Upgrade triggers a chase for profits, Ethereum liquidity staking soars to $20 billion

As the largest liquidity collateral token, Lido’s stETH represents over $14.6 billion worth of Ethereum staked and has grown by over 28% since the introduction of staking withdrawals in April.

Max Shannon, a digital asset analyst at CoinShares, told DL News: “In Ethereum DeFi, liquidity collateral tokens are more popular than Ethereum as collateral.”

Shannon noted that on Aave, the largest DeFi lending protocol with over $6 billion in total deposits, Lido’s stETH has surpassed Ethereum to become the largest collateral asset.

“People who hold liquidity collateral tokens can easily trade those tokens, use them as collateral, or take advantage of yield opportunities through lending protocols,” said Shannon.

Within Ethereum’s DeFi ecosystem, protocols are increasingly replacing Ethereum with liquidity collateral tokens such as stETH.

By doing so, protocols can incorporate the underlying Ethereum staking rewards (currently yielding around 4% to 5% annualized returns) into their DeFi products, increasing potential returns.

TN Lee, co-founder of Pendle, told DL News: “Ethereum staking rewards have undergone a paradigm shift and become the reference for DeFi annualized returns. As the number of liquidity collateral assets grows, the demand for them will also increase.”

However, Ethereum analyst Alice Kohn says the pursuit of higher returns for LST is changing the way DeFi users deposit funds. DeFi users are increasingly inclined to deposit their LST into lending protocols rather than using them to provide liquidity for decentralized exchanges, which is necessary to ensure that DeFi users can easily trade between Ethereum and its staked version.

Since April, the value of the stETH-ETH Curve Pool has fallen 39%, while the wstETH-ETH Pool on Balancer has fallen 71%. Meanwhile, the total locked value of stETH on the lending protocol Compound has increased by over nine times. According to Kohn, this is primarily in pursuit of higher yields. LST can be used as collateral to hedge against Ethereum’s leverage risk, allowing LST holders to increase their exposure to LST through leveraged borrowing and double their returns on LST.

Circular Ethereum Staking

What Kohn describes is “circular” – a common way to increase returns on assets such as stablecoins, collateralized and non-collateralized Ethereum. DeFi users deposit LSTs (such as stETH) into lending protocols such as Aave or Compound, and use their deposits as collateral to borrow Ethereum. They then deposit the borrowed Ethereum into stETH obtained through Lido staking and repeat the process. The result is that the Ethereum staking reward is compounded multiple times, pushing up the yield. However, circular Ethereum staking also carries risks.

If the price of Ethereum and stETH differ significantly, those who are leveraging in lending protocols will face the risk of being liquidated. Additionally, because Lido’s stETH is currently the most popular circulating LST, there is a risk of concentrating most of the collateralized Ether in one place. Many DeFi enthusiasts are concerned that this situation could threaten the decentralization of Ethereum and potentially reduce network security.

Although other LST providers such as Rocket Pool and Frax Ether have weakened Lido’s dominance in recent months, it still maintains the most dominant position in liquidity staking protocols, with a 74% market share.

Shannon said that this situation is unlikely to change soon: “Lido’s stETH will continue to dominate the LST market because of its network effect and integration of stETH in DeFi.”