analysis of the social and economic headwinds facing stETH, how these headwinds are reflected by market conditions creating tailwinds for rETH, an analysis of the broader LSD, and the general rETH bull case
1 - Power is not Law
2 - Social Headwinds to stETH Growth
Rapidly Changing Fee/Incentive Structures
The Multichain Dilemma
3 - Economic Headwinds to stETH Growth
Staking––Risk Free or Risk Fee?
4 - The Orange Cascade
The Orange Creep - Pre-Withdrawals
The Orange Migration - Withdrawals
5 - A New Challenger Arrives
The Drain of cbETH
frxETH - Liquidity vs Design
Shadowy Super Stakewisers
6 - The Underappreciated Art of Counterparty Tokenomics
7 - Conclusion
8 - Postscript
In an unbalanced system lacking external inputs, power tends to concentrate in the hands of the few. This phenomenon is known as the Pareto principle and is most commonly used to describe a situation in which 20% of a group control 80% of a resource or outcome. Also known as the power law, a well-known example is global wealth accumulation but similar patterns can be seen across a diverse range of subjects including ecology, economics, sociology, and language.
The Pareto principle was the foundation of a now-famous research paper from Hasu and Georgios of Paradigm, a Web3 investment firm. Writing about the nature of liquid staking, they argued that Ethereum’s proof-of-stake (PoS) system would be dominated by pools that were socially scalable and delivered the highest possible returns by accepting MEV (Maximal Extractable Value). They argued that a Pareto distribution would result whereby most staked ETH would be controlled either by a centralized exchange, or a less-centralized alternative that could launch first. A first-mover would benefit from the Lindy effect, with its growing time in the market translating to increased investor trust. Another advantage of being early is that liquidity tends to beget liquidity - this protocol lifeblood being all the more critical for any liquid staking endeavor, as the name suggests. The authors would go on to help found Lido, a protocol which now holds an oppressive ~90% of the Ethereum Liquid Staking Derivative (LSD) token market cap used in DeFi, much higher than the power law might suggest is natural.
Indeed, the Pareto principle only holds true in the presence of some environmental limiting pressure that prevents total ecosystem domination. To use a common Biological example, balanced predator/prey power law dynamics normally keep both populations in check, but artificial disruptions from external factors such as hunting can quickly result in complete ecological collapse if left unchecked.
The claim that PoS ETH is already in a power law distribution often skips an important component--the limiting pressure. In Biology, the logistic curve demonstrates the growth of a bacteria colony through various phases. Exponential growth quickly brings the population to an extreme from essentially zero. In the middle of the curve, growth reaches an inflection point and slows as some pressure begins to mount. For predatorial species, this may be decreasing food rations from over predation. The final part of the curve is the approach towards carrying capacity – an asymptotic relationship for the population’s ceiling wherein risk or lack of food inhibits any further growth. Here the bacteria holds a dominant, yet fluctuating, grasp on the ecosystem. Further growth is repudiated as it would diminish resources causing population collapse, which in turn would boost reproduction as resources become plentiful again -- a constant cycle around the steady state. Now, imagine if the counter force could be suppressed or hidden. What would happen to the bacteria population? It would consume with no end.
I posit that Lido has been artificially suppressing power law dynamics to maintain an unsustainably high proportion of the Ethereum LSD market. The long-term effects of this behavior are simple and inevitable – as the seemingly endless liquidity incentives dry up and the DeFi integration gap lessens, the market’s invisible hand will drive reversion towards a Pareto distribution. The outright dominance of Lido’s LSD token (stETH) should drop as rational actors diversify risk.
Much as the US Federal Reserve printed billions of dollars in repsonse to the Covid-19 pandemic, Lido has been rapidly inflating and spraying their governance token (LDO), to the tune of millions of dollars per month. By paying to elevate the utility of their stETH LSD, Lido has been attempting to entrench the first-mover advantages outlined in Hasu and Georgios’ paper. Retail investors therefore face a prisoner’s dilemma, with self-interested and profit-chasing actors seeking out stETH’s boosted value despite inherent risks being obscured beneath a flood of LDO incentive payments. Lido’s mask briefly slipped during the 3AC (Three Arrows Capital) collapse in June 2022 when stETH rapidly attracted a risk discount of as much as -6.6% compared to liquid ETH, repsresenting around 18 months of rewards temporarily wiped out. To understand how this risk materializes is a symptom of Lido losing its place as the current power law majority player we have to consider the social and economic headwinds acting against Lido’s relentless quest for total market dominance.
Hasu and Georgios lay out the social arguments themselves:
“One metric that matters for PoS security is how much of the stake is controlled by a single entity. For [centralized] exchanges 15-30%; at more than that, there might be social concerns about power centralization in the Ethereum ecosystem. A decentralized staking pool can control any share of the network, as long as each individual validator in the DAO is not too big and as long as the withdrawal credentials cannot change / be voted on.
We have to emphasize how important it is that the decentralized staking pool by that point has shed all of its governance functionality. Neither fees, nor withdrawal addresses, nor the validator registry can be allowed to be changed by human inputs.”
Italics are not my own, but the emphasis is. In this section, the authors suggest that social limits placed on centralized exchanges may not apply to a decentralized protocol that meets the requisite governance criteria. It is Lido’s failure to meet these very criteria that is actively creating a resistant force to the protocol’s continued growth and dominance.
Lido now sits at >30% of the network, still bathed in governance. It seems that, despite their important emphasis two years prior, Hasu and Georgios have now conveniently forgotten this core part of their 2020 paper. In contrast to Lido’s ferocious appetite for growth, steps to “shed all of its governance functionality” have been conspicuously lackluster. An updated dual-governance structure gives voting power to LDO holders and a secondary veto power to stETH holders. But if anything this acts as a distraction to the fact that there have been no real steps taken to diminish Lido’s governance - something that has understandably drawn the ire of some of Ethereum’s influential core developers.
Unfortunately, it’s probably not suprising that a small number of powerful individuals who are on a self-proclaimed mission to corner the Ethereum LSD market are slow to give up control of Lido. Should these same individuals become corrupted, they could effect significant negative changes to the core Lido protocol which would spill over to infect the wider Ethereum ecosystem.
One example would be misusing Lido’s outsized control of the Ethereum network for added value extraction, namely through multi-block MEV or reorg attacks. There is already a precedent that these legal but immoral actions are not taboo for a purely profit-driven Ethereum organization, as F2Pool has been known for small-scale attacks on blockchain consensus to increase their own profits. If Lido compels their hand-picked validators to implement these immoral value extraction methods at scale, the credible neutrality of Ethereum itself becomes challenged. This threat of cartel-ization is exactly why Hasu and Georgios placed great emphasis on stating that any protocol with governance control should have a hard upper ceiling on their market share.
Reviewing a different liquid staking protocol helps to provide some interesting contrast in governance. Eschewing a tightly controlled and centralized structure, Rocket Pool presents more as a rough consensus between different groups of stakeholders. Overall protocol direction is driven by a DAO of node operators (the pDAO), with changes then worked on by a team of core developers. The actual implementation is controlled by a second, external DAO (the oDAO), which operates at arms length to review and action protocol upgrades.
The quadratic voting power of individuals within the pDAO is linked to both their validator count and a capped amount of the RPL utility token. This is a much more robust system of governance than having individuals gain power from simply holding a large quantity of LDO tokens.
After rewriting the entire protocol in 2018 following the Capser PoS contract change, the team has demonstrated their fierce alignment to the core ethos of Ethereum including a public statement of intent to self-cap Rocket Pool’s market share.
The oDAO is comprised of major parties from across the breadth of the Ethereum ecosystem and are strongly aligned by a combination of three ties: a financial bond, considerable social capital, and a natural alignment with the core principles of Ethereum.
This multi-party governance system provides anti-fragility in the face of attacks. In fact, it mirrors the rough consensus that Ethereum itself follows wherein multiple different parties signal towards the core developers, but no single party could do so in isolation. Rocket Pool’s governance is still nascent, but its methodical and deliberate progress down the pathway toward full decentralization ensures that the protocol is less likely to fall victim to a social attack.
One of the governance red flags raised by Hasu & Georgios that should lead a protocol like Lido to self-cap is that “Fees… [should not] be allowed to be changed by human inputs.” It perhaps will not be of much surprise to the reader to learn that not only can Lido’s fees be changed, but they are actively being adjusted. While the protocol’s top-line 10% commission rate is steady, the flow of these funds has recently been redirected away from insurance towards a more generic treasury for other uses such as marketing. The fact that LDO token holders voted in this change to arguably strengthen their position while putting stETH holders at heightened risk raises questions about how effective Lido’s dual governance really is. The ability for Lido’s entire insurance profile to change based on a vote decided by a core group of founders is a distinct weakness.
An even more shocking development was the recent attempt by Dragonfly, a powerful VC firm, to pass a controversial vote to sell itself 2% of Lido’s treasury at a favorable price and with no vesting protection.
On-chain governance voting lacks the information rights afforded by the traditional finance world. The resulting information asymmetry means that those who have the best interests of the protocol at heart need to work hard to identify and raise the alarm against exploitative governance proposals.
An initial influx of favorable voting on the Dragonfly proposal was only reversed once a social response was organized to draw enough votes against the proposal to see it fail. But the vigilance of Lido’s stalwart defenders cannot be guaranteed in perpetuity, and it takes only a single lapse for a proposal with unfavorable components to slip through. As long as the flows of Lido’s capital remain unossified, the protocol will continue to be the focus of governance exploitation.
Lido’s small group of 30 carefully selected validator companies can be very quick to respond to protocol changes, including unfavorable changes, leaving stETH holders with little time to react. By comparison, Rocket Pool’s decentralized structure of over 1,600 node operators worldwide tends to move much slower, meaning that any change to the flow of incentives would be a more gradual adoption, such that rETH holders can respond.
A related issue is the general infancy of on-chain governance. DeFi tokens act as voting shares without any of the information rights the traditional finance world would have afforded to you. As such, the information asymmetry between those with the most to gain from governance (VCs, other protocols) and those who have the best interests of the protocol at heart (founders, active community members) results in occasional exploitative governance votes. Dragonfly, a VC firm, attempted to pass a highly controversial vote to sell itself tokens from the Lido treasury. Due to a strong social response, this vote failed; however, DAOs cannot rely on someone sounding the alarm every time a vote is secretly malicious. The web of governance is broad and all aspects of the protocol are indirectly affected by each other. As long as the flows of capital remain unossified, the protocol will continue to be the focus of governance exploitation.
For Rocket Pool, the set of node operators running validators is incredibly large and so attempts to change the flow of incentives will require gradual adoption. For example, the future change to lower ETH collateral in minipools will also change the rETH commission rate; however, since there are hundreds of operators that each have to make the decision to upgrade, this process is made gradually, such that rETH holders can respond. With a set of only ~30 operators, coordinating changes that would change the flow of capital is much simpler and quicker.
One of the claimed advantages of a hand-picked set of corporations running most of Ethereum’s validators is that for-profit enterprises will be more dedicated than home stakers. Lido’s CTO recently went so far as to claim that “[home stakers] who run nodes for fun will drop them…when it’s no longer fun…If your business [and] career depends on blockchains, you tend to be thoughtful and committed”. However, the elephant in the room is that many of Lido’s professional validators are providing their services to multiple different chains concurrently. This glaring conflict of interest calls into question just how committed Lido really is to Ethereum. In the case of a widespread technical disruption event that knocks multiple validators offline across multiple chains, it’s unlikely that any professional operator would have sufficient staff resource available to restart all chains simultaneously. An incident in September saw 7,390 of Lido’s Ethereum validators operated by Bridgewater Capital go offline for over eight hours following the pre-planned bellatrix hard-fork, Bellatrix. If response times were so slow for a pre-planned event on a single chain, think how many more hours or even days it would have taken them to recover from a real crisis, and at what cost to their liquid stakers. It also raises the risk of a more profit-focused or centralised blockchain such as Solana offering monetary incentives for prioritised crisis handling. By comparison, the logisitcal realities of staking as an individual means that home stakers are far more likely to be truly dedicated to a single chain.
But it can get even worse. In a true doomsday scenario where multiple blockchains halt and require a restart, a high degree of coordination is required between the validators. Attempting to do this for a single blockchain is difficult enough, but managing several at once would be all but impossible. Again, home stakers being more thoughtful and committed to ETH means that while more decentralized, they are also more likely to accomplish a smoother restart.
Further, the negative effects of multichain validation extend to everyday scenarios too. Every chain a professional validator is responsible for has its own incentive structure. New incentives could be misaligned with old ones or vice versa. For example, becoming the majority validator in two competing chains and causing the smaller chain to fail or underperform relatively is a real concern for more centralized, smaller Cosmos chains. As Lido continues to expand across chains with no principles guiding it, users must begin to question how aligned Lido is with Ethereum. Meanwhile, Rocket Pool serves only Ethereum, though users are free to run other validators on their hardware.
Another of Hasu & Georgios’ governance red flags that Lido exhibits is that Lido’s “validator registry can be … changed by human inputs.” This remains a fully centralized and opaque process that is solely determined by human inputs from a select committee. It is not a stretch to imagine Lido’s elites falling to corruption and seeking personal gain from their positions of power. Examples might include requiring validators to conduct immoral value extraction at scale, or succumbing to pressure to censor transactions. Despite the glaring security risk it poses, there remains no plan for Lido to decentralize this onboarding process away from humans. In contrast, Rocket Pool remains the only staking service that provides permissionless onboarding of node operators. Anyone can be a node operator for Rocket Pool, and hence the protocol is immune to these centralisation risks.
For these social reasons, the broad Ethereum ecosystem has exhibited an increasing pushback to Lido’s dominance. I would argue that while these social factors are significant, they are still ancillary to economic forces. While the online narrative for Lido soured, the 3AC capitulation and ensuing mass stETH liquidation cascade presented, for seemingly the first time, a new element to the stETH market – risk.
Many retail investors have been lulled into viewing Lido’s stETH LSD token as infinitely redeemable for ETH given the vast liquidity reserves and the history of being on-peg. As often happens in such cases, this perceived security was abused to the point that the price of an overleveraged stETH collapsed by as much as -6.6% vs peg. While priced at peg, it takes a significant force to overcome a token’s inertia and cause this kind of drop - in this case the 3AC bankruptcy - but this same inertia means that a return to stability is not guaranteed and can only be accomplished through significant effort.
The various different LSD tokens fluctuate around their peg or reference price. The largest and most persistent discount vs peg is for Coinbase’s cbETH, followed by stETH, and the smallest is Rocket Pool’s rETH, which sometimes even trades at a small premium. The persistence of stETH’s depeg can be traced back to the hundreds of thousands of tokens minted on leverage and subsequently dumped on secondary markets, depressing the price. Because every stETH minted on leverage is just as eligible to be redeemed for ETH, Lido is essentially engaging in fractional reserve banking by facilitating the creation of many more deposit receipts than there exists deposits.
Nansen analysis of stETH’s -6.6% depeg event during the 3AC capitulation revealed that most sells came from large wallets whereas buying pressure came from smaller retail investors. Thus, stETH’s price deviation from peg represents the risk discount or perceived likelihood of a bank run on Lido’s ETH deposits from small retail. Thus, the price at which retail became willing to buy up stETH is an accurate reflection of the risk the market associated with stETH.
Looking at it from the other side though, anyone buying stETH shortly before the collapse would have seen around 18 months of allegedly low-risk rewards temporarily wiped out in a matter of days - it is important not to undersell how big this depeg is. During this event, there were clearly very few individuals who perceived stETH to be a risk-free wrapper on future ETH redemption.
It’s worth noting that rETH also de-pegged at the same time, but to a much lesser extent and also exhibited a quicker recovery. The APR in ETH staking is lower than other avenues in DeFi and as such the losses are more painful as they are much harder to earn back. In such a capital-intensive, low-yield environment, having proper risk management is crucial. Fortunately, the market has more or less ordered all the LSD tokens by perceived risk using their degree of ‘de-peg’ and we can use this to draw some conclusions about LSD token risk. But where does this risk come from? It can be grouped into three main categories: execution risk, centralization risk, and tail risk. I will show that Lido is at dangerously high risk levels in the latter two categories and that this is calculable by comparing execution risks between tokens.
If the market saw stETH as a risk-free wrapper on future ETH, the spread would very quickly be eaten up. As it has instead only slowly climbed up and plateaued around a 3-4% depeg pre-Merge, the market clearly has concerns about Lido. It is important not to undersell how big this depeg is. If a user bought stETH shortly before the capitulation event, they very quickly found themselves down nearly2 years worth of yield, gone, vanished in days. Notably, at that point the stETH depeg was twice that of rETH, meaning stETH holders who sold incurred an additional year worth of losses compared to rETH holders. In other words, if a user had staked with Lido at the launch of the Beacon chain and panic sold during the depeg, they would have lost all the rewards they had ever earned. The rate of growth in ETH staking is slower than other avenues in DeFi and as such the losses are more painful as they are much harder to earn back. In such a capital-intensive, low-yield environment having a proper risk assessment is crucial. Fortunately, the market has more or less ordered all the LSD tokens by perceived risk using their degree of ‘de-peg’ and we can use this to draw some conclusions about LSD token risk.
Where does this risk come from? I argue that there are three major elements to any risk calculation of an LSD token. They are execution risk, centralization risk, and tail risk. I will show that Lido is at dangerously high risk in the latter two categories and that this is calculable by comparing execution risks between tokens.
I define execution risk as existential threats to a protocol that stem from necessary future upgrades.
Some marginal risk between tokens can be allocated to individual protocols themselves and would largely be correlated with the extensiveness and complexity of the respective smart contracts. But upgrades to Ethereum itself also fall into this category and hence would apply equally to all LSD protocols since they are similarly at risk of a failed hard fork, for example. The successful completion of The Merge demonstrated the role of execution risk. Following The Merge, the stETH depeg dropped to 1% and rETH hit parity. It can be inferred then that a large part of the remaining depeg is now due to centralization risk and tail risk.
Next up, tail risk is a collection of various potential on- and off-chain governance abuses such as smart contract exploits, slashings, quadratic leaks, massive hardware failures, and custody errors. These tail events are all exceptionally unlikely to happen or to predict, but risk management basics would always assess any unlikely but severe occurrence to be of equivalent importance to a more likely but less severe event. Further, an antifragile DeFi primitive must be measured by its worst-case scenario resistance.
Node operator penalty events in the Ethereum ecosystem such as offline losses and slashings scale with the number of validators involved. With each of Lido’s small number of node operator companies managing thousands of validators each, there is an inherently higher protocol-wide tail risk exposure compared to a more decentralized set of operators running a smaller number of validators each.
Despite this inherent risk to the staked ETH that Lido manages for investors, they lack sufficient insurance to cover worst-case scenarios and as mentioned previously have even begun diverting funds away from the small protection fund that they do possess, worth around 5,000 ETH. Any losses that exceed this amount would be socialized across all stETH holders. In contrast, other LSDs such as rETH and sETH2 have a much higher degree of protection, though only rETH offers true tail risk protection through a large amount of over-collateralization. For a proper comparison of how different LSD tokens provide insurance, see this analysis by dabdab.
But to make matters even worse for Lido, there is no short-term path to solve the substantial dependence on the early Lido node operators, even when their existing operators show signs of poor performance, such as the Bridgetower capital incident mentioned earlier. The staked ETH that these operators manage cannot currently be withdrawn. Mitigating this risk through diversification by onboarding additional node operators is not possible, since it only leads to an increase of the third and final category: centralization risk.
While the above two categories are bad enough for Lido itself, any event occuring within what should be a DeFi primative has the potential to be realized as considerably worse, with its effects cascading through the entire industry build on top. This centralization risk is the idea that execution and tail risks have a greater impact as the size of any protocol grows. Since Lido has refused to self-cap at any size, it could one day hold a supermajority of staked ETH. Any failing within Lido would therefore spill over and affect the entire Ethereum ecosystem like a parasite killing its host. This risk should manifest in an increasing sell pressure as Lido’s market dominance rises. Even if governance risks are resolved, the mere appearance of a risky supermajority from Lido could still generate this kind of sell pressure.
Sitting at just over 30% of all validators and 75% of all liquid staked ETH, stETH is an order of magnitude larger than rETH at 1.5% of all validators and 5% of liquid staked ETH. Though Lido does not yet have a supermajority of all ETH, they have refused to self-cap and have maintained an exceptional, perhaps unnatural, lead.
In times of risk-off or volatile market conditions, the de-peg gap between stETH and other lower-risk assets such as rETH represents a “flight to safety” with the market pricing in the potential adverse scenarios that could befall Lido.
The researchers at Paradigm suggested that the first socially scalable and pre-MEV LSD could quickly attract lindy effects and dominate in a power-law distributed fashion. I suggested that Lido’s growth has been too aggressive such that what should have been a power-law field had become a single-player market with stETH at a dominant >90% of LSD market cap. There has been a growing resistance to this stETH dominance both socially and economically. In terms of social barriers to growth, Lido is overly governance dependent with corruptible human-appointed whitelists. Economically, the crashing liquidation cascade and lasting depeg in June demonstrated how stETH in fact has significantly larger centralization and slashing risks relative to other LSDs.
I will now discuss how stETH’s market share can drop from being a near monopoly to less than a majority. The fact is that most ETH remains unstaked and more funds are expected to enter in the months ahead. With a greater awareness of risk in the market compared to the heady days of 2021, a much more stringent eye will be placed on tail risk scenarios.
With stETH’s inflexible and inadequate insurance already being siphoned off towards generic ‘treasury’ uses, Lido will find itself unable to safely scale further. It may be the case that stETH has hit its relative peak already. A single major slashing event at any one of Lido’s node operators will permanently reduce trust in the system–since across large time scales this becomes a question of when not if, will large investors be willing to play ball? There is already proof that simply shaken confidence in wider markets can lead to years worth of yield being wiped away. How much worse would the impact be of a Lido-specific incident? What would the reaction be to mass stETH rebalance towards the red? It may be necessary for the ecosystem to learn this lesson the hard way through a major slashing event, but the pressure remains regardless.
Even as Lido attempts to push stETH’s LSD dominance higher with distorting incentives, better alternatives provided by competitors could very well see the market settle back into a traditional Pareto distribution.
Rocket Pool is already the most tail risk resilient, socially scalable, and MEV friendly decentralized LSD protocol. it makes sense for it to be the one that benefits most. This era will also be marked by the LEB8 and Staking as a Service (SaaS) upgrades, the former reducing collateral requirements to 8 ETH per minipool and the latter opening up complex staking arrangements with different parties providing different assets.
The supply multiplier on LEB8s is sufficient to double the rETH TVL alone. Then, we can consider the significance of lowering the barrier to entry. Far more people will be willing to bond 8 ETH than 16 ETH and so, despite a floor projection of a 2x, we can expect much more than that.
The supply multiplier from SaaS is harder to quantify. The upgrade will introduce super nodes that can create novel relationships between the node operator and providers of ETH and RPL collateral. By introducing an in-protocol way to separate the risk of these three tranches, Rocket Pool stands to greatly expand it’s TAM. Many individuals express the desire to only stake ETH, not wanting RPL exposure, or vice versa. The SaaS design will allow third-party groups like the Node Operator Association to onboard these users and shift the burden of RPL collateral. Current development progress indicates a release after withdrawals but before forced exits.
To draw parallels to another Web3 power struggle, Sushiswap was never able to flip Uniswap despite the fanfare with which it launched. But at the same time, Sushi was also never able to offer a compellingly better product which perhaps explains why it was able to break the monopolist grip that UNI had on dex volumes but make no further progress. It has been established that Lido’s stETH has both social and economic forces pushing against it, with liquidity and lindy effects propping up its dominance. But with the advent of a level playing field between mature & established players, Rocket Pool’s superior social narrative and higher resilience can push rETH's market cap over stETH's. The trendline for primitive DeFi assets is toward maximal security. This is how rETH will flip stETH.
Potentially, in under 6 months, withdrawals will be live, and rETH will gain three massive unique tailwinds: solo staker migration, the flight from stETH, and liquidity mitigation.
The first group that will be able to move to Rocket pool post-withdrawals is the solo stakers who deposited prior to Rocket Pool’s relatively late launch. There is a strong economic argument for converting a single validator into multiple minipools and earning commission on liquid staking deposits. The smoothing pool is another benefit only available to Rocket Pool node operators which not only decreases the volatility of rewards but for most participants also increases their average return.
The second wave of migrators will be from stETH. Being able to redeem LSDs for ETH without having to execute a secondary market sale means investors can instantly adjust their risk allocation without liquidity concerns. Had this facility been available during the June 2022 collapse of 3AC, Lido’s TVL likely would have collapsed completely. As it was, the considerable price drop of stETH vs ETH plus slippage concerns for larger portfolios acted as twin disincentives to discourage investors for exiting their stETH position at a loss. I expect several cohorts each with different reasons to go through this transition; a moral transitioning, as a response to a slashing event or hack depegging steth, or perhaps yield-seeking.
Finally, and perhaps most importantly, is that withdrawals will cause the cost of maintaining adequate LSD liquidity to plummet, removing one of Lido’s strongest advantages. A natural arbitrage opens up via the purchase and redemption of a mispriced LSD. Rocket Pool already demonstrates the value of this in the Deposit Pool where rETH mints and burns help keep DEX prices stable. Liquidity can be concentrated tightly around the NAV with strong assurances that arbitragers will keep the peg close.
Having this arbitrage opportunity become supported by Ethereum itself will greatly diminish the cost of liquidity, evening the playing field across all staking protocols. Suddenly, the liquidity Lido gets from its multi-billion dollar Curve pool that costs $20MM a month to maintain will be available to everyone for essentially free through the exit queue. MEV bots will patrol LSD prices looking to squeeze out any ETH for themselves. The type of liquidations that previously saw the price of stETH spiraling would now simply create a feast for arbitrageurs as market prices barely budge. The Lido permissioned operator set can accept new Ethereum deposits as fast as the Ethereum network allows. But just as Lido was a black hole taking in ETH, it may yet follow a black hole’s life trajectory and spew out all that ETH in the future.
Once the ability to enter and exit an LSD position becomes trivial, expect a surge in Lido’s competitors being integrated in DeFi apps. Further, and perhaps more nefariously, the drop in baseline risk level for all LSD tokens will spur on leveraged staking. Any asset will be readily folded just as icETH and others leverage stETH. While these tokens promise incredible returns, they introduce huge risk to markets. The exit queue is not infinite and it is possible that we may see a second, larger rush in leveraged staking. If this is to pass, the fallout and dust will settle in favor of the most resilient asset.
In fact, the first cases of liquidation from stETH deppegs are starting to creep up as novel leverage strategies develop. For example, the Gearbox protocol has created generalized leverage. One user used this generalized leverage to go long on stETH/ETH 8x. A slight depeg on stETH mixed with some oracle technicalities led to this user’s position being the first on the Gearbox protocol to be liquidated. Greed will push users to chase what appears to be safe returns by leveraging LSD tokens. The LSD that is most resilient will survive this.
Here is how I project the coming years:
First, the rETH flywheel takes off as DeFi integrations are spurred on by liquidity incentives and an increased node operator capacity. This erodes stETH’s greatest advantage over the field and since liquidity begets liquidity, the lindy effects of rETH will quickly catch up. This initial effect will be somewhat muted, not pushing stETH below 50% until it can be redeemed. The redemption era will start a mass market-wide position re-evaluation as supply can now contract to meet demand without damaging the price. Thus, users will be able to leave stETH and join rETH at will. This starts the march to parity. As soon as stETH experiences at least one major upset such as a slashing incident, I expect the outflow to be rapid as the market will likely overvalue safety in the aftermath. The strong community roots and Ethereum mission alignment is ultimately all that separate the two protocols over long time frames.
One of the main points raised by Hasu & Georgios is that CEX dominance in the Ethereum staking world can only be avoided by a competitor focusing on rapid scaling. Lido’s interpretation of this has been to prioritize growth at the expense of decentralization. But curiously, the release of Coinbase’s cbETH LSD has actually provided a helpful demonstration of how, in the absence of incentives, market participants will gravitate to the most decentralized option, and how Lido’s massive incentive payments are so grossly distorting the market. Currently, the majority of usage cbETH has is on Uniswap. Approximately $15 million is locked in the cbETH/ETH 0.3% and 0.05% pools, a reflection of the low daily volumes. Uniswap is staunchly permissionless and easy to use so it is logical that this is where most cbETH has ended up. Outside of Uniswap, adoption has been poor. Curve, the dApp where stETH is most dominant, only has 168 cbETH in its cbETH/ETH pool. This shows that without a strong liquidity incentivization campaign or a supportive public ethos, tokens do not naturally gain deep liquidity.
The general illiquidity of cbETH has a myriad of effects. It has made impossible the safe use of cbETH in lending platforms like Euler, Maker, or Aave. The image below is taken from Euler’s frontend. It shows that cbETH would depend on a very insecure Uniswap v3 TWAP oracle. This oracle is easily attacked and any debt positions built around cbETH could be liquidated by malicious actors. A robust oracle, like one provided by Chainlink, requires high volume across multiple CEXs or DEXs. Further, lending platforms that want to be able to safely liquidate positions require tokens that have a large amount of inactive liquidity. The Curve stETH/ETH pool is the best example of this. The pool has several billions USD worth of liquidity but only sees some 10s of millions USD in trade daily. The excess buffer is useful in blackswan events when large amounts have to be sold, like during the 3AC capitulation.
As mentioned previously, illiquidity and the depressed prices that result, can trap holders and prevent them from selling. Those that do sell are likely selling to arbitragers as there are no productive uses for cbETH and competitors are higher earning. Currently, 1inch, a popular DEX aggregator, shows that only 3500 cbETH can be sold before incurring 1% slippage. With no yield opportunities, most cbETH buyers on uniswap are likely holding the token for the arbitrage that will be available post-withdrawals. Thus, a pipeline is being constructed.
Over time, existing or new Coinbase users will at some point want to exit their positions to cbETH. This could be due to ETH price collapse or a desire to explore DeFi. Both of these users will quickly realize that their best bet is to sell their cbETH to an arbitrager. More and more cbETH will end up purchased with the explicit purpose of being burned. This huge cohort of buyers has no need for DeFi integrations and so are happy to sit on their illiquid cbETH and accumulate until withdrawals create a pathway for any LSD to be converted into ETH. There will not be a reshuffling between small holders and big whales like the ecosystem saw with stETH during the 3AC crisis. There will be a unidirectional current pulling cbETH rapidly toward the burn address.
Consider the wallet 0x7f507739b6242B048Be9185cf462BE816b8eFf1f, which has accumulated 1% of all circulating cbETH. This wallet has slowly migrated from wstETH to cbETH to buoy the token and consolidate for withdrawals. The owner is taking a risk, of course. There is a possibility that Coinbase will see the writing on the wallet and try to stop the damage. Instead of allowing these sleuthy cbETH whales from mass exiting, which would greatly hurt Coinbase’s cash flow, Coinbase may limit or even block cbETH redemptions. Such a move, exceedingly unlikely may it be, would have devastating effects on the cbETH/ETH peg as all confidence is lost. A bank run scenario may become possible. This is the gamble of engaging in the opaque world of CeDeFi.
In conclusion, though it may seem scary to see how quickly cbETH supply has grown, it does not represent an existential threat to DeFi. In fact, DeFi has roundly rejected cbETH and, if what I believe is correct, DeFi is playing Coinbase into a long con – slowly accumulating cbETH to drain away Coinbase’s stake after withdrawals. The course of this grand arbitrage has sucked away liquidity, crippling any hope cbETH had of gaining DeFi adoption. Unless Coinbase makes an active stance to promote the DeFi usage of cbETH, it appears that DeFi will remain the battlegrounds of Lido and Rocket Pool.
One of the most recent entrants to the LSD landscape is frxETH from the FRAX ecosystem. FRAX, a stablecoin, came to prominence through the FRAX DAO’s aggressive acquisition and use of liquidity-directing tokens (veCRV/vlCVX). The DAO attracts users to mint their stablecoin by creating profitable liquidity provision strategies for FRAX holders through the voting power of their DAO tokens. This model has clear merits. Pre-withdrawals, all major LSD tokens have to create liquidity and usually pay to rent it. By owning these liquidity-directing tokens, FRAX sets itself up to avoid the capital expenses incurred by competitors such as Lido. Since FRAX has had such great success with this model for stablecoins, the DAO has decided to venture into a new kind of stable, an LSD pegged to ETH.
The frxETH tokenomics are unique in the world of LSDs. Most tokens either rebase for rewards (stETH) or passively increase in value (rETH). FRAX went a different route. The frxETH token itself does not accrue any staking rewards. In order for token holders to access the APR earned by the ETH locked in validators, users must deposit the frxETH token into a staking vault. All the rewards earned by the protocol’s staked ETH, minus fees, are then distributed to whatever users staked in that vault. Any users holding frxETH, not staking in the vault, will receive no rewards. Users are forced with a choice - either pursue yields in DeFi with frxETH or earn staking rewards.
The goal here is valiant. This binary option will force the staked frxETH APR to be higher than any other LSD token simply because the DAO is pitting its own LPs against its own stakers. If the APR to LP in the Curve pool, the current main DeFi integration, was a hypothetical 20% while the staking vault reflected a 7% APR then users are likely to naturally migrate out of the vault and into the Curve pool. At equilibrium, the APR of the leading DeFi frxETH integration should come to close parity with the staked frxETH return, potentially over 10%. In theory, holders of other LSD tokens would see this yield and convert.
Now the catch. First off, this model is counterintuitive to some core DeFi principles, namely those of capital efficiency and composability. This model is purposefully not capital efficient. FRAX could have incentivized a yield bearing token such that the liquidity providers earn LP rewards along with the staking rewards. By forcing users to choose one or the other, the cost ends up being higher. Take for example a long term hypothetical where the staked frxETH token is yielding 9% while the frxETH token in curve earns 11%. The Curve liquidity providers would not provide liquidity unless the incentives beat out the staking rate. This has to be paid for - either in incentives or by directing liquidity. The cost of paying LPs in this example to maintain the same level of liquidity would likely be dropped by ~30% since the Curve pool could have been 14% APR (assuming a 6% ETH rewards rate) had those ETH rewards not been redirected. As the TVL in the ecosystem builds, the cost savings become more and more important.
Another confusing element to frxETH is that the staking vault *is* a liquid token, sfrxETH. The FRAX DAO is currently choosing only to incentivize the frxETH pool. Ostensibly, savvy DeFi buildors will want to integrate sfrxETH as the actual ETH reward bearing token. This will put FRAX in a similar situation to the one Lido faces in trying to migrate liquidity from the stETH token to the wstETH token. Having to support an ecosystem of two tokens is going to be more expensive than just a single one. As discussed earlier, financing liquidity for a top tier LSD can cost millions of USD/month. As such, even though FRAX is starting with a large capacity to incentivize liquidity, it is doing so on an inherently less capital efficient system. For a stablecoin provider, this is worrying for a second reason.
The costs of incentivizing frxETH are twofold. First, it is capital inefficient compared to other LSD tokens in order to create a facade of higher APRs (LSD APRs when including their DeFi strategies ought to be even with or higher than staked frxETH). Second, and for FRAX more importantly, liquidity tokens used to incentivize frxETH cannot be used to incentivize the FRAX stablecoin that underpins the whole FRAX ecosystem. By shifting incentives from FRAX base pairs towards frxETH pairings, the strength of FRAX is weakened. Liquidity is a zero-sum game and FRAX are using the liquidity power they have on an inefficient schema.
In the post-withdrawal world, the liquidity-directing tokens that FRAX has accumulated suddenly will become much less valuable for LSD tokens. The exit queue will enable large orders to navigate outside the open market without damaging the LSD peg. Thus, FRAX will have lost its major edge in the LSD token wars.
The most difficult LSD to analyze is one that currently does not exist – osETH. Stakewise is staking service that currently operates with a permissioned set of nodes and a two token model. This is being completely redone for Stakewise v3, slated to launch sometime in 2022 or 2023. In this release, Stakewise is attempting to take on Rocket Pool’s dominant position with solo node operators by becoming permisionless. Users will be able to spin up validators and mint osETH against said validators in a fashion reminiscent of Loan-to-value calculations. Many of the fine details about osETH have not been released and so this section should largely be taken as conjecture.
The Stakewise v3 platform will allow individualized debt markets. The benefit of this structure is that risk can be managed on a case by case basis and so the previously lacking insurance cover provided by Stakewise may improve. Further, depending on the ratio for LTV that Stakewise allows, it may be possible to start running a validator with as little as 4-8 ETH. However, many difficulties lie ahead for the Stakewise team.
The elephant in the room is that the SWISE team will have to migrate all their liquidity from sETH2 and rETH2 into a single token – osETH. A complete rebrand and tokenomic redesign is a costly venture that will force them to start over on integrations. DeFi governance is slow and this can be a time-consuming process. Another issue is that Stakewise is going to hope for a strong migration of solo stakers. This cohort, however, is notoriously risk-averse. Rocket Pool node operator registration is a good proxy of this, as the period following launch did not see a surge in registrations. Many solo ETH stakers will likely want to see mainnet resilience without any hacks before trusting funds to the protocol. It may be the case that most of the osETH supply is minted by Staking as a Service providers using Stakewise. However, it is not clear how these SaaS groups will draw demand.
Concerns also remain around the reward schema. MEV stealing is a problem that has driven much of Rocket Pool’s insurance discussions. It is unclear how Stakewise will account for this issue in extreme LTV vaults.
I now want to touch on the broader tokenomics around LSDs. There is an important tension that exists between the protocol utility/governance token (LDO, RPL, SWISE) and the LSD token itself (stETH, rETH, sETH2). This tension is ignored by most protocols but is fundamental to a sustainable staking protocol. All staking protocols are two-sided ventures; most simply opt to centralize one of the sides. I will discuss LDO’s fee switch and RPL’s collateral system.
As a means of deriving sustainable value, the fee switch is capitally insignificant and will perpetuate the dangerous elements of LDO governance. Practically, the fee switch is soft capped at 5% of staking returns, since the other 5% has been guaranteed towards the elite node operator set. This already hints at the problem as a small core group of operators is due the same rewards as the entire DAO. There is an inefficient alignment as the node operators seem to be extracting too much value. For that 5% to be worthwhile, LDO will have to be at a maximum of one-twentieth (1/20) of the market cap of stETH, and not deviate. If LDO/ETH drops, your existing stake will be worth less. If LDO/ETH increases, your stake will be worth more, but the rewards will be a smaller percent gain. In the vast majority of cases, it appears that holding stETH would be more rational for token holders. There is no unique value added, other than freely accessible governance, to LDO.
In the fee switch design, the protocol token acts as a pure rent extraction mechanism and does not serve to align incentives. This has already become problematic as greed pushes DAO governances to distribute fees irrationally. This perhaps is already taking place as LDO has capped its insurance pool and opted to redirect those funds toward the treasury. This is not a diversion for direct rent extraction, however, it is emblematic of the type of behavior that simple structure DAOs tend towards.
The Rocket Pool design does respect the tension between the protocol token holders and LSD token holders. Node operators are required to post RPL bonds in order to service the rETH demand and spin up minipools. This enables both a permisionless node operator set and ties the growth of rETH to RPL. There is no protocol treasury nor protocol commission so there is no impulse towards rent extraction broadly. Further, Rocket Pool recognizes that governance ought not to be open as the desires of rETH holders require protocol alignment to be maintained. Thus, only RPL that is staked as a bond can be used in governance. This RPL does have a unique value add as both a license to collect commission and as collateral in case of a severe loss. This protocol alignment and lack of an extraction mechanism on top of a more capital-efficient system make the RPL system far more conducive to long-term survival.
The team behind Lido served an important role. The research Paradigm presented suggested that whatever entity was able to quickly and efficiently capitalize on liquid ETH staking would become wildly dominant. If the choice was either Lido exists or all Lido's ETH was split between Coinbase, Kraken, and Binance then clearly Lido's existence is net good. However, it is no longer the early days of the Beacon chain. The utility that Lido's stETH has offered to the ecosystem has peaked and now it is time to transition towards Rocket Pool and competitors. The tailwinds that brought Lido to dominance were all one-time affairs and will soon be rendered obsolete.
In this paper, I began with an overview of the liquid staking ecosystem. In it, I described the near monopoly Lido has on the LSD market and how it extends beyond just a power law dynamic. I make the bold claim that rETH will flip stETH's market share and begin to outline the social and economic reasons for believing so.
In the social world, stETH has already hit critical mass and attracted the ire of core ETH developers. I present 4 major arguments; the system is governance attackable, the fee distributions are volatile, the DAO and its operators are multichain, and the validator registry remains a powerful and centralized carrot/stick. In terms of economics, I detailed the rETH and stETH peg histories as a means of understanding the market implied risk. This risk I then break down into execution risk, centralization risk, and tail risk. The major point of this section is that rETH is engineered to be resistant in extreme scenarios which is the ideal trait for a base layer asset.
After presenting these stETH headwinds / rETH tailwinds, I give my projection for how the shift in power will proceed. Major accelerants will be full rETH DeFi integration, a major CEX/Lido slashing event, enabling of withdrawals, and reducing collateral requirements. The post-withdrawal era will see Lido’s greatest asset, it’s powerful liquidity mining campaign, become nerfed as the exit queue reduces the costs that protocols will have to pay to maintain liquidity.
With the case against stETH established, I shift focus towards the newest challengers in the LSD space. Starting with cbETH, which has quickly raced to second most dominant LSD, I point out that there is no DeFi adoption and that cbETH may end up as a stepping stone for users to migrate towards rETH. Next, frxETH, by FRAX I consider to be built on a capitally inefficient system wherein the staking rewards are kept separate from the liquidity providers. Finally, I provide some conjecture on a future rival, osETH of Stakewise v3. This token aims to challenge Rocket Pool on permissionless node operators, however, the product is not yet live and will require a complete protocol reboot – no cheap, quick, or easy ask.
Lastly, I provide a short description for why the fundamental models behind RPL and LDO are different. I suggest that LDO's endgame is just a stETH wrapper giving users no unique value, not even governance, whereas RPL adds value to the system by functioning as collateral. These divergent models give LDO a clear value ceiling, but not for RPL.
Why does this matter? LSDs are going to be an intrinsic part of Ethereum. Staked ETH will be the future bond market. If an LSD becomes too dominant, it can become an attack on the host chain. The asset that propagates and survives will be the one that is resilient in extreme cases just as Ethereum is. Rocket Pool has built towards that future since 2017. The invisible hand of decentralization will test market participants. Today, people are free to run validators in any country. This may be a luxury of the moment as nation-states have not set their target on Ethereum yet. When that day comes, LSDs will not be the reason Ethereum fails. rETH is the path forward. You can choose to ignore it or bet against it, but rest assured, the Orange Cascade is coming.
Following the merge, LSD pegs all quickly converged back towards parity. rETH held consistently at a premium during this process. Suddenly, the stETH/ETH ratio was where it was prior to the 3AC capitulation. Is this deserved? Has the risk left the ecosystem or has the rush of new stake post-merge combined with a dearth of yield opportunities obfuscated the risk Lido poses once more?
FTX is dead. Volatility and calamity are crypto’s best friends Thus, it should come as no surprise that the markets have been rocked yet again with cascading liquidations hitting most DeFi markets. The value of the SOL token has been cut in half in days. Many lenders, institutional and unsuspecting retail, are now bereft of their assets. For an asset aiming to be the base layer of DeFi, the market capitulation we experienced should be like a passing breeze. This recent fiasco has proved just the opposite for Lido. I will briefly discuss how the stETH peg held up, what is happening with stSOL, and why contagion is a real threat.
Once again, when the broader market hits a downturn, the stETH peg collapses. This time the losses extended to ~1.5%. It is likely that many leveraged stETH/ETH positions were liquidated in this process as this was the largest single day peg hit since the 3AC cascade. Had this event occurred after withdrawals, Lido would have seen a max exodus of stake while Rocket Pool would have gained stake. While stETH dropped 1.5%, rETH increased its premium against its NAV, signaling how resilient rETH is in the eyes of the market.
More concerning for the Lido DAO is the performance of stSOL, Lido’s liquid staking derivative for Solana. The entire Solana network has been struggling since the FTX news. Large swatches of SOL have exited or are waiting to exit, degrading the network’s security. At points, stSOL was reported to be trading at -10% on open markets compared to SOL. Volatility for the LSD is not an issue at face value, but this arbitrage opportunity has pushed large sums of SOL into their withdrawal queue. As such, the network is being stress tested and the Lido node operators that run Solana nodes have exceptional duties to attend to.
The node operators are shared between all chains Lido operates on. The Lido Solana validators likely also run Ethereum validators. Perhaps not on the same hardware, but the same teams must manage both chains. The complexities of properly running one validator for one blockchain can be profound. Having to constantly monitor Telegram for updates about the Solana reboot is directly inhibitory to a team’s ability to service other networks. Imagine if the events of the FTX collapse had triggered severe fallout in the Ethereum ecosystem. Would the Lido operators who run both blockchains be forced to dedicate resources one way or the other? Further, Solana may have represented a cash cow for some validators. By abruptly losing a huge income stream, a professional validator may be forced to adjust staffing. As long as Lido continues to diversify across chains, their dedication towards Ethereum will fall and the risk for stETH holders will multiply. It is further unclear if the insurance pool extends across every chain. If so, then the security model of stETH is even worse than I have described.
There is only one LSD that has a value set identical to Ethereum itself - rETH. In the endgame, the social layer rules above all else. When that day comes, the decentralization and security of rETH will push it into the bedrock of DeFi.