Long-term effects of Shapella’s upgrade on profitability, competition, and LSD-Fi

Shapella's upgrade: Long-term effects on profitability, competition, and LSD-Fi.

Author: Lawrence Lee, Researcher at Mint Ventures. Source: Mint Ventures

On April 13th, 2023, Ethereum’s Shapella (Shanghai at the execution layer and Capella at the consensus layer) upgrade officially went live, primarily adding support for withdrawing staked ETH. With this upgrade, Ethereum’s PoS process can now be considered “complete.” In this article, we will discuss potential future changes to ETH staking yields, competition in the staking market, and the potential impact of LSDfi on the ETH staking ecosystem.

ETH Staking: Past and Present

Before we begin, let’s briefly review ETH staking. Unlike most other PoS blockchains currently in operation, Ethereum’s PoS does not support native delegation, and it limits the maximum stake size for any single node (which could otherwise be profitable) to 32 ETH. This staking method has obvious benefits: it minimizes the possibility of any single entity controlling Ethereum’s consensus by controlling a large node, thereby keeping the Ethereum network as decentralized as possible. However, due to the high complexity of node operation for ordinary users, in addition to solo staking, three other types of staking have emerged in practice: staking pools, liquid staking, and cex staking. The characteristics of these four staking methods are as follows:

  • Solo staking is a method in which the staking user handles all staking processes and subsequent maintenance on their own. Its main disadvantage is the high requirements for devices, funds, knowledge, and networks.

  • Staking pools relieve the staking user of some network and hardware requirements. Staking users only need to pay a certain fee to have professional staking service providers stake their own 32 ETH to generate income. At the same time, this method also ensures that the withdrawal private key is still controlled by the staker itself, providing a high degree of control over the funds. However, stakers still have high requirements for funds and knowledge. In some classifications, this staking method is also known as staking as a service.

  • Liquid staking goes further than staas, outsourcing node operation to professional node operators. The staking pool collects users’ ETH for staking operations, allowing users to stake any amount and issuing a staking derivative called LSD (Liquid Staking Derivatives/Tokens, which we will refer to as LSD in this article), which has a rich set of use cases in DeFi. Of course, in the liquid staking model, all staked funds essentially belong to the staking pool contract; stakers need to trust the staking pool. In some classifications, this staking method is also known as pooled staking.

  • Cex staking is a method in which a cex handles all staking processes, also allowing users to stake any amount and usually issuing staking certificates (such as Coinbase’s cbETH or Binance’s bETH) to users.

Below is a chart showing the historical changes in the relative share of ETH staking. The data comes from https://dune.com/hildobby/eth2-staking (note: due to the complexity of the statistics, the share of solo staking is difficult to calculate, and in most of the classification statistics on staking, there will be a category labeled “unidentified” (as shown in the figure), and according to recent analysis by Rated, currently 6.5% of the total staking volume is provided by solo stakers.)

From the above chart, it can be clearly seen that, except for the first two months after the beacon chain went online, until April 2022, due to the fact that CEX naturally has a lot of ETH held by users, it quickly became the leader in staking as a natural way of generating interest, which is not what the Ethereum Foundation and community members would like to see. With institutions such as Blockinradigm investing in Lido, as well as the gradual construction of good liquidity and composability of stETH, Lido quickly developed and subsequently led to the development of the entire liquid staking category. Liquid staking has been leading in the race since then.

After the successful launch of Shapella, CEX’s staking share has seen a significant decline, with a considerable portion of users who originally staked ETH on CEX turning to liquid staking and solo staking (unidentified).

Looking at the specific staking entities, Lido currently occupies 31.8% of the total staking market share, followed by 3 centralized exchanges in positions 3 to 5, another liquid staking service provider Rocket Pool in position 6, and staking pools in positions 7-10.

Future Yield of ETH Staking

The level of staking rewards is a determining factor for ordinary users to participate in staking. To explore the future development of ETH staking, we need to understand the composition of staking rewards and the future development trend. After Merge, staking Ethereum can not only receive rewards at the consensus layer, but also rewards at the execution layer. Currently, the combined APR of these two parts is 5.4%.

The rewards at the consensus layer are ETH newly issued by the Ethereum network, and the release of the rewards increases as the total staking amount increases, but the APR of staking will decrease as the total amount of staked ETH increases. Currently, the APR of rewards at the consensus layer is 3.4%, and it is generally estimated that the ETH staking rate will be around 25-30% by the end of this year. When the staking rate reaches 30%, the APR rewards at the consensus layer will be roughly 2.4%. This reward is much lower than that of most PoS chains, and is also a reflection of the Ethereum Foundation’s principle of “minimizing ETH issuance.”

Ethereum staking rewards consist of two parts for the execution layer: 1) the priority fee, which is the portion of gas paid by users that is not destroyed, and 2) MEV. The common feature of these two parts is that their income does not increase with the increase of staked ETH quantity. This is the main variable of ETH staking rewards, which requires further research.

Source: https://transBlockingrency.flashbots.net/

Source: https://dune.com/LidoAnalytical/lido-execution-layer-rewards CL_APR represents the yield of consensus layer; EL_APR represents the yield of execution layer.

Flashbots compiled the total income of proposers (i.e., validators) since the Merge. Lido also calculated the yield of consensus layer and execution layer since the Merge as shown above. The trend of these two is consistent. Lido also calculated the comparison of yield between consensus layer and execution layer. We will use Lido’s chart for detailed analysis.

We can see that after the Merge, the consensus layer APR is slowly decreasing with the increase of staked amount, while the execution layer APR fluctuates greatly, averaging around 1.5%, making the return on staking reach 5%. When there is frequent on-chain activity (such as the meme season in May), the APR from the execution layer can even exceed that from the consensus layer, making the return on staking Ethereum close to 10%. Staking rewards, as the “risk-free return rate” of the Ethereum network (see Mint Clips | How should the native benchmark interest rate of the crypto world be defined?), are highly attractive to ETH holders.

So how will the yield of the execution layer evolve in the future? First, we need to understand the proportion of priority fees and MEV to the rewards earned by stakers on the execution layer. We can refer to the detailed analysis of income data of various roles in the Ethereum execution layer ecosystem by MEV data service provider Eigenphi for January to February 2023:

Source: https://eigenphi.substack.com/p/value-allocation-in-mev-supply-chain

We can see that in two months, the priority fee and MEV basically accounted for the Ethereum staking rewards (Validator fee) on the execution layer in a ratio of 55% to 45% (44.12 million:34.72 million).

Next, we will explore the trends of priority fees and MEV in the future.

Ethereum network priority fees Source: https://tokenterminal.com/terminal/projects/ethereum

In terms of priority fees, after the launch of EIP-1559, the current market has gone through a bull-bear conversion. We can see that priority fees are closely related to market heat. During the bull market period in 2021, the daily average priority fee can reach nearly $10 million, while during the bear market period in 2022, the daily average priority fee is around $800,000. During the Meme Season in May this year, the daily average priority fee can reach about $3 million. In the future, priority fees will still fluctuate with the market, and this part of the income is ETH-based, and will continue to fluctuate with the market in the future.

The MEV aspect is more complicated. In addition to MEV that cannot be fully analyzed on the chain, it mainly includes three types of arbitrage, sandwich attacks, and liquidation. We have not found the latest trend data on MEV after the merge. However, the Ethereum Foundation has been relatively negative about MEV for a long time. A year ago, they proposed a plan called PBS (Proposer-builder separation), one of which aims to eliminate the impact of MEV on small stakers’ income. Recently, Justin Drake, the Ethereum Foundation Research Institute, proposed a plan called MEV burn, planning to burn all MEV in the next 3-5 years as another force for Ethereum deflation. Although this plan is still in the planning stage and involves many interests, from the successful transition of Ethereum from PoW to PoS, they have the ability to “convince” key stakeholders in the ecosystem to give up their interests and achieve the Ethereum roadmap.

Therefore, MEV, which accounts for about 20% of the current total staking income, is likely to be reduced or even disappear in the medium to long term because it does not conform to the value orientation of the Ethereum Foundation.

Another marginal factor worth noting is L2. Driven by the Ethereum roadmap centered on Rollup, more and more transactions will inevitably be transferred from Ethereum L1 to L2, which will inevitably reduce the MEV and priority fees on the Ethereum mainnet. Currently, L2’s MEV/priority fees are handled by L2 itself and have nothing to do with Ethereum mainnet stakers. Especially after the Canquan upgrade further reduces the cost of ETH L2, it may drive further development of L2, and the total fees+MEV that L1 can obtain may also be further reduced as a result.

Considering MEV burn and L2 impact, when ETH staking ratio reaches 30%, the yield of ETH staking will likely drop to around 3% (including 2.4% consensus layer yield and 0.6% execution layer yield). This yield will significantly affect users’ enthusiasm to participate in staking.

Liquid Staking will still be the mainstream staking method, and its concentration may increase further

Shapella’s upgrade activated the withdrawal function of ETH, which provides liquidity to ETH staked in solo staking and staking pool methods. The core factor for the rapid development of liquid staking from 2021 to 2022 is that the liquid staking protocol can provide liquidity to LSD, which indirectly achieves the exit of staking. Therefore, Shapella’s upgrade clearly reduces the advantages of liquid staking. Although solo staking still has a considerable operational threshold, the tools serving solo stakers are increasing, and the threshold for solo staking will gradually decrease. Moreover, solo staking has the legitimacy to maintain the decentralization of the Ethereum network and has received strong support from the Ethereum Foundation.

Why do we still believe that liquid staking will maintain its advantage in the staking track and even further increase its concentration?

The main reason lies in composability. LSD has good composability, which means a higher possibility of obtaining higher returns/efficiency. Users participating in staking are naturally sensitive to returns and tend to choose staking methods with higher returns. Since the high composability of LSD actually provides staking users with higher returns.

At present, when the basic yield of staking is 5.6%, LSD can easily obtain an APR of 10%. Taking Lido’s stETH as an example:

Source: https://defillama.com/yields?token=STETH

We can see that the current stETH LP can easily obtain an APR of more than 50%. Considering the capital occupation of the paired assets, the total APR can also exceed 25%. The single coin stETH in Asymetrix (LSD’s pool together) and Ribbon (option agreement) can also obtain an APR of more than 25% (although it may face some risks). When stETH’s own 5.6% APR is added, the total income of users staking through lido can reach 30%.

Aside from high returns, stETH is widely integrated in DeFi blue-chip protocols: Maker, Aave, and Compound all support stETH (wstETH) as collateral, with little difference in collateral parameters compared to ETH. The stETH-ETH pool on Curve still has over $1.1 billion in liquidity, which makes it more convenient to obtain liquidity whether directly swapping or using stETH as collateral for borrowing.

These advantages are not available for solo staking and staking through pools. Especially, if the ETH staking yield drops to only 3%, people will likely choose the simpler and more profitable option, considering the devices, knowledge, time, and energy that solo stakers and pool stakers have to put in for the 3% yield.

Ethereum community users are willing to maintain Ethereum’s decentralization, but they also need to consider opportunity costs. “Maintaining Ethereum’s decentralization is important and cool, but I still hope to choose 30%.”

LSD and LSD-Fi

After the Shapella upgrade, many LSDfi projects emerged on the market, which share the common feature of attracting LSD deposits from users for various financial applications. Many people believe that we will encounter an LSDfi summer.

Source: https://dune.com/defimochi/lsdfi-summer

We do not discuss the advantages and disadvantages of specific LSDfi projects in this article, because in my opinion, LSDfi does not create a specific business category, but only allows LSD to be used as collateral for many businesses. Essentially, what these protocols do is still stablecoins, yield aggregation, DEX, and interest rate services. Whether their businesses can succeed still depends on their understanding of the stablecoin, yield aggregation, DEX, and interest rate service market. Among the LSDfi projects that have actually launched products, we have not yet seen any projects that can get rid of Fork and pure yield farming games. Of course, there are still more high-quality LSDfi projects that have not yet been launched, and we look forward to more innovations relying on LSD in the future.

What we want to discuss is the impact of LSDfi on the entire staking industry.

LSD holders must have two characteristics: they hold ETH on-chain and have some understanding of DeFi; they are sensitive to yields (which is why they choose to stake). These two characteristics make them the target users of any DeFi entrepreneur on the Ethereum network: they hold ETH on-chain, so they can perform on-chain operations and may also understand their business; they are sensitive to yields, so their behavior can be influenced through incentives. In fact, even today, when DeFi has developed to a relatively mature stage, there are still many ETH holders who only hold ETH on centralized exchanges.

Source: https://etherscan.io/accounts

Based on the recent LSDfi hype, more and more LSD projects are expected to go live with new tokens that come with new market budgets. What has happened on unshETH, Agility, Lybra may happen again in the next 3-6 months in LSDfi. LSD will continue to offer APRs that far exceed those of ETH on-chain, and this may create a self-reinforcing flywheel effect between LSD and LSDfi: the more LSDfi, the higher the yields it generates, the more incentive ETH holders have to convert their ETH into LSD; more LSD will encourage DeFi protocols to target this user base by offering high yields and attracting them through the cold start phase of the protocol.

Eventually, all DeFi protocols may be referred to as generalized LSDfi, as they all more or less support LSDfi (in fact, with the exception of a few stablecoin protocols, most DeFi protocols are already associated with LSD). Clearly, LSD can capture the beta of LSDfi. The heat of LSDfi will further promote the proportion of liquid staking in the overall staking track.

Ethereum Foundation’s Attitude

The Ethereum Foundation has shown the following attitudes regarding staking-related issues:

  1. Do not want too much ETH to enter staking. Too much ETH entering staking will increase the amount of ETH rewards released at the consensus layer, which contradicts Ethereum’s “minimal viable issuance” philosophy, and will also reduce Ethereum’s economic bandwidth (economic bandwidth is a concept proposed by Bankless, which refers to the liquidity market value of Layer 1 and is the foundation for supporting all Dapp operations on it).

  2. Negative view of MEV. For each Ethereum staker, MEV is a huge reward that can fall from the sky at any time, with a low probability. If not intervened, it is easy to create forced centralization (such as BTC and ETH in PoW mining pools), and build new alliances on Ethereum’s consensus layer (such as the current MEV-boost), causing unnecessary and potentially unsafe complexity in the consensus layer. In the medium and long term, the Ethereum Foundation will push for the destruction of MEV, turning it from a privilege of a few validators into a joint reward of all ETH holders.

  3. Do not want to see an LSD that is too powerful to “replace” ETH on the Ethereum mainnet. This will also bring more unnecessary security risks to ETH.

The main idea behind Ethereum is to maintain a decentralized consensus layer while not affecting ETH’s characteristics as the primary collateral asset of the Ethereum network, and not wanting Ethereum’s consensus layer to be influenced by protocols built on top of Ethereum.

Source https://ultrasound.money/

Currently, stETH is the largest non-native stablecoin asset on the Ethereum network. USDT and USDC rank higher than stETH, and their use cases are indeed very wide, but they are essentially maintained by the credit of Tether and Circle. If they have problems, it may have a great impact on Ethereum, but it will not consume Ethereum’s credit.

However, stETH is special in that it has almost been integrated by all DeFi protocols as collateral similar to ETH. Let’s do a thought experiment. If Lido Finance’s contract is attacked and all Lido withdrawal private keys on the beacon chain are controlled by hackers, will Ethereum need to undergo a hard fork like the DAO event?

Nobody wants to see this happen, so we can understand why the Ethereum Foundation needs to work hard to support solo staking, why the Ethereum community discusses whether to limit the scale of Lido, and why Lido will focus on decentralization as its main task. But the problem is that the appearance of a large liquid staking service provider is not intentionally caused by some evil centralized organization, but is a natural result of market competition. Even if the Ethereum Foundation/core community can control the scale of Lido in some form, there will be Mido or Nido appearing as the next staking hub.

There are two worlds in front of us:

  1. One is what the Ethereum Foundation originally hoped to see: the proportion of ETH staking is not high, enough to maintain security, and most ETH is still used as collateral assets on the main network to maintain the normal operation of various Dapps, and the staking entity is Solo staker;

  2. The other is what we are likely to see in reality: due to the existence of one (or several) powerful LSD, more ETH enters liquid staking, and this (or these) LSD becomes the collateral of various DApps, to a large extent, this (or these) LSD “becomes” ETH.

Looking at it now, the latter is much more likely.