The Rise of LSD New Growth Point in the DeFi Ecosystem

LSD A New Growth Point in DeFi

Author: Gate Ventures Source: Medium Compilation: LianGuai, Shan Ou

Introduction to LSD

Following Ethereum’s recent transition to proof-of-stake through “merging,” staking ETH to validate the network’s behavior has become a popular low-risk passive investment strategy for global investors. A significant amount of total locked value (TVL) is tied up in Ethereum contracts and protocols, all in pursuit of “real yield.”

However, the drawback of locking such a large amount of ETH is the lack of capital efficiency. To address this issue, developers quickly introduced a solution called Liquidity Staking Derivatives (LSD). LSD is a specific type of financial instrument that allows users to earn staking rewards on their staked cryptocurrency assets without locking them up. Instead, idle liquidity is transformed into a new token called stETH (short for “stakedETH”). This innovative approach allows users to participate in staking while retaining access to their funds and the ability to trade their positions on the liquidity market provided by these derivatives.

This article aims to delve into the current state of liquidity staking derivatives. First, we will explore the origin of LSD and how they initially became pioneers in the realm of generating income through network validation. Then, we will examine the current state of LSD and identify the protocols that play the most significant role in this field. Finally, we will assess the potential impact of LSD on the broader DeFi ecosystem, analyze the observed growth thus far, and speculate on their influence on the future development of the cryptocurrency market.

The Origin and Current State of Ethereum LSD

The concept of liquidity staking derivatives was initially proposed by Ethereum co-founder Vitalik Buterin in 2016. Buterin proposed that liquidity staking could allow individuals to participate in staking activities without locking up their funds. This approach aimed to broaden the accessibility of staking to a wider range of users while potentially enhancing the security of the Ethereum network.

Today, the valuation of the liquidity staking market has reached billions of dollars. Lido is one of the most well-known ETH liquidity staking protocols, with a total locked value (TVL) exceeding $14 billion at the time of writing this article. Lido offers users the opportunity to stake ETH by depositing it into a liquidity staking pool. As a result, participants receive stETH tokens representing their staked ETH. These derivative tokens can be traded on decentralized exchanges, used as collateral, or even provide new DeFi services such as bond interest or stablecoin yields.

LSD Market Share

As of July 10, 2023, Lido holds the largest market share at 79%. The top 5 platforms combined account for over 95% of the market share. In addition to Lido, there are several other well-known liquidity staking protocols in the market, including Rocket Pool, Frax, and Stakewise. Each of these protocols has unique features and advantages. Generally, the most widely adopted liquidity staking protocols are those that offer the highest level of security and have established support in terms of total locked value (TVL) figures and a strong community.

In addition to the liquidity staking protocol itself, liquidity staking derivatives involve various other participants. These include lending protocols, decentralized exchanges, DeFi yield aggregators, and staking service providers. DeFi protocols enable users to access financial services in a fully non-custodial manner by utilizing liquidity staked tokens. On the other hand, staking service providers cater to users who are unwilling to manage their own staking pools by offering staking services.

Top-tier Liquidity Staking Protocols

  1. Lido Finance: Lido Finance has the largest market share in the Ethereum liquidity staking market, accounting for over 79% of the Total Value Locked (TVL). It is a decentralized lending platform built on the Ethereum blockchain. Leveraging Collateralized Debt Positions (CDPs), Lido allows users to borrow funds while earning interest from the deposited collateral. The platform uses the Lido token ($LDO) for lending and staking. Lido aims to provide a decentralized and efficient alternative to traditional lending methods. It is worth noting that it offers users the advantage of earning yield rewards, with the Annual Percentage Rate (APR) based on the current Ethereum consensus. Lido charges a fair fee of 10% for staking rewards, which is distributed among node operators and the DAO treasury. The Lido token can be used on both decentralized exchanges (DEX) and centralized exchanges (CEX), such as Sushiswap, 1inch, Uniswap, and Hotbit. However, it does not distribute income to token holders.

  2. Rocket Pool: Rocket Pool is the second-largest liquidity staking protocol, aiming to improve the opportunity for small-scale investors to stake ETH. It operates as a decentralized staking pool, allowing users to stake as low as 0.01 ETH and immediately receive rETH tokens. Rocket Pool charges a commission ranging from 5% to 20%, depending on non-operator deposits and node operator availability. However, it does not share income with token holders.

  3. Stakewise: Stakewise is a current staking protocol aimed at improving decentralization of the Ethereum network. The protocol tokenizes deposits and rewards, with deposits represented as sETH2 and rewards provided in the form of rETH2 tokens. Stakewise charges a fixed fee of 10% for each stake, and users can withdraw deposits and rewards on exchanges such as Sushiswap, Curve, and Uniswap.

  4. Fraxfinance: Frax Share (FXS) is a utility token in the Fraxfinance ecosystem that grants holders governance rights and other utilities. Fraxfinance offers a range of DeFi products utilizing stablecoins, such as $FRAX and $FPI. The protocol supports two types of ETH: frETH (Frax Ether) and sfrxETH (Staked Frax Ether). Token holders can lock their FXS tokens to create veFXS, which provides special benefits, governance rights, and Automatic Market Operator (AMO) profits. Compared to many liquidity staking protocols, Fraxfinance shares approximately 8% of ETH staking rewards with veFXS holders.

Distributed Validator Technology to Benefit from the Prosperity of the LSD Industry

Distributed Validator Technology (DVT) is another sub-industry that benefits from the prosperity of the LSD industry. DVT is a method that enhances the security of validators by dispersing key management and signature responsibilities among multiple parties. This strategy aims to minimize vulnerabilities caused by single points of failure and enhance the resilience of validators.

To achieve this, the private keys used to protect validators are assigned to numerous computers organized into “clusters”. The fragmentation of the keys makes it difficult for attackers to gain unauthorized access since it is not stored in its entirety on any single machine. Additionally, this setup allows certain nodes to become inactive without affecting the system, as a portion of machines in each cluster can handle the necessary signature tasks. As a result, the network has a stronger resistance to single points of failure, thereby enhancing the overall robustness of the validator set.

DVT provides the following benefits for Ethereum: decentralized Ethereum proof-of-stake consensus, ensuring network liveliness, creating validator fault tolerance, minimizing trust in validator operations, minimizing slashing and downtime risks, enhancing diversity (client, data center, location), regulatory compliance, and increasing the security of validator key management.

One interesting DVT protocol worth mentioning is the SSV network: SSV.network is a fully decentralized and trustless DVT network that provides reusable infrastructure options for decentralized Ethereum validators. It is an open-source protocol that facilitates the Ethereum validation layer by distributing validator tasks among multiple untrusted nodes called operators. These operator node clusters represent stakeholders and perform validator operations, addressing key challenges of centralization, redundancy, and security in Ethereum’s proof-of-stake consensus.

The Significance of LSD in DeFi

Liquidity Staking Derivatives (LSD) offer various advantages to the DeFi ecosystem, contributing to its growth in terms of total value locked (TVL), user base, trading volume, and applications. Upon careful examination, we can identify specific areas where LSD’s benefits have the greatest impact:

  • Enhanced liquidity: LSD facilitates increased market liquidity in DeFi by allowing the trading of liquidity staked tokens on decentralized exchanges. This accessibility enables users to buy and sell these tokens more easily.

  • Improved accessibility to staking: LSD allows users to participate in staking without locking their funds, thereby widening the accessibility to staking. This increased accessibility enables a broader range of users to engage in staking.

  • Enhanced security: Liquidity staking helps strengthen the security of the DeFi market. Users can stake their funds without worrying about losing access to them, making the DeFi market more attractive to individuals who prioritize security.

  • Real yield: LSD generates a stable and consistent yield, known as “real yield,” derived from the network validation process. This genuine interest makes LSD an ideal use case for DeFi composability.

What is LSDFi?

LSDFi refers to a collection of protocols built on top of LSD. These protocols cover a wide range of projects, from traditional decentralized exchanges (DEX) and lending platforms to more complex protocols that leverage the unique properties of liquidity staking tokens (LST).

As the adoption of LSD becomes more widespread, these protocols will play a crucial role in the DeFi ecosystem. They will lay the foundation for the DeFi space, while projects that develop more complex products using LSD as a base will operate at the next layer. LSD has become the dominant category in terms of Total Value Locked (TVL), with notable projects including Lido. LSD has not only become a standard in Proof of Stake (PoS) ecosystems but also an important trend in DeFi. LSD provides a reliable and low-risk source of passive income, contributing to the overall stability and maintenance of blockchain networks.

Therefore, LSD plays a significant role in driving the development of the entire DeFi ecosystem. LSDFi is the logical extension of LSD, creating an economy that generates substantial income while simplifying interaction with LSD projects. As of the time of writing, the Total Value Locked (TVL) of LSDFi exceeds $709 million, reflecting a substantial integration between DeFi and the LSD industry and becoming a significant trend. Currently, LSDFi has developed into a separate field within DeFi and has made significant progress. It includes both traditional DeFi protocols and more complex protocols such as money market protocols, stablecoins, DEX, and profit strategies.

LSDFi Market Share

As of July 10, 2023, the overall TVL of LSD in various protocols is $709 million, an increase of approximately 700% compared to about $100 million at the time of the Shapella upgrade on April 12, 2023. The LSDFi market as a whole is expected to continue to grow due to the small proportion of TVL locked in LSDFi, indicating significant growth potential.

Among various LSDFi protocols, Lybra Finance leads with approximately 48.4% market share and over $343 million TVL. The top 10 protocols account for over 90% of the overall market share.

LSDFi Landscape

The LSDFi landscape is quite diverse and can be roughly divided into several subcategories: interest rate swaps, LSD-backed stablecoins, diversified baskets of LSD, and lending protocols.

  1. Interest rate swaps: Protocols like Pendle allow LSD holders to trade their staking yields. Additionally, they can earn additional rewards by providing liquidity to these platforms.

  2. LSD-backed CDP stablecoins: Lybra and Raft are stablecoin protocols that utilize Collateralized Debt Positions (CDP) and allow users to mint stablecoins using LSD as collateral. Lybra utilizes the income generated by LSD to create interest-bearing stablecoins.

  3. Diversified baskets of LSD: Unsheth and Asymmetry Finance offer diversified baskets of LSD, providing users with various liquidity staking derivatives. Additionally, protocols like unshETH have incorporated swap functionality in these baskets, allowing users to earn additional swap fees and achieve higher yields.

  4. Lending protocols: Lending protocols like Aave allow LSD to be used as collateral to obtain loans, thereby unlocking liquidity and leverage for LSD holders. Aave has been widely used for leveraged yield farming with stETH.

Top LSDFi Protocol

Pendle

Pendle is a decentralized protocol with minimal governance that allows people to generate R (a USD stablecoin) by efficiently collateralizing their capital. R is the first USD stablecoin supported exclusively by stETH (Lido Staked Ether). Since its launch less than a week ago, the Total Value Locked (TVL) of Raft has surged to $40 million. Raft enables users to generate stablecoin R by depositing $stETH and $wstETH, providing efficient capital utilization, strong incentives, stable anchoring mechanisms, and ample liquidity across multiple trading pairs.

To participate, users must borrow at least 3,000 R and maintain a minimum collateralization ratio of 110% per borrowed R. The borrowing interest rate is determined by the sum of the base rate and the borrowing spread, with a maximum cap of 5%. Currently, the borrowing interest rate is 0.01% (resulting in a fee of 0.3 R for borrowing 3,000 R).

There are three ways to repay the borrowed R. The first option is repayment: users can repay the borrowed R tokens in Raft and receive $wstETH as a reward. The second option is redemption: users can exchange their R for $wsETH collateral with other borrowers. The final option is liquidation: users can obtain $wstETH as well as liquidation rewards from liquidators. The R stablecoin in Raft also performs well, with deep liquidity in its trading pool.

Conclusion

In this article, we have discussed the benefits of Liquidity Staked Derivatives (LSD), which allow stakers to maintain liquidity of their staked tokens while still earning staking rewards. With LSD, stakers no longer need to worry about price fluctuations of their locked tokens as the tokenized assets or derivative tokens they receive can be used for trading, lending, and other crypto activities within the DeFi ecosystem. Furthermore, the introduction of LSD increases earning opportunities for equity holders and contributes to the overall strength and growth of the crypto network.

In summary, we firmly believe that the concept of Liquidity Staked Derivatives will continue to exist and represent the next major advancement in the DeFi space. Therefore, we can anticipate further breakthrough and exciting developments in the DeFi field.

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