ETH 2.0/ Proof of Stake explained:
When looking into Lido and Liquid Staking ETH 2.0 and Proof of Stake are key Topics. The following are high level overviews.
What is ETH 2.0?
ETH 2.0 or (Serenity) is an Upgrade to the existing Ethereum Blockchain which aims to make the network more scalable, more secure and more sustainable. The Upgrade has been planned since the release of the Ethereum Whitepaper in 2013 and consists of three Parts:
1. The Beacon Chain:
The Beacon Chain is the Hearth of the ETH 2.0 upgrade. The Beacon chain is a Proof of Stake Blockchain which runs independently of the existing Proof of Work Ethereum Mainnet. The Beacon Chain is responsible for running the Proof of Stake consensus Algorithm for itself and all Shard Chains.
2. The Merge:
The Merge (or Docking) is the Upgrade, where the existing Ethereum Mainnet will merge will the Beacon Chain. This will mark the end of the Proof of Work Algorithms and mark the full transition to Proof of Stake. This will bring the Ability to run Smart Contracts on the Proof of Stake System plus the full history and current state of the Ethereum Chain to insure a smooth transition. The Upgrade is planned for Q1/Q2 2022.
Withdraws of staked ETH on the Beacon Chain will be enabled after the Merge.
3. Shard Chains:
Shard Chains are a multi-Phase Upgrade planned to improve Ethereum’s scalability and capacity. Shard Chains spread the Network load across 64 new Shard Chains. They make it easier to run a Node by keeping the hardware requirements low. Shards will be used to store and access data but wont be used for executing code. Shard Chains will likely also be implemented in 2022.
Proof of Stake explained:
Proof of Stake is a consensus mechanism by which decentralized systems can agree on a single source of truth, since unlike centralized systems, the truth isn’t decided by a single entity. This is achieved by the cooperation of large numbers of nodes, which come to agreement by using identical cryptographic algorithms.
Unlike in Proof of Work, Validators don’t need to use significant amounts of computational power, because they are selected at random and aren’t competing. They don’t need to mine blocks; they just need to create blocks and include transactions when they are chosen and validate those proposed blocks when they are not. They earn rewards for doing those two activities correctly.
Everybody can lock up a given amount of the Blockchains native currency to become a Validator (32 ETH). This locked up stake turns into an incentive to keep Validators honest, since they risk losing their Stake if the majority of total Validators reject their proposed block. (This is called “slashing”). Validators are can also be penalized partially if they aren’t following through with their responsibilities when it is their turn to do so (i.e., if they are offline). Penalties for being offline are relatively mild and equate to about the same as the expected rewards over time. So, if a validator is participating correctly over half the time, then the reward should be net positive.
Proof of Stake by itself does not improve scalability, however POS architecture allows the implementation of Layer 2 scaling Solutions like Sharding.
The Stake at Risk concept also to prevent 51% attacks on the Network, since an Attacker would need to own 51% of the total staked ETH (and a successful attack would make the value drop significantly).
Why Proof of Stake > Proof of Work?
With the transition away from energy intensive GPU Mining on Ethereum, the energy consumption will be reduced drastically. The move away from Proof of Work removes many of the current Barriers to Entry / Economies of Scale which make it economically unfavourable for the everyday Person to become an Ethereum Miner and favours bigger players which can contribute lots of capital and can often choose more favourable geographic locations with cheaper electricity costs. Since the only requirements to becoming a Validators in a Proof of Stake system are ownership of 32ETH and a Laptop. This can help to make the whole Network more decentralized (more single individuals taking part) and help combat geographic centralization.
Another Advantage of PoS over PoW is a harder punishment towards attempted attacks on the networks. Via the slashing Mechanism even unsuccessful Attacks run the risk of getting their entire Stake “slashed” while attempted Attacks by PoW Miners only results in the monetary loss of energy costs used to acquire the necessary hash power. (The Slashing Mechanism in Proof of Work would be similar to burring down whole mining farms of malicious Miners).
Furthermore, many also argue that in a Proof of Stake System the Alignment of Consensus Agents (Validators) and Coin Holders (also Validators) can be beneficial for the price of the PoS Currency since compared to PoW a large often net selling third Entitty is left out (Miners). Miners often have to sell large Part of their earned Stake to cover expenses (like electricity bills or mining equipment), which can suppress the Price of the underlying Coin further. Compared to a PoS System where Holders and Validators are the same Entity (aligned interests), which only has to sell earned Stake to cover tax expenses.
Like mentioned previously POS also allows the implementation of Scaling Solutions.
The Ethereum Staking Landscape:
There are currently over 8.3 Million ETH staked in the ETH 2.0 deposit contract. There are different ways to stake your ETH and in the following I will look into Advantages/Disadvantages different Staking Solutions provide.
Solo Staking:
Solo Staking on Ethereum means running your own Validator Node/s and signing blocks when its your turn to do so. To become a full Validator you have to deposit 32ETH to the ETH 2.0 deposit contract per Validator you wish to run. You then have to download the ETH 2.0 client to your computer in Order to set up/run your Validator Node.
Returns for Stakers consist of two Parts:
- The inflation fee, which depends on the total Amount of ETH staked (APY inversely correlated with total staked ETH in the Network)
2. Transaction fees and (possibly) MEV: After the Merge when Smart Contracts are enabled on the Beacon Chain Transaction fees and MEV (if extracted by User) are part of the rewards for Stakers.
Since there are no Third Party / Service Provider involved in Solo Staking the Inflation fee earned should be the highest (since most service providor have to take a fee for their service). Regarding MEV running your own Validator can be an Advantage for savvy Individuals who know how to extract MEV and a Disadvantage for those who don’t.
A big Disadvantage regarding solo staking are Requirements needed to operate your Node.
Firstly ownership of 32ETH (that’s 131.000$ at todays ETH Prices). Secondly certain hardware requirements are needed in Order to run your own Validator Node and thirdly some technical knowledge about the set up/running of your Node.
Some other Factors to consider before deciding to Solo Stake are that Maintenance, the correct Security and Internet Connection in Order to ensure uptime are your Responsibility and can lead to serious slashing of your Stake if done incorrectly.
Lastly ETH staked on your own today will only be withdrawable after the Merge in 2022 so a momentary loss of Liquidity for your Stake has to be kept in Mind.
Staking on Centralized Exchanges:
Staking on Centralized Exchanges is very popular due to good user experience and being in a place where users already transact and store there assets. Staking on CEX accounts for about 30% of total ETH staked with the most popular being Kraken (12.6%), Binance (8.4%) and Coinbase (4%) of total ETH staked. Staking on Centralized Exchanges works via Staking Pools. This means users can deposit any Number of ETH, which then get pooled together to pairs of 32ETH. This is great because it allows Staker with smaller Balances to part taken in Staking. Exchanges often Partner with one or two Service Providers who spin up and operate the Nodes. The user doesn’t have to deal with running the Node and the Exchange gets a Percentage of the total Stake earned as Revenue. Until the Merge Users won’t be able to withdraw their ETH which is staked on the Exchange but after the Merge Users should also be able to staked and unstake their ETH on the Exchange. However, User definitely won’t be able to withdraw their ETH from the Exchange while it is being staked creating a lock of Capital. Furthermore, since keeping ETH on an exchange means not being in charge of your coins private keys a few security and private key management assumptions have to be made. Since Exchanges also only use a few centralized service providers for validator nodes Centralization Issues like a Single Point of Failure could occur e.g. if “slashing” of Stake occurs.
Liquid Staking:
Liquid Staking works similar to decentralized staking pools however with the addition of liquid tokens which represent your share of the staked ETH. From the user’s perspective it works very simple. They deposit ETH into a smart contract and receive a staked Derivative token back (in Lidos Case: stETH) this token can then be used in different Defi applications while still earning yield. This allows Users to stake any amount of ETH similar to CEX staking while being non-custodial and without having to trust any third parties. Furthermore, the staking derivative can easily be sold back to ETH via e.g. (stETH — ETH) pairs.
Liquid staking also supports the security mechanism of Proof of Stake and helps it not to get cannibalized by Defi Yields. Imagine Yield on staking ETH are 4% but Yields on lending ETH in Defi are 6.5% (Hypothetical Scenario). Users would be economically disincentivized to stake their ETH but rather lend it in Defi, which in the extreme case could massively harm the security of the whole chain (less total ETH staked -> less security). By introducing Liquid staking users can earn yield on their staked ETH while also earning defi yields on it. (Increasing Capital Efficiency on PoS Assets within Defi)
More detailed explanation of this idea here:
Currently about 20% of staked ETH is staked via Liquid Staking, with Lido holding about 87.68% Market share making Lido the biggest Depositor to ETH 2.0 staking contract.
Liquid Staking Market Dynamics:
Even though Lido and many of its competitors are open-source projects there are some key market dynamics at play which have allowed Lido to capture a majority market share in the liquid staking market and making it look very much like a winner take most market. The two most important factors which provide Moats in this Market are Liquidity & Integrations.
This can be closely compared to the Stable coin Market where Liquidity and Integrations are the main Moats as well, which has also lead to a winner takes most market (USDT and USDC currently hold over 76% Market share but USDT alone held over 90% Market Share in late 2019.
Liquidity:
For a Staking protocol to be liquid Market Participants have to be able to swap between the staking derivative token (stETH in Lidos case) and ETH seamlessly and with as much volume as desired. To achieve that a liquid swap pair has to exist & be incentivized, which holds its peg as close as possible (1:1 from stETH and ETH in Lidos case). Unstaking your stETH is currently not possible but will be after transactions are enabled on the beacon chain. This helps the pool pairs (stETH-ETH) to hold its peg since Market participants know that if stETH trades at discount relative to ETH it can easily be bought with ETH and swapped back after unstaking is available, generating an arbitrage profit.
Integrations:
The utility of a liquid staking token is derived from the liquidity of the swap pairs as well as the amount of different integrations / use cases. These use case can span from being able to generate yield on your derivative token in Defi protocols to using the derivative token as collateral to trade on a CEX like FTX. In theory a Market winning derivative token could replace ETH in many use cases and be a better version staking yield earning version. (Gas still has to be paid in ETH).
Total Addressable Market:
The TAM of any one Liquid Staking Protocol is huge. Not only is it every ETH which could participate in liquid staking but also every native Currency of every Blockchain which uses Proof of Staking as Consensus algorithm (e.g. SOL, ADA, ALGO, XTZ etc.) In total there are over 100 projects using POS, these account for over 400b in Market Cap or 15% of the total Crypto Market Cap (not including Ethereum which will Transition to POS soon and currently has a 500b Market Cap.
Liquid Staking with Lido DAO:
Lido DAO (Decentralized Autonomous Organization) is a community governed liquid staking provider. Lido currently offers their liquid staking Solutions for three Networks: Ethereum 2.0, Terra and Solana with 6.2b, 2.9b and 0.2 in TVL respectively.
Staking with Lido works simple. User send their funds to the Protocols Smart Contracts and receive a liquid staking derivative token (stETH (Ethereum 2.0); bLUNA (Terra); stSOL (Solana) which can be used in different Defi protocols / on certain centralized Exchanges (ftx.com)
The funds are then pooled and each time 32ETH are collected a Validator is selected from a governance-controlled registry. Every Validator has a maximum stake (maximum amount of Nodes), which is check by an Oracle, which then distributes bundles of 32ETH based on the availability of each validator slot. The deposit contract will be called and 32ETH will be assigned to the validators public key with the use of Lidos withdraw credentials (Validators can’t withdraw ETH).
Lido currently has 14 different Node Operators in the Registry which are centralized Companies like Certus One, Chorus One, p2p.org, StakeFish, Staking Facilities and many more.
https://mainnet.lido.fi/#/lido_dao/0x55032650b14df07b85bf18a3a3ec8e0af2e028d5/
They then spin up individual Validator Nodes per 32ETH.
The stETH Token:
stETH is native Lidos ETH liquid staking derivative token and a rebase token. This means to in order to pay staking rewards the total supply is expanded daily to reflect the staking yield earned after one day. This happens once a day at 12PM UTC. Because rewards are paid out via rebasing stakers of stETH won’t see transactions sent to their wallet (with high gas price this wouldn’t be very economical).
The rebasing effect also establishes a socializing of rewards. Every stETH holder will get the same daily rebase, it doesn’t matter if you staked your ETH with the Lido Smart Contract, bought stETH on the open Market or received it from a friend. This rebasing effect for stETH works across integrated Defi Platforms like Curve and Yearn (so you can earn your staking yield via the rebasing effect while also liquidity providing or farming)
Uniswap, 1inch and Sushiswap are not compatible with rebasing tokens like stETH, it could result in you missing your rebasing yield. To avoid this problem Defi users can wrap their stETH to wstETH (https://stake.lido.fi/wrap) wstETH will keep your balance constant and pay out your staking yield which was incurred during the period after unwrapping it back to stETH.
But how does Lido make money?
Protocol Revenue
The Lido Protocol takes a 10% fee of all staking rewards accrued which is then split between paying Node Operators, a slashing insurance fund (which can cover losses in case slashing of stake occurs) and Revenue for the Lido Dao (which is 50% of the fee; so 5% of total staking rewards)
Since its launch in early 2021 Lido has generated a total revenue of about $100m (Supply-side revenue: $88.6M and Protocol Revenue: $9.8M) at current rates this would annualize to about $336.54M Annualized total Revenue and $33.65M Annualized Protocol Revenue (since 10% fee)
Since a 10% fee on all staking rewards is the revenue driver a close eye on TVL (Total Value Locked) is important. Lidos TVL is currently $9.65b ($6.45b in ETH, $2.98b in LUNA and $220.5M in SOL)
Which Factors impact Lido Revenue?
- The Value of the underlying staked Coins (ETH/LUNA/SOL). If they rise in Value Lido generates more dollar denominated Revenue.
- Growth in TVL: This can be achieved in two ways:
1. Achieving higher Market Share in already supported Assets (more ETH/LUNA/SOL gets deposited into Lido)
2. Inflow of TVL by Addition of new PoS Assets to Lido
- Extraction of higher APYs for Stakers by usage of MEV.
MEV in PoS
MEV (Miner Extractable Value) refers to the Value Miners can extract from a given Network by being able to sequence Transactions and deciding which unconfirmed Transaction from the Mempool get included into the next Block. Miner usually order Transaction by the Highest gas fee, which however is not a requirement of the network. Sometimes Opportunities arise where Miner can earn more from ordering/censoring Transactions favorably, which lets them take advantage of Arbitrage Opportunities (e.g. Large DEX trades get front ran by Arbitrage bots, which buy the Asset before the large DEX trade is confirmed and sell it back after its confirmed for a Profit)
MEV is an invisible tax on Ethereum user since they are the Victim of the Arbitrage and get filled for a worse Price.
Since the process of ordering transaction will still be the same after the Transition to Proof of Stake as the PoW Ethereum of today it is reasonable to expect the same MEV opportunities to exist as we know them today. However, the main difference is the change in block proposers from Miners to Validators in a PoS World.
There currently is no public statement from Lido regarding how they will handle MEV in the future however Lido team member have confirmed that the extraction of MEV in Lido is planned and for MEV Profits to be passed along to Stakers (and not kept as Protocol Revenue).
https://twitter.com/_vshapovalov/status/1453616505640345603?s=21
Since MEV is a complex topic where rewards depend on the sophistication of execution it isn’t exactly clear how much MEV rewards will raise the APY for stETH staker however it is assumed for MEV Rewards to be up to 50% of the total staking rewards, which would bring a doubling of staking APY from 5% to double digit percent.
The LDO Token:
LDO is Lido DAOs Governance token. LDO was initially distributed as an Airdrop to early Stakers using the Protocol as well as Liquidity Mining rewards on the swap pairs (stETH-ETH) on Defi Platforms like Curve. The most important governance aspects of LDO are voting rights over the Node Operators Registry (adding/removal of Node Operator; setting limits of maximum Validator Stake) and Treasury fund decisions.
The are currently no direct value drivers between the protocol and the LDO token like Token Burns or a revenue share with token holder, however the team has mentioned to be open towards exploring a revenue share with token holders in the future. This would represent a model more similar to traditional growth equity model with a focus on growth first and revenue share later.
The current circulating Supply is low (6% of total supply is circulating) with the total supply of 1b LDO distributed among (DAO treasury 36.32%; Investors 22.18%; Validators and signature holders 6.5%; Initial Lido developers 20%; Founders 15%)
Which will be unlocked in a 1 year vesting period after 17 December 2021 in a linear block per block basis until the whole supply is circulating the year after (17 December 2022)
These heavy unlocks staring in December could lead to strong selling pressure of the LDO Token.
Centralization Concerns:
Lido currently relies on 14 Validator Node Operators which are whitelisted. This imposes certain centralization concerns since these 14 Operators are centralized Companies and mixing them together and distributing stake among them doesn’t exactly make for a fully decentralized system. However, it is still a more decentralized way than most staking services on centralized Exchanges which often only rely on 1 or 2 Node Operators. Creating a fully trustless staking experience is something the Lido team is currently working on.
https://blog.lido.fi/the-road-to-trustless-ethereum-staking/
Some liquid staking Competitors have chosen a different way, with a higher focus on decentralization like Rocketpool, which requires Staker to lock up RPL (Rocket pool Token) to then managed individual Nodes (currently 381, consisting of 16 ETH each). This leads to more decentralization however at the cost of more complexity and a worse user experience which can also be observed in the staking Numbers (Total ETH staked in Rocket Pool: 6,880 VS Lido: 1,461,868)
Thanks for reading! (^_^)
