The Last Bull Standing: The Year Ahead for Ethereum and Liquid Staking Protocols

Marthe Naudts
Venture Beyond
Published in
7 min readJan 29

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Index Coop releases its staked Eth index, ready for Ethereum’s upcoming Shanghai Upgrade which finally unlocks staked Eth. The upgrade means liquid staking derivative protocols like Lido and Rocket Pool have both their governance and derivative tokens receiving one of the strongest tailwinds in the crypto industry this year.

Last year was painful. But if you look — maybe squint — past the destruction, you’ll also see the biggest and most progressive event since Satoshi released the Bitcoin white paper and disappeared into the smoke. On September 15th, after years of testing and development, The Merge marked Ethereum successfully transitioning from proof-of-work to proof-of-stake, the more efficient consensus mechanism by any metric. It should allow DeFi to have its own, crypto-native yield-bearing instrument, given that Eth can now be staked to secure the chain in exchange for yield. Yield-bearing assets in traditional finance (e.g. derivatives) have entire industry verticals built around them, and having a crypto-native equivalent could be a major inflection point for the industry.

Initially, two major features of staking needed to be addressed: 1) staking Eth requires 32 Eth, equivalent to ~$50k, 2) staked Eth is illiquid. This would exclude all but the wealthiest and most patient investor. Liquid staking protocols solve for both these issues. But there’s two more: 1) staked Eth remains indefinitely locked, and 2) liquid staking derivatives are becoming more centralised, and there’s no easy way to diversify exposure between them. This Spring, the upcoming Shanghai upgrade and Index Coop’s new dsETH index solves for both of these outstanding issues. That means this year, liquid staking is one of the major narratives for Ethereum and for crypto as a whole.

What is staking and when is it liquid?

Participants in blockchain networks need to reach consensus about the correct ordering of transactions in the chain- i.e., they need to agree on a shared, single version of history. In Proof-of-Stake, nodes validate blocks (rather than the ‘mining’ described in proof-of-work), by committing and locking up a stake to prove ownership and vested interest in the blockchain’s success. A randomised process selects which nodes become validators for each new block, and the vested interest mechanism disincentivises participants from undermining the system.

So, in the proof-of-stake consensus mechanism of Ethereum 2.0, the chain is secured through people (validators) locking up (staking) their Eth. In exchange, they receive staking rewards in Eth in proportion to the quantity of Eth tokens initially staked.

However, in order to stake on Ethereum 2.0, you need a minimum of 32 Eth (~$50k), excluding all but the dwindling supply of rich crypto investors. And once you’ve staked, you’ve locked away your Eth and cannot use it for anything else.

Enter, liquid staking protocols.

Liquid staking protocols developed to reduce barriers to entry as they let Eth holders stake without running a validator node. Users can stake fractions of Ether, and this is then pooled so a single user does not need to meet the minimum threshold of 32 Eth for staking.

These protocols allow users to stake their tokens with validators in exchange for a portion of the interest yield they earn. Essentially, users deposit their Eth into a third party app which then deposits it into the Ethereum deposit contract for them through their own validators. The protocols give derivative tokens (e.g. Lido’s stETH) in exchange for staked Ether on the proof of stake network, and the user can trade with stETH while earning yields from the staking contract. This token can be transferred, stored, spent or traded as one would a regular token, thereby maintaining Eth liquidity whilst earning rewards.

Their popularity has exploded over the past year in anticipation of and reaction to the Merge. The leader in the liquid staking space is Lido DAO, and Rocket Pool, Frax Finance, Ankr, and Stakewise are the other major decentralised players. According to Dune, the amount of Eth staked in pools ballooned 2,470% from 265,000 Eth in early 2021 to over 6.8m Eth now. Native tokens like LDO and RPL have surged 115% and 80% year-to-date, indicating rising interest in the platforms.

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With 16.3 million Eth deposited into the staking contract, the value of staked Eth alone would equate to a top 6 cryptocurrency by market cap.

But, although this is a huge amount of money, it only accounts for about 13.5% of supply. This is very low compared to other proof of stake blockchains like Cosmos Hub (62.5%), Cardano (71.8%), and Solana (71.4%).

Why? Well, partly due to the head start and lower entry barriers of staking other chains. But also because transactions are not currently enabled in the deposit contract- meaning staked Eth is indefinitely locked. The indefinite waiting time naturally dissuades users from staking their Eth, since it leaves them unable to actualise their losses and/or gains.

Users currently have to ‘unstake’ through the use of, e.g. stEth-Eth liquidity pools, which trade at an arbitrage because of the uncertainty around the real unlocking of the staked Eth. In other words, without withdrawals from the Beacon Chain being enabled, there are no hard mechanisms, or ‘pegs’, in place to prevent liquid staking tokens from trading above or below their fair value in Eth terms. And so therefore, the price of different liquid staking tokens is dictated by the market, often resulting premiums or discounts of net asset value.

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The Role of Shanghai

On December 8th 2023, Ethereum’s developer team met to discuss the next stage for Ethereum. Maintenance upgrades had been avoided in the Merge era to avoid added complexity to the already highly intricate technical event. The AllCoreDevs meeting therefore saw many improvements jockeying for consideration, but one upgrade in particular was prioritised by most: a hard fork, called ‘Shanghai’.

The Shanghai upgrade, scheduled for March 2023, includes a component called Ethereum Improvement Proposal (EIP) 4895. EIP 4895 allows those who have Beacon Chain staked ether (ETH) to finally withdraw funds and staking rewards. Staking tokens will no longer trade at a discount to Eth, providing another catalyst for dsEth and all its components.

Index Coop’s Staked Eth Index

Diversified exposure is the first principal of investing, and Index Coop just this week released its Diversified Staked Eth Index (dsETH) to provide just that. At launch, it is composed of rETH (Rocket Pool), wrapped stETH (Lido), and sETH2 (StakeWise).

dsETH harnesses the massive growth in the liquid staking market, while driving competition and efficiency within the liquid staking ecosystem. Indeed, to be eligible for inclusion, liquid staking tokens must meet all inclusion criteria, which centre around security, transparency, liquidity, and client diversity.

As of January 2023, over 55% of staked ETH was held by Lido, Coinbase, Kraken, and Binance according to data from Rated Network. Many are concerned about this centralization of staked ETH as decentralization is critical to prevent censorship and ensure a resilient network. dsETH gives token holders diversified exposure to liquid staking tokens, with weightings that favour decentralised protocols.

Notably, the inclusion criteria also stipulate that only protocols with competitive yield will be added to the index. To incentivise decentralisation at component protocols, tokens that meet these criteria are assigned equal weights before applying two factors: 1) the number of node operators supporting a protocol and 2) the distribution of stake across those node operators.

We hope dsETH will positively influence the liquid staking market by rewarding the most efficient and decentralized protocols with higher allocations in the index token. This should mean lower fees and better returns for holders, as well as a more robust, decentralized network,” said Dev, Index Coop’s Head of Growth.

So, TL;DR:

By Spring, staked Eth is a fully fledged yield-bearing asset native to DeFi. Index Coop’s dsETH index offers diversified exposure. This is huge. Billions of dollars are at stake.

Disclosures

White Star Capital invested in Index Coop tokens, but not in dsEth.

The information provided here does not constitute investment advice, financial advice, trading advice, or any other sort of advice and you should not treat any of the website’s content as such. White Star Capital does not recommend that any cryptocurrency should be bought, sold, or held by you. Do conduct your own due diligence and consult your financial advisor before making any investment decisions.

Sources and Materials

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Marthe Naudts
Venture Beyond

VC @ White Star Capital