Deep Dive: Rocket Pool
Co-authored by: Kai Xuan, Megan Aw & Reuben Yang
Nothing following this constitutes financial advice — if construed otherwise, NGMI.
All data presented henceforth are accurate as of 26 October 2022.
Introduction
Macro Overview
Bitcoin and the digital asset ecosystem have become increasingly correlated with the equities market, performing like a risk-off asset amid the current macroeconomic conditions.
The increase in interest rate by the federal reserve to fend off rising inflation rates has resulted in a dip across all asset classes, with Bitcoin returning to levels not seen since late 2020.
The total market capitalization of crypto assets has been on a decline since it peaked in Nov 2021, falling from the high of US$3T to US$870B as of Oct 2022, representing a 71% downturn.
It is important to note that a continued macro downtrend may negatively impact the performance of RPL and therefore it should be taken into consideration in the analysis of this project.
DeFi Overview
The DeFi sector has not been spared in the overall downturn of crypto assets. The DeFi market capitalization fell from its peak of US$200B in Nov 2021 to US$40B in Oct 2022, representing an 80% contraction.
Despite the wipe-out, the present sentiment leans towards “value” buys, with certain sectors showing signs of strength and continued growth.
Yield Farming Overview
Aligning with the current risk-off sentiment, the present narrative is to look for a safe haven to generate passive income. Yield farming and staking protocols possess elements to thrive in this economic climate due to the lower risk these protocols present while simultaneously allowing passive yield generation.
Today, the market capitalization for Proof-of-Stake (PoS) blockchains stands at US$249.1B generating over US$8B in annual revenue from their locked holdings and JP Morgan analysts predict that staking returns from securing PoS blockchains will rise to US$40B by 2025.
The number of ETH deposited in the Beacon Chain has been increasing steadily, signalling strength in this segment. This continued growth is a positive sign should Rocket Pool be able to capture some of that increase.
At the time of writing, the market capitalization of the Ethereum network sits at roughly US$157B — approximately 12% of all ETH in circulation is staked and liquid staking pools account for approximately 33% of that figure. In fact, in Q3 2022, out of all the DeFi primitives, liquid staking had a whopping 271.70% Q-o-Q change, signalling that large capital inflows into liquid staking pools have already begun.
Problems
Liquidity
Staking in the Beacon Chain is not without its own set of issues. Chiefly, staking in Ethereum itself is not accessible to most and even if you had 32 ETH to spare, your stake and the rewards accrued can only be withdrawn after the Shanghai update that is slated to happen anywhere from half to a year post-Merge.
“Long illiquidity windows remain a contentious point with many ETH holders who want to participate in early staking. […] representation of tokenized staking positions that provide a degree of liquidity without compromising ownership present a valuable market opportunity to drive better adoption” — Mara Schmiedt, The Internet Bond (August, 2020)
This begs the question: where else can I stake my ETH? There are several options (pictured below in Fig 1.5) — one of which is liquid staking. Liquid staking, as the name suggests, resolves the liquidity issues of staking in Ethereum 2.0.
(De)centralisation
Decentralisation is one of the core tenets of blockchain technology. Decentralisation is related to the minimum Nakamoto coefficient metric which reflects the minimum number of entities that can disrupt the entire blockchain. As the coefficient decreases, the network gets less decentralised and the risk of attacks, such as the 51% attack, increases.
In the context of the Ethereum network, the way the Ethereum attestation system is designed results in a situation where if a single entity controls more than ⅔ of the total number of validators, it can decide which transactions are processed.
For such a situation to occur, that single entity would require
( ⅔ • N • 32) ETH
where N represents the total number of validators (447,496 at the time of writing)
This represents a very large amount of ETH (9,594,314ETH) and a single entity holding that much ETH would be incentivized against disrupting the network. However, the risk arises where this single entity constitutes a single point of failure for the network — if that single entity is attacked, it could potentially mean halting the entire Ethereum network.
Liquid Staking (Lido)
Currently, roughly 15.1M ETH is staked and Lido Finance contributes ~4.3M ETH — approximately 28.4% of all staked ETH. To contextualise it further, of all the ETH staked in liquid staking pools, Lido represents roughly 70% of that figure. As a result, many have raised concerns regarding how potentially monopolistic Lido is — and, as mathematically represented above, their fears are not unfounded.
CEX Staking
As for CEX staking, otherwise known as custodial staking, the current number of ETH staked in CEX pools represent roughly 29% of all staked ETH. Apart from the issues pertaining to attack vectors stated above, staking in CEX pools adds another layer of complexity to the equation.
Custodial staking entails giving up both your public and private keys to the custodian (which, as the picture above illustrates, is undesirable). In other words, custodial staking requires the individual to trust that the custodian will secure your assets and will not act in a way that jeopardises your activity.
The issues surrounding custodial staking is as enunciated by Ethereum: “The trade-off here is that centralised providers consolidate large pools of ETH to run large numbers of validators. This can be dangerous for the network and its users as it creates a large, centralised target and point of failure, making the network more vulnerable to attack or bugs.”
Solutions
Liquidity
Liquid staking derivatives (LSD) protocols allow participants to access liquidity that would otherwise be impossible in traditional staking methods. In exchange for the asset staked, you receive an LSD token, which is a derivative of the asset staked, of similar value to the amount staked.
This LSD token can in turn be used to participate in other DeFi protocols through yield farming, LPs, loans etc. As a result, through liquid staking, you can earn both the passive income from the stake and the potential rewards from participation in DeFi protocols — talk about best of both worlds.
Against the backdrop of the criticisms pertaining to environmental harm arising from Proof-of-Work blockchains and the push for green finance, we believe that we will witness greater capital inflow to greener alternatives such as Ethereum 2.0.
Additionally, liquid staking, as a market, is continually growing both in value locked (see Fig 1.7) and in technology and the two share a synergistic relationship. For the reasons stated above, we believe that the entire staking market, and consequently, liquid staking, will enjoy the benefits of such a growth as envisaged by JP Morgan.
Decentralisation
As expressed by Ethereum themselves, solo staking is the “gold standard for staking. It provides full participation rewards, improves the decentralisation of the network, and never requires trusting anyone else with your funds.”
Solo staking refers to running a node on the Ethereum network and staking 32ETH to activate a validator in order to participate directly in network consensus. A solo staker is responsible for the operability of the hardware required to run the node and all rewards/penalties are borne directly by the solo staker. In that regard, solo stakers get to earn the full block rewards in the usual case and such block rewards are often rather attractive.
While solutions to centralization do not flow naturally and directly from liquid staking itself, Rocket Pool does have in place certain features that allow it to be the first truly trustless and permissionless liquid staking protocol.
To be a node operator on Rocket Pool, a minimum stake of 16ETH is required as opposed to the minimum requirement of 32ETH on Ethereum. This lowers the barrier to entry for participants who wish to be node operators, thus facilitating the inclusion of a greater number of participants. A greater number of node operators helps to better secure the Ethereum network because of a higher degree of redundancy and as Ethereum themselves expressed, “solo staking is the most impactful way to stake”.
Protocol Overview: Rocket Pool
Rocket Pool is a liquid staking protocol that was designed to be community owned, decentralised, trustless and compatible with staking in Ethereum 2.0.
The core ethos of Rocket Pool aligns very much with that of Ethereum and DeFi, specifically the non-custodial, trustless nature that allows for self-sovereignty to truly thrive.
First conceived in 2016 by David Rugendyke (Founder, CTO), Rocket Pool has been in the works for 5 years, in preparation for Ethereum 2.0 staking.
The team behind Rocket Pool adopts a long-term mindset and this is evidenced through the patience the team has had over the past 4 years in developing and beta-testing this key primitive. Rocket Pool had 5 successful public betas before going live on 9 November 2021.
Rocket Pool’s Products
Rocket Pool aims to serve two groups of users:
- Those that wish to simply stake ETH (liquid staking)
- Those that wish to operate nodes (solo staking)
Crucially, Rocket Pool lowers the barrier to entry across both groups: for the first group of users, the minimum stake is a mere 0.01 ETH and for the second group, the minimum stake to run a node is 16 ETH.
Below, Fig 1.9 visually represents a 6-months comparison of growth of Rocket Pool’s network stats.
Stakers
For the first group of users, participants can stake a minimum of 0.01 ETH and get an equivalent amount of rETH in return. rETH can be exchanged back for ETH at any time (hence liquid staking), so long as Rocket Pool’s deposit pool has enough ETH to match the withdrawal amount. The ETH in the deposit pool comes from:
- Other Rocket Pool stakers; and
- ETH that was returned by a node operator after they exit one of their validators.
In a situation where there is not enough ETH in the deposit pool to match the withdrawal amount, users can still trade rETH for ETH on DEXes that support the rETH/ETH pair, albeit at a premium. One reason why the deposit pool would not have enough ETH to match the withdrawal amount is that all pending MiniPools get priority to the ETH in the deposit pool. As such, if the number of ETH required by these pending MiniPools is large enough to drain out the deposit pool, there would not be enough ETH to match the withdrawals.
rETH, an ERC-20 token, is Rocket Pool’s LSD token that is multichain and can operate on L2s such as Optimism and Arbitrum to further increase utility options and transaction efficiency of the token. The moment rETH is obtained, regardless of how it was obtained, it begins accruing rewards. At the time of writing, the APR for Rocket Pool’s liquid staking stands at 4.8%. This yield comes from the staking APR on the Beacon Chain minus the ~15% commission that is passed on to the node operators.
Node Operators
For the second group of users, participants who wish to be node operators can stake 16ETH (as opposed to 32ETH) and a minimum 10% bond in RPL. The RPL bond is denominated in ETH and the maximum amount of bond an individual can put up is 150% of the value of the stake.
Rocket Pool makes up for the 16ETH difference to form a MiniPool by drawing from the deposit pool and the node operator running the MiniPool then begins its validator duties on the Beacon Chain. Node operators will receive the full reward of their 16ETH stake and ~15% of the rewards accrued by the 16ETH contributed by the deposit pool. Additionally, node operators also receive RPL rewards, and can earn up to 7% APR from all 3 avenues.
The RPL bond that node operators put up serves two functions:
- Ensures stability of the Rocket Pool network
- Protect the value of rETH
In the event a node operator does something against the protocol (most commonly running the validator in two places at the same time) and gets slashed, that is the loss of a validator’s staked ETH due to the negligence of their validation responsibilities, the node operator will incur losses in the following order:
- Node operator’s staking rewards
- Node operator’s own 16ETH stake
- Node operator’s own RPL bond
- Deposit pool’s 16ETH
Hence, only when the total slashed stake accumulates to a figure greater than 16ETH will the node operator have its RPL auctioned for ETH to make up for the penalty — this mechanism serves to protect the people who staked their ETH for rETH.
Incoming upgrades
Currently, the Rocket Pool team is working on rolling out Less ETH Bonded (LEB) MiniPools which could potentially reduce the required minimum ETH stake to as low as 4ETH. There are two proposals for this upgrade — LEB8 and LEB4. At the time of writing, there is no news about the potential rollout date of LEB4.
As for the LEB8 upgrade, it is predicted to be launched some time before the Shanghai update. Such an update would further lower the barrier to entry for participants interested in being a node operator and can help in driving growth for Rocket Pool as a whole.
An additional benefit of LEB MiniPools is that the Ethereum network can achieve an even higher degree of redundancy and can be even more secure than before. This is due largely to the increased accessibility LEB MiniPools provide to those who were previously unable to afford staking 16 or 32ETH.
Competitors
Rocket Pool’s main competitors in the liquid staking market are:
- Lido Finance
- Centralised exchanges.
Lido Finance had the first mover advantage as they went live almost an entire year before Rocket Pool. As a result, Lido also has greater DeFi integrations which would naturally increase demand for their LSD, stETH.
As for centralised exchanges, because of the perceived safety of staking with a custodian, they have managed to build up rather large staking pools despite the issues discussed above.
Competitive Advantage
Advantage over Lido
For Rocket Pool, the only requirement for a participant to qualify as a node operator is, apart from the usual hardware requirements, the 16ETH stake and this feature gives rise to the permissionless-ness of the node operators on Rocket Pool.
Contrast this with other liquid staking protocols such as Lido Finance where node operators must be voted in by the Lido Decentralised Autonomous Organisation (DAO). Put another way, the node operators on Lido are permissioned, as opposed to the permissionless ones on Rocket Pool. It is no wonder that Rocket Pool has 1,634 node operators while Lido only has 29. The effects of only having 29 node operators are profound — we are talking about roughly 4.3M ETH in the hands of just 29 nodes. While it can be argued that having 29, as opposed to 1, nodes is a form of decentralisation, the potential attack vector still exists, and this potential is inversely related to the number of nodes. Mitigating this risk is pertinent because in the event such an attack occurs, it would have far-reaching repercussions on the Ethereum network at large as we are talking about the potential risk of millions of dollars being wiped out.
Relative stability of rETH as an LSD
Additionally, Rocket Pool’s rETH presents itself as a much more robust alternative to stETH because of the relative stability of its peg to ETH. Since inception, rETH maintained a much smaller range of movement, maintaining a peg range of 0.9902–1.0523ETH, with major ratio depegs lasting from over a day to at most a week. In contrast, stETH has a peg range of 0.9223–1.0524, with major ratio depegs lasting up to months at a time. Additionally, rETH’s peg to ETH rarely dips below 1, while it has happened multiple times for stETH. At the time of writing, rETH:ETH’s 7-day OHLC volatility is a mere 0.66% compared to the 1.35% of stETH:ETH, over double of rETH’s volatility estimate.
These numbers all indicate a relatively higher degree of overall stability and price reliability for rETH, compared to its biggest competitor stETH, presenting it as a safer option to prevent this aspect of capital erosion.
DeFi integrations
Since Rocket Pool launched a full year later than Lido Finance and carries a much smaller market share, it does have a lower degree of existing DeFi integration. While stETH is applicable to a wide variety of use cases, including liquidity pools, lending protocols, yield aggregators (for yield farming), derivatives, and even cross-chain integrations with other blockchains (formerly bETH on Terra), rETH can currently only be used for liquidity pools on Uniswap and Balancer. While a significant disadvantage at the moment, this is not necessarily a gap that Rocket Pool will never be able to close: they allegedly already have plans in place for lending, yield farms and constant leverage. As long as Rocket Pool continues to grow at a steady pace, there is no reason to not expect their number and variety of integrations to expand in the future.
Potential tax benefits
Taxes are an increasingly prominent concern for most crypto investors, given the overt attention government agencies like the SEC have begun to show. Unlike other LSD tokens like stETH (which uses a rebasing mechanism), rETH uses a price accrual mechanism — meaning that unlike stETH, a staker’s balance of rETH does not change each day, only the resultant exchange rate between rETH and ETH. Bearing in mind that specific guidelines on crypto taxation events are still very much in transition and may take several years to be fully implemented, stETH’s balancing rebase event occurs one a day at 12pm UTC for all holders of the token, regardless of whether or not the staker’s actual ETH has been deposited into the pool (or is still in queue).
While directly trading in both tokens is likely to result in a “profit-generating event” via the capital gains on the purchase and sale of tokens, stETH’s daily rebasement pays out a reward (in the form of additional stETH, affecting the staker’s overall token balance). Because of this, stETH can potentially incur a daily taxable event, which creates both a significant amount of taxing inconvenience and the loss of overall profits. In contrast, rETH dodges this second “profit-generating event”, meaning that it has the potential to return higher profits for the staker.
Response to MEV issues
With the move to PoS, Ethereum 2.0 validators now must deal with Maximal Extractable Value (MEV) more than ever. Rocket Pool’s response to the MEV issues surrounding the Beacon Chain is known as smoothing pool.
Smoothing pool is an opt-in/opt-out mechanism that allows validators who have opted in to share their MEV rewards with the rest of the validators who have opted in. Opting in will reduce the volatility of the MEV rewards a node operator receives. That also means that once opted-in, it will be unlikely one can get outsized MEV rewards, but you should, more likely than not, consistently receive more block rewards than mere attestation as long as one of the validators that opted-in was assigned a block proposal transaction.
As shared by Ken Smith during the recently concluded Devcon Bogota, by opting-in you stand to earn more rewards 90% of the time. This is visualised in Fig 2.5 below.
Tokenomics
rETH
rETH is the LSD token that supports Rocket Pool’s ecosystem. Similar to what stETH is to Lido Finance, rETH is the derivative token given to stakers in return for their ETH within Rocket Pool’s staking pools. Though initially pegged at a 1:1 ratio between rETH:ETH to facilitate a smooth movement of capital into the staking pools, rETH now trades at a premium against ETH because its underlying value includes not only the original ETH, but also a share of all accumulated staking rewards across the staking pool.
“rETH:ETH ratio = (total rETH supply) / (total ETH staked + total rETH contract balance + total rETH share of priority fees + total rETH share of MEV rewards)”
Demand for rETH is mainly driven by its consistent value accrual. Over time, the ratio of rETH:ETH continues to become more favourable for rETH, generating greater demand and widespread collection of rETH. As the number of DeFi integrations for rETH grows, the greater the expected demand for it will become, meaning that more stakers willingly deposit their funds in Rocket Pool’s staking pools.
The chance of depegging is fairly low because Rocket Pool offers a 1:1 swap between rETH and ETH. Depegging can only occur at a point where Rocket Pool’s total liquidity runs out — considering that their liquidity comes from all staked ETH and any exited validators, the number of withdrawals would have to be fairly significant. Since validator rewards cannot currently be withdrawn from the ETH network, this further reduces the number of withdrawals that can occur.
RPL
In order for the node operator to first create the MiniPool, the node operator has to stake 16 ETH and a minimum 10% RPL bond that is denominated in ETH. This minimum 10% bond is crucial as the node operator has to have this minimum bond during each checkpoint in order to be eligible for RPL rewards. The checkpoint, simply put, is a snapshot that determines the RPL and ETH rewards earned by a node operator.
If, however, the node operator does not fulfil the 10% minimum at the checkpoint, the MiniPool is unharmed, and the node operator just does not receive the RPL rewards for the checkpoint. A node operator can fall below the minimum 10% requirement in many situations — one of which being that the value of ETH rises while the value of RPL remains the same. In such a situation, the node operator would have to top up the RPL bond in order to requalify for the RPL rewards for that checkpoint. This drives demand for RPL as the value of ETH rises and this creates a positive feedback loop where the value of RPL will increase as the value of ETH increases.
The protocol also rewards node operators proportionately to the number of RPL tokens that they’ve staked against their MiniPools, capped at 150% of the value of their ETH stake. This way, there is incentive for node operators to stake more RPL in order to capture a greater percentage of reward, thus increasing the demand for RPL.
Since the main source of demand for RPL comes from this 10% minimum and potential staking rewards of up to 150%, a growth in the total amount of ETH staked on the platform would indicate a growth in overall volume — meaning more users, more ETH staked and more demand for RPL. As such, the success of RPL’s sustained price action can be used as a rough proxy for the success of the overall protocol.
Price action for RPL is expected to be somewhat controlled by the price of ETH, considering that the 10% RPL bond is denominated in ETH. If the price of RPL dips, then more buyers will enter to facilitate the restoration of their desired staking percentage or minimum bond: by regular supply-demand mechanics, the price of RPL will be restored again — and vice versa. As such, there is a theoretical floor for the price of RPL, since the total market capitalization of RPL tokens ideally cannot fall beneath the total value of (10%) rETH bonds from all validators/stakers participating in the system.
Risks
Market Risk
To avoid flogging dead horses, we will briefly address market risk in the context of Rocket Pool. As mentioned in the first section, any broad-based downturn in crypto markets will definitely affect Rocket Pool negatively. More pertinently, if the value of Ethereum tanks, it would be bad news for Rocket Pool and the DeFi ecosystem at large. It is worth noting, however, that Rocket Pool is battle-tested and has survived the peaks and troughs of the markets for the last 6 years and hence we believe that it will continue to thrive in the coming years.
Smart Contract Risk
As with all DeFi protocols, smart contract risk is an ever-present one. For Rocket Pool, the team has gone to great lengths to minimise the smart contract risk by undergoing multiple audits between May 2021 to November 2021. Auditors include renowned ones such as: Sigma Prime, Consensys Diligence and Trail of Bits. This is not to say that there are no risks or vulnerabilities in the protocol but that the team has covered as much ground as it could leading up to the mainnet launch — an encouraging sign for investors looking to park some cash with Rocket Pool.
Conclusion
To conclude, we believe that there is significant upside to investing in RPL because, along with attractive tokenomics, RPL directly captures the value generated by the different products Rocket Pool offers. As such, one can invest in RPL as a proxy to the growth of the entire Rocket Pool protocol.
“However bullish you are on Rocket Pool, you are wrong. You are insufficiently bullish.”
Appendix:
https://dune.com/hildobby/ETH2-Deposits
https://dune.com/ratedw3b/Eth2-Liquid-Staking
https://docs.rocketpool.net/guides/staking/overview.html
https://medium.com/rocket-pool/rocket-pool-staking-protocol-part-1-8be4859e5fbd
