This post was conducted by Blockdata and sponsored by Index Coop. This roundup features executives from liquid-staking protocols sharing their perspectives on Ethereum liquid staking and the new dsETH token.
Ethereum’s successful shift to a proof-of-stake model has spurred the rise of liquid staking.
Ethereum’s pivot to a proof-of-stake model (PoS) was a critical part of the network’s long-anticipated shift to a more efficient and flexible validation model. It has also turned out to be a momentous event for decentralized finance (DeFi).
Similar to Bitcoin, Ethereum’s previous proof-of-work (PoW) model required excessive computational power from mining nodes that validated activity on the blockchain.
This evolution to PoS lowered the energy, capital, and tech barriers for network validation — while maintaining a system of collateral to support the ecosystem and incentivize performance.
The new model, essentially a system of distributed incentives, eliminates the need for miners. Instead, it requires node operators to collect staked ETH — Ethereum locked up in the network via smart contract — in order to be authorized as a validator. By staking this collateral and validating transactions on the blockchain, node operators are rewarded with yield (and, conversely, penalized for any network-destructive actions).
Now that staked ETH is being used to validate transactions on the Ethereum blockchain, staking yields have increased meaningfully. Today, the yield on staked ETH is a cornerstone DeFi benchmark, and the nearly $44 billion in ETH now staked by investors now matches the amount held on exchanges, as of June 26, 2023. This in large part was due to the recent Shanghai upgrade.
The Shanghai upgrade: unlocking staking withdrawals
The most recent Ethereum update, on April 12th, 2023, was another critical step in the proof-of-stake transition. The update — a hard-fork dubbed ” Shanghai” — enabled withdrawals of staked Ethereum. Until then, withdrawals had not been allowed in order to ease the transition to proof-of-stake.
In March of 2023, just ahead of the Shanghai Fork, Index Coop invited Blockdata to a roundtable-style webinar, “Index Coop’s dsETH and LiquidStakingPanel.” The group discussed Ethereum liquid staking and the new dsETH token.
Executives from three leading liquid-staking protocols — all of which are included in the dsETH Index — joined Index Coop in the discussion:
- Lido Finance: “Izzy,” head of node-operator management at Lido, a DAO.
- Rocket Pool: Darren Langley, or “Langers,” general manager at Rocket Pool.
- StakeWise: Jordan Sutclifee, or “JStar,” business development lead at StakeWise.
- Index Coop: Crews Enoch of Index Coop, or “Crews,” moderated the conversation.
The panel covered top-of-mind questions and implications of the Shanghai Upgrade, compared the validator network models for liquid-staking protocols and their associated risks, and the outlook for upcoming innovation around liquid-staking and peripheral technologies.
Editor’s Note: quotes from the discussion below may be edited for clarity and brevity.
How liquid staking works
The move to staked ETH gave a boost to organizations including DAOs that began offering protocols enabling liquid ETH staking.
In a liquid staking model, a protocol coordinates or oversees the operator nodes that validate the blockchain through staked ETH. In order to collect the needed collateral, the protocol uses a tokenized incentives system. In exchange for depositing into a protocol’s liquid ETH staking pool, depositors receive staked ETH tokens , which have value that is representative of the underlying collateral. These tokens can then be used to generate additional yield and participate in other DeFi projects.
This enables ETH enthusiasts and HODLers to earn staking yield without necessarily having to self operate nodes and validators, or deposit the full 32 ETH that is currently required to operate a node (at one time it required 1,000 ETH to become a node operator).
Leading protocols
Lido Finance, a DAO and one of the first liquid-staking protocols, has now grown to be the largest by market share.
“The initial idea revolved around creating a new type of digital asset that would represent a claim on an underlying asset, such as a loan or an investment, and allow holders to transfer and trade the digital version freely over the internet,” says Izzy, head of node-operator management at Lido.
Lido and other liquid staking protocols are focused on creating optionality for users in two vectors: liquidity and composability.
- Liquidity meaning that stakers can access assets — or a representation of them — while they are staked on the consensus layer.
- Composability meaning that these accessible assets could be used simultaneously within the decentralized finance ecosystem for transfers, collateral, cold vault storage, or in other yield bearing projects.
Another leading protocol, Rocket Pool, was founded with a goal of providing capital pooling options, and also to provide kits that help “solostakers” get started more easily.
“With liquid staking you’re essentially contributing to a pool and your tokens can be generated based on the amount — however small — that you stake,” says Darren Langley , general manager at Rocket Pool.
The DAO protocol Stakewise also offers a turnkey UI and node operator software designed to be as simple as possible and democratize access to staking and liquid staking.
An indexed approach to liquid staking
Index Coop is a DAO that offers index-style vehicles and structured products, including the DeFi Pulse basket of top DeFi tokens.
With liquid staking emerging as a widely discussed DeFi theme and use-case post-merge, Index Coop launched its Diversified Staked ETH Index($dsETH) in January 2023.
The strategy token gives users turnkey access to leading Ethereum liquid-staking protocols in one place. Rocket Pool ETH, Wrapped stETH, sETH2, and Staked Frax ETH.
Since launch, the Index has been expanded and rebalanced. It now includes Rocket Pool ETH, Wrapped stETH, sETH2, and Staked Frax ETH.
Above: The dsETH was launched as an index token of three leading Ethereum liquid-staking tokens, which met Index Coop’s criteria favoring decentralization and efficiency. The rebalance added Frax LST. Its composition was 37.32% rETH, 24.00% wstETH, 22.02% sETH2, and 16.66% sfrxETH, as of July 28th, 2023.
“The composability of liquid staking highlights the best of DeFi. It’s something that at Index Coop we try to embody in all of our products,” says Crews from Index Coop. “For example, all of our structured products can be self-custodied, and can be used as collateral throughout the ecosystem.”
Additionally, Index Coop’s Interest Compounding ETH Index, (icETH) offers enhanced ETH yields through a leverage liquid staking strategy built on Set Protocol. The superior yield is accomplished through recursive cycle – icETH deposits stETH (Lido’s staked ETH token) as collateral to borrow ETH which then again procures more stETH, and then the cycle begins again of this automated leverage strategy.
The growth of liquid staking’s popularity.
Long before the 2022 Ethereum Merge and the Shanghai Fork this year, white papers and DeFi pioneers saw the possibility of enabling an asset that can be put to work in multiple ways simultaneously.
“The roots of liquid staking can be traced back to the notion of ‘internet bonds,’ theorized in a paper published some time ago that remains influential in crypto circles,” says Izzy. “This idea began to take added shape on some Cosmos chains as a proof-of-concept, but the use-case really came to life on Ethereum.”
Langers believes that staking’s attractive yields — and recent changes to the network as a whole — are driving the surging popularity.
“Essentially, since the counterparty for staking is Ethereum, as long as you believe in Ethereum, it’s kind of like a no-brainer,” says Langer. “The Merge was quite worrying for many. But since its success, we’ve seen a massive uptick in liquid staking deposits. With withdrawals coming up now, that’s another massive de-risking event. I’m honestly surprised at how much has been staked [already], considering you could not withdraw for a time.”
How withdrawals will affect staking
“Some fear that many depositors are going to unstake because they want to get their rewards,” says Langers. “In actual fact, Shanghai’s affordances are encouraging partial withdrawals. In other words, anything above 32 ETH now gets withdrawn automatically. So, in many cases people will have access to their rewards, even as they maintain their original staked amount and continue staking. People don’t necessarily have to draw from their staked ETH to get those rewards.”
Even in the long-term, protocol executives see improved stability in the cards.
“A lot of people in the industry, including financial institutions, are signing contracts with node operators,” says Jordan. “This space is front-and-center with institutions now. The Shanghai fork is the final stage to opening the floodgates. It’s going to be a massive catalyst not just for liquid staking, but for staking in general.”
As the stability is proven out, withdrawals will become more fluid. Value will move more smoothly and at greater scale in and out of staked and liquid-staked ETH. Protocols will be able to offer near-immediate access to unstaked ETH.
“We will eventually have “immediate liquidity” from a withdrawal’s perspective. It may not be immediate in the sense that you can unstake and get your ETH back the next day, but you will probably get it back within a couple of days at the most,” says Izzy.
How Slashing Impacts Operator Networks and Stakers
Slashing events and other penalties that operators face due to network-destructive behavior are one of the primary risks that protocols must plan for and protect against to protect their customers and their own integrity.
“Slashing is a bit of a misnomer in the sense that there are penalties that you can receive in Ethereum staking, but those commonly received are for downtime — or not keeping your node online,” says Langers.
“The penalty for downtime is not severe, you can earn rewards back quickly. So downtime is actually not a huge deal — but that’s not slashing,” he adds. “Slashing is essentially when you break the consensus rewards.” The most common way this happens, he says, is when operators run a validator in two places at once, which results in a “double-vote” on the blockchain.
The operator incurs penalties for doing this, which in Rocket Pool’s case is 1 ETH and a ban from the network. However, security such as so-called doppelganger protections are increasingly being put in place to ensure that validators aren’t doing this and working with identical keys across two instances.
Working towards liquidity, efficiency and stability
Penalties and slashing are worth mentioning because part of a liquid-staking protocol’s function is to organize staking and collateral to protect the integrity of tokens for staked ETH. Now that withdrawals are in play, that calculus is more complex.
“With withdrawals, one of the key risks affecting the stability of your liquid-staking token is the amount of ETH backing a token has, and what can happen to the value of that token with slashing and penalties — if the collateral is eroded,” says Jordan. “Post-Shanghai, stability is defined by the amount of ETH backing the token, and preventing any drops from slashing and penalties.”
Capital buffers are key for reducing slashing risks now that staking withdrawals are enabled, but more liquidity overall will also help to that end. That’s because liquidity strengthens market participants’ ability to spot arbitrage opportunities that help balance the overall market and improve general price stability.
Arbitrageurs will help keep the prices of staked tokens — relative to their underlying collateral — more stable.
For example, “dsETH are permissionlessly redeemable for their underlying assets,” says Crews. “The index can maintain its spot price on decentralized exchanges relative to the net-asset value of the tokens underneath it, because arbitrageurs can mint and redeem if there’s a premium or discount on the spread.”
“Now that withdrawals are enabled, essentially everyone can do that with liquid staked ETH tokens and the underlying collateral,” he adds.
Node-operator sets: permissioned vs. permissionless
Protocols manage their sourcing of node operators in one of two fashions: permissionless or permissioned operator sets.
Permissionless sets, such as RocketPool’s, have few-to-no restrictions for joining anonymously. One benefit of this is the ability to recruit operators at scale to share, absorb, or dilute risk. “With permissionless node operators, who you don’t really vet actively, you instead require them to be over-collateralized,” says Langers. “If there are any issues — including if the node operator is slashed — any penalty comes out of their collateral rather than the collateral provided by liquid stakers.”
Expansive permissionless networks can also improve diversification and resilience to operating risks and censorship. “The more decentralized your validator set, the more resilient it is. We’ve got over 2,000 node operators spread out over 100 different geographic locations,” says Langers.
In contrast, permissioned sets, such as Lido’s, require operators to apply through the DAO and undergo an evaluation and onboarding process. Instead of requiring overcollateralization, a smaller set of professional node-operators maintain the set under stricter supervision.
“We currently have 29 node operators on ETH,” says Izzy. “It allows us to encourage certain behaviors and dynamics, and track results. But, we plan to start introducing infrastructure that will allow permissionless entry into our node-operator set as we introduce the next protocol upgrade.”
This professional, experienced bode operator set allows Lido to ensure that validators are following best practices, strict security guidelines are followed, and that guarantees are in place for robustness and fallbacks. Izzy notes that their operator set has not yet had a single slashing event.
Looking ahead: healthy competition from innovative new technologies, products, and platforms
Liquid staking creates a “lego building block” type of asset that theoretically can be used for an infinite amount of applications, even as it attracts value.
“Liquid staking ETH is limitless in the sense that what you can build on top is limitless, and the assets themselves are permissionless,” says Izzy. “They can be used as ‘legos’ to build things like diversified staked ETH.”
“ETH drives the underlying security of the protocol writ large, but it’s also how things move on the network, because ETH is what drives transactions,” he adds. “So in a sense it’s the circulatory system and the blood that flows within it as well. The idea that you can have an asset that works in all these different ways is immensely powerful. It’s a new kind of financial primitive that doesn’t exist in traditional markets. I think this will allow us to allocate capital in totally new ways.”
“Infrastructure wise, distributed validator technology (DVT) — which splits a validator’s private security key across many computers and nodes — will reduce the risks of a single point of failure or attacks. This allows protocols to reduce the surface area of risk for staking, especially with permissionless participation. By reducing collateral requirements as nodes are split across multiple entities, they will change what operator and validator sets look like in one to two years.”
Jordan at Stakewise takes a similar stance. “DVT’s are the next major tech hurdle, and it’s a very exciting next step, especially on the permissionless side,” he says. He also believes that the portion of staked Ethereum will continue to grow — from around ~40% of total supply in March 2023, towards north of 50%