade on April 12 has further strengthened this journey, consolidating LSD’s place within the Ethereum infrastructure.
These advancements, however, were not without their challenges. With both upgrades, there was a clear sense of uncertainty among the investment community. Given the novelty of these changes, there were legitimate concerns about the operational efficiency of the staking process and LSD services. Following the Shapella upgrade, the market also grappled with the potential risk of a significant influx of staked Ether (ETH) returning to the market, which could have induced substantial selling pressure on the asset.
Against this backdrop of uncertainty, the Ethereum ecosystem displayed its resilience. Both updates were implemented successfully, and the staking protocol demonstrated its robustness. Contrary to apprehensions, the Shapella upgrade saw minimal requests for unstaking by validators.
The successful execution of these upgrades, combined with an increase in the proportion of staked ETH, has fostered a growing sense of optimism among investors. This positive sentiment has spurred the LSD narrative, driving expectations of robust growth and solid performance in the LSD market as staked ETH volumes continue to rise.
In this article, we take a deeper look at LSDs on the Ethereum blockchain from various perspectives and explain technicalities to provide a thorough insight into LSDs and their:
- Core Elements
- Influence
- Technical Intricacies
- Service Providers
- Infrastructure on Top
- Regulatory Challenges
- Legal Landscape
Understanding Liquid Staking Derivatives — Parallels with Traditional Financial Models
When trying to understand the intricacies of Liquid Staking Derivatives, it can be beneficial to draw comparisons with concepts more familiar to those in the traditional financial sector. A potent analogy can be made with real estate investment, specifically the practice of owning a property and appointing a management company to handle tenancy.
Much like owning a house, the inherent value of Ethereum (ETH) assets is clear. However, to derive revenue, there is a certain degree of maintenance and management involved. An owner could choose to self-manage the property, handling the search for tenants and maintaining the property, similar to operating an ETH node personally. This approach demands a substantial amount of work and constant oversight but ensures the owner enjoys the entirety of the revenue generated.
Alternatively, one might engage a property management company to handle these responsibilities, paralleling the role of an LSD provider. The company, or provider, would deduct a proportion of the generated revenue or levy a flat rate as a fee for their services. Although this arrangement results in a reduction in the owner’s net revenue, it significantly lightens the load of their responsibilities.
The concept of liquidity in real estate investment also translates to the realm of ETH liquid staking. Once a property is managed efficiently and generates consistent revenue, the owner may leverage it as collateral for a loan. This borrowed capital can then be deployed to finance another property or invest in other promising ventures. Similarly, once ETH is staked and yielding returns, users receive staked ETH (stETH) or a comparable derivative, based on the specific protocol. This derivative can be further invested, providing liquidity or used as collateral for a loan.
Finally, just as property management companies operate to ensure revenue exceeds their costs, LSD providers adopt a similar business model. This long-term revenue surplus creates enticing investment opportunities, as these entities are likely to sustain their profitability over time. In summary, the understanding of LSDs can be enhanced by viewing them through the lens of traditional financial models, thereby bridging the gap between these seemingly disparate financial landscapes.
The Broader Perspective — The Establishment and Influence of LSD in the Crypto and Traditional Financial Worlds
The transformative shift to Ethereum 2.0 has fueled a robust narrative around Liquid Staking Derivatives within the cryptocurrency world and beyond. A key term within this discourse has been “ultra-sound money”, a concept that has bolstered the LSD narrative. The opportunity to secure a steady annual percentage yield (APY) by contributing to network security, in a setting where the supply of Ether (ETH) is continually diminishing, presents an enticing prospect for any investor.
This enticing prospect has not gone unnoticed by institutional investors, whose interest in this emerging opportunity is keen. They, too, have recognized the potential inherent in a diminishing supply coupled with steady returns, leading to a steady influx of institutional capital into the Ethereum ecosystem. This institutional involvement has significantly amplified the LSD narrative, attracting even those investors with holdings smaller than the 32 ETH usually required for staking. The result has been a growing demand for a share in the opportunities provided by LSD, regardless of the size of the stake.
One of the most compelling aspects of LSD protocols is the unique value proposition they offer to investors. These protocols allow investors to put their capital to work with minimal effort, whilst the process for further utilising the capital carries little to no additional risk. This ease of capital deployment, combined with the low-risk profile, provides an attractive package for both cryptocurrency enthusiasts and traditional financial sector participants alike.
In essence, the broader narrative of LSD has been characterized by growing interest from various sectors, increased institutional involvement, and the promise of solid returns. These developments are playing a pivotal role in firmly establishing LSD within both the crypto and traditional financial landscapes.
Unravelling the Technical Intricacies — The Emergence of LSD Providers Following the Move to Proof of Stake
When diving into the technical aspects of Ethereum staking, it becomes clear that individual staking has some considerable thresholds investors must pass to take part. These include both the technical acumen required to operate a node and the substantial capital investment required — approximately $58,000 at the time of writing — for purchasing the necessary 32 ETH. These barriers potentially exclude a broad range of interested participants, providing a clear opportunity for Liquid Staking Derivatives protocols to fill this gap. These protocols enable users to stake any amount of ETH, regardless of the size of their holdings, and without the need for extensive technical knowledge.
However, what truly sets LSD protocols apart and makes them a compelling alternative is the ‘Liquid’ feature embedded in their staking programmes. Unlike setting up an individual node, where the invested 32 ETH becomes illiquid until the user decides to unstake, LSD protocols provide an elegant solution. Upon staking, users receive staked ETH (stETH) or a similar derivative, depending on the specific protocol. This derivative can then be further deployed, for example, in a liquidity pool or as collateral for a loan.
This process keeps the capital within the system, ensuring liquidity and allowing users to continue to utilize their capital while simultaneously contributing to network security. In effect, LSD protocols offer users the ability to have their proverbial cake and eat it too — they can participate fully in the Ethereum ecosystem without tying up their capital, maintaining the flexibility they need to optimize their investments.
LSD Service Providers — The Big Three and More
Given the considerable barriers to becoming an Ethereum validator, several projects have emerged to bridge this gap while simultaneously leveraging the profit potential inherent in the staking mechanism. Prominent among these are Lido, Rocket Pool, and Frax Finance, with Lido currently staking around 30% of all ETH.
While each of these service providers has its unique characteristics, they share a common approach. Essentially, they take on the responsibility of staking your ETH, relieving you of the complexity and effort involved in setting up a node individually. In return, they retain a minor percentage of the ETH generated.
Lido utilizes staked ETH (stETH), a transferable rebasing utility token representing an individual’s share of the total ETH staked through the Lido protocol. The protocol’s total stake comprises user deposits and staking rewards. As stETH re-bases daily, it provides a transparent reflection of the user’s share position daily.
Rocket Pool, on the other hand, employs Rocket Pool ETH (rETH), which represents both the quantity of ETH deposited and the timestamp of the deposit. This ratio incorporates the rewards earned by Rocket Pool node operators, leading to a steady increase in the relative value of rETH compared to ETH.
Frax Finance, along with the Ankr protocol, also makes use of this indexed token mechanism.
Stakewise separates sETH and its yield into two different tokens, the accrued r(eward)ETH can be managed and spent separately while the sETH remains in the contract.
Other Providers, such as SharedStake and Ether Finance, use mechanisms similar to the big players in the LSD ecosystem.
Aside from these decentralized protocols, significant exchanges such as Coinbase and Binance offer LSD services to their customers through their respective platforms, as do many other major Centralized Exchanges (CEXs).
For a comprehensive overview of all LSD providers, one can refer to a variety of resources available online (such as DefiLlama) which offer detailed insights into the growing LSD marketplace.
The Role of Infrastructure on Top of Single LSD Providers (LSDfi)
As the Liquid Staking Derivatives narrative regains momentum, and the annual percentage yield (APY) for Ethereum staking surges to an impressive 9%, the appeal of ETH staking is as potent as ever. However, it’s crucial to keep in mind that participating in these protocols comes with its own set of risks. For instance, the peg of stETH tokens isn’t guaranteed to hold, and contract risks are ever-present in the cryptocurrency space. In the end, staking ETH is one of many investment strategies one can choose. Given the mentioned potential pitfalls, a strategy to diversify ETH holdings across several LSD protocols can be a prudent approach.
Overall, LSD protocols have given birth to a completely new category, LSDfi; protocols built on top of LSD providers, leveraging the yield and liquidity provided in various manners and giving end users various opportunities to further use their staked ETH:
Lending: Old as well as new LSD-specified lending protocols have emerged enabling users to redeem their staked ETH for stablecoins which in turn then can be used to generate even more yield. The twist is that, due to the yield-bearing nature of sETH, the loans have 0% interest, with some protocols even enabling self-repayment of the loan itself.
Leverage: Lending always comes with leverage. Even though, as of now, no protocol is officially offering this service and users still have to leverage up manually, it is very likely to emerge at some point. The stablecoins lent out against the sETH can be swapped for more ETH which is then also staked and creates even more yield. By looping through this process several times yield is increased significantly, but so is the risk.
Separation: As sETH is yield-bearing, its yield and actual value can be separated into different tokens, resulting in even more options for users. As ETH is ‘guaranteed’ to generate yield in the future, users can get their future yield paid upfront by simply locking their ETH for a specified amount of time.
Baskets: The number of LSD providers is numerous already which opens the opportunity for other protocols to aggregate them.
This is where solutions like Spool come into play. Currently offering diversified and risk-adjusted DeFi solutions via stablecoin yield farming, Spool is about to release a permissionless toolbox that includes volatile asset strategies and, particularly, the ability to combine single LSD strategies into one easy to use vehicle. With this service, users can select their preferred LSD provider strategies and create a customized Spool “Smart Vault”, optimizing the risk-to-return ratio according to their individual risk preferences. On the institutional level, this opportunity gives institutional clients access to the whole world of digital asset strategies out of one hand through Spool’s safe and compliant middleware offering without any further maintenance costs, building on top of the Ethereum network. One great example for this is StakingRewards who are utilizing the given infrastructure by Spool to offer their own white labeled product.
Getting the technology right and secure is not an easy task and, so far, not many solutions that combine LSD strategies are known. Besides Spool’s solution, another comparable endeavor of creating an ETH staking index was announced from CoinDesk and CoinFund but what that exactly entails and how it might work is yet to be seen.
The world of liquid staking derivatives is a thrilling technological frontier with a multitude of possibilities. Despite the potential risks and the current regulatory uncertainties, the growth trajectory and the ongoing institutional interest in this space do suggest that it will continue to be a crucial part of the wider cryptocurrency ecosystem. Will LSDFI be the next big thing?
Institutional Interest and Future Sentiment in Light of Regulatory Challenges
With recent regulatory pressures from the U.S. Securities and Exchange Commission (SEC) bearing down on entities such as Binance and Coinbase exchange and market makers like Jump Trading, the immediate future outlook for Liquid Staking Derivatives and Ethereum staking is somewhat clouded. It is a common sentiment that such regulatory uncertainties have a damping effect on the institutional interest in the sector, especially within the U.S.
Simultaneously, Blackrock is filing for a Bitcoin ETF which shows the interest in crypto has reached even the highest level institutions. It is important to note that the crypto landscape is global, and the impact in one region doesn’t necessarily translate into a global downtrend. While the U.S. market may be facing regulatory headwinds, other regions are largely unaffected and they are more likely to absorb and capitalize on the market share left vacant in the U.S. The interest in ETH staking remains robust on a global scale, despite these regulatory challenges.
It is essential to acknowledge that the SEC, among other regulatory institutions, plays a gatekeeping role. This position may deter potentially interested institutional parties from entering the crypto-staking realm and participating in LSD protocols. However, the space is evolving rapidly, and a long-term view may yield a more optimistic outlook. As regulatory landscapes develop and mature alongside these innovative technologies, it is conceivable that the gate may open wider for institutional participation in the future.
Legal Landscape — Existing Provisions and Future Implications for Stakers
As with all cryptocurrency-related activities, the regulatory environment varies greatly from jurisdiction to jurisdiction, and at times it can seem rather nebulous. Thus, the choice between operating an individual node or utilizing Liquid Staking Derivatives services could have significant implications in terms of regulatory exposure.
LSD services could be considered a financial service utilizing unregulated securities. This becomes even more complex when taking into account the annual percentage yield (APY) that is generated. In most jurisdictions, solo staking is, at least on a surface level, viewed differently from LSD services. This is based on the understanding that the underlying purpose of the activity is to support the wider ecosystem through participation, although many jurisdictions argue that the benefit of yield is a convincing factor in them being defined as securities. LSD services provide a clear difference of purpose from a market perspective. Therefore, they are much easier to define as securities and would be treated as such.
The situation in Europe tends to be less stringent and less based on the criteria presented by the ‘Howie Test’ in the US, especially with the rollout of initiatives like the Markets in Crypto-assets (MiCA) regulations and its successor programmes. As a result, LSDs are likely to face fewer regulatory hurdles in these regions.
Whilst the rollout of initiatives like MiCA provides some clarity, it remains to be seen whether regulators choose to take into account nuances present in individual protocols or an individual’s level of control and choice when interacting with a given asset. It should be noted that, even for derivative products whose underlying assets are virtual, the Market Abuse Regulations apply.
Taxes have to be taken into consideration as well:
“Using an LSD protocol might in some jurisdictions be regarded similar to carrying out a taxable exchange, leading to capital gains taxes.”
– Niklas Schmidt from Wolf Theiss.
“A common-sense approach should be taken with regards to any decision to offer, or to invest in, any yield-producing product, whether as principal or agent. As crypto investments find themselves further understood by regulators, so too will they find themselves subject to regulatory requirements akin to those covering traditional financial products. We are some way off from a comprehensive and bespoke approach towards viewing virtual asset derivatives and LSD protocols as a fully separate and unique financial instrument, or even asset class, with specific qualities. As a rule of thumb, market participants should take the same sophisticated approach towards complex virtual assets as they would towards complex fixed-income products, as it is highly unlikely that, in the long run, any real leeway would be afforded to virtual assets over and above traditional financial products.”
– Ali Khan from AS Legal.
It follows a more detailed view of potential tax considerations of stETH / wstETH (Lido) in Switzerland:
“The conversion of ETH into stETH, as well as the potential wrapping into wstETH, should not trigger any taxes.
During the holding period, an inflow of additional stETH would likely constitute taxable staking income (similar to a direct staking of ETH). In case of wstETH, there is no inflow of additional token during the holding. Instead, the wstETH should gain in value as in principle the staking income is retained within the Lido smart contract. The “wrapper” used is, however, in the case of Lido not set up in the form of an opaque legal entity, but a smart contract. This in my view should lead to a similar tax treatment on investor level like an investment via a transparent vehicle. In case a Swiss resident individual e.g. invests into an accumulating investment fund on a contractual basis (transparent from a Swiss tax perspective), the passive income generated by the fund would upon realization and accumulation in the fund be deemed (pro rate) taxable income in the hands of the investor. An exemption would only apply for capital gains, which would upon their realization and accumulation in the fund could also be deemed a tax-free capital gain in the hands of the investor (we understand, however, that this is not applicable in the case of Lido). From my perspective, wstETH should accordingly be treated from an income tax perspective in the same way as stETH. The (indirectly received) staking income would in my view likely constitute taxable income in the hands of the investor once the respective income is realized respectively accrued on Lido. I.e. taxation in my view should also in case of wstETH already happen prior to the unwrapping (and also independent of the development in value of the ETH). It shocombineuld be reviewed further whether and to what extent Lido provides respective tools to track the respective pro rate income.
Subsequent to an unwrapping (and potential conversion back of stETH into ETH), an investor could dispose again over the ETH fed initially into the smart contract as well as the additional ETH received (indirectly) via staking and potentially sell it. With the sale, it could in general realize a tax-free capital gain or non-deductible loss (depending on the development in value of the ETH fed into the smart contract and since received (indirectly) as staking reward).
Similarly, a direct sale of stETH / wstETH should in general lead to a tax-free capital gain (to the extent ETH as underlying token has increased in value and there is an excess in value at time of sale over the already taxed staking income, as outlined above) or non-deductible loss. Staking income from deploying stETH / wstETH in a DeFi protocol in general would lead to additional taxable income.
As a preliminary conclusion, an investment in stETH and / or wstETH via Lido in general in my view includes components of a potential tax-free capital gain (i.e. the realization of a value increase of the underlying token in the form of ETH) or non-deductible loss and taxable income (i.e. in the form of the „indirect“ staking income). It would need to be assessed further, how these components could be tracked in the case of Lido.”
– Cyrill Diefenbacher from Bär & Karrer.
None of these comments constitutes any legal advice and are personal views only.
It’s important to note that the legal guidelines surrounding crypto-assets and staking services are still in a state of flux, with countries and regions evolving their approach as the technology and use cases develop. Looking to the future, it’s plausible that governance issues might arise, particularly if there’s an unequal distribution of ETH among stakers. In addition, regulatory arbitrage between different jurisdictions, whilst potentially presenting opportunities, may serve to obfuscate the rationale behind regulatory decisions. All of these factors combine to make the legal landscape an important consideration for any potential stakers.
The Dawn of a New Era — Embracing the Potential of Liquid Staking Derivatives
The shift to Proof-of-Stake and the subsequent introduction of Liquid Staking Derivatives protocols have ushered in a transformative phase for the Ethereum network. No longer is Ethereum merely an infrastructure layer operated by a select group of experienced developers and organizations. It has evolved into an inclusive platform where every investor, regardless of the size of their capital, can participate and benefit from its services.
LSDs are an exciting emerging technology with a multitude of possibilities. They democratize staking by lowering the barrier to entry, plus introduce unprecedented liquidity to staked assets. By fostering inclusivity and liquidity, LSD protocols have the potential to redefine the landscape of the Ethereum ecosystem and beyond.
However, as with any nascent technology, LSD solutions are not without their challenges. These include regulatory complexity, technological risks, and evolving market dynamics. But with every challenge comes an opportunity for innovation and adaptation. As we move forward, it will be interesting to watch how these protocols navigate these challenges and continue to push the boundaries of what is possible in the world of cryptocurrency staking.
The Ethereum network has once again demonstrated its capacity for innovation and transformation. As it continues to evolve and mature, it offers a wide range of opportunities for both developers and investors alike. By embracing these changes, and most importantly, by participating in them, we can all play a part in shaping the future of this dynamic network.
