Market Byte: Ethereum’s Shanghai Update & Liquid Staking Derivatives

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The upcoming Shanghai hard fork (EIP-4895) on the Ethereum network, set for March 2023, aims to unlock a significant amount of staked Ethereum (“ETH”), which currently makes up more than 13% of the total supply of Ethereum.1 Enabling the withdrawal of staked ETH is a highly anticipated milestone, as stakers have been earning yield since December 2020 but have not been able to withdraw the principal or realize yield until the Shanghai upgrade takes place.

 

In order to get withdrawals enabled on schedule, Ethereum developers have decided to delay the implementation of features like proto-danksharding, which would improve the performance of rollups like Optimism and Arbitrum. However, this delay is not expected to have a significant impact on Ethereum users.

 

Expectations that the Shanghai fork will take place on schedule appear to be positive for the industry’s second largest asset, as ETH gains 36% this year.2 More impressively, however, has been the performance of Liquid Staking Derivative (LSD) tokens. Three of the largest LSD protocols3—Lido Finance (LDO), RocketPool (RPL), and Frax (FXS)—have increased between ~80% and ~150% in the same period (figure 1).

Figure 1: Year-to-Date Returns

Source: TradingView. Data as of 1/1/2023 to 1/23/2023

Background on LSDs & Why They Matter

 

When Ethereum staking was first introduced in December 2020, the requirements for participation were high: individuals needed 32 ETH and the technical knowledge to operate a validator. This created a financial and intellectual barrier, making staking inaccessible to a majority of potential users. Stakers also had to lock up tokens for an indefinite period of time, as there had been no concrete target date for when withdrawals would be enabled. Uncertainty for investors was amplified by the transition to Proof of Stake4 being repeatedly delayed for several years before finally launching in 2022.

 

To address these issues, liquid staking derivatives (LSDs) were developed to allow users to both provide an easier way to stake, and to retain liquidity of their tokens despite being locked on the blockchain. The protocols behind LSDs enable users to stake any amount of ETH and provide a liquid market for claims on the locked ETH. With liquid staking protocols, individuals can stake a smaller amount of ETH and receive a collateral token, such as Lido Staked ETH (“stETH”), in return, which serves as an economic proxy for the locked ETH, representing the principal and yield.

 

The growing popularity of liquid staking derivatives has led to the acceptance of these tokens as collateral on protocols such as Aave. This has made LSDs an appealing option for traders seeking exposure to ETH and the staking yield of the network. LSDs, however, are not without their limitations. For example, these tokens do not enable users to transact on the Ethereum network, as network fees must be paid in ETH. To use an LSD to stake, the user must have ETH in their wallet to pay for transaction fees.

 

Similarly, it’s important to recognize some of the risks associated with LSDs, primarily due to the fact that the staked ETH has not yet been withdrawable. Because of this, the peg5 between stETH and ETH is mainly based on confidence in withdrawals being enabled. While it should theoretically remain at 1:1, there is no mechanism to enforce it algorithmically.

 

For example, the peg has historically been compromised in periods of market capitulation, like when Celsius and 3AC rushed to liquidate stETH in May 2022. More recently, the discount between stETH and ETH has closed by approximately 1%6, presumably on the news of the March 2023 Shanghai date being reaffirmed at the beginning of the year. Enabling the withdrawal of staked ETH should significantly reduce or eliminate some of the risks associated with LSD protocols, particularly peg instability; this makes staking through an LSD protocol a potentially more attractive option than staking without one.

 

Ethereum Post-Shanghai – Will Staking Increase or Decrease?

Interestingly, the percentage of total ETH staked is very low compared to other popular blockchains, ranking in the bottom 10 of Proof of Stake platforms—despite having the largest staking market cap.7 Below, in Figure 2, we rank the largest Proof of Stake networks by staking percentage. It’s worth noting that the majority of networks ‘competing’ with Ethereum have staking percentages three to six times higher than ETH. Given that a significant portion of users on other Proof of Stake networks stake their tokens, it is possible that Ethereum staking may see a significant increase after the Shanghai upgrade enables withdrawals.

Figure 2: Proof of Stake Network Staking Metrics

Source: Staking Rewards as of 1/19/2023

Conversely, the staking percentage may decrease following the upgrade on the assumption that stakers will withdraw tokens, wanting to realize their rewards after locking up capital for more than two years. However, of the 16 million ETH staked, ~8.1m ETH is staked via LSDs.8 Given the market volatility and rapid sell-off of LSD ETH derivatives like stETH, it’s reasonable to assume that many stakers have already exited their positions to other potentially longer-term holders. The Ethereum network also has a que system for validators to protect the network against a mass exodus. Therefore, while a decrease is possible, we believe it’s more likely for staked ETH to increase as a percentage of the total ETH supply in the medium and long-term.


How is this Relevant to LSDs?


The market appears to believe that the percentage of staked ETH will increase following the upgrade, specifically via liquid staking derivatives, as indicated by the price of tokens like LDO and RPL significantly outperforming ETH (figure 1). As mentioned above, LSDs provide the most flexible staking solution for all market participants—both retail and institutional investors—and, as a result, are likely to experience significant inflows if staking increases after Shanghai. 

In the case of Lido Finance, the largest liquid staking derivative protocol, the LDO token functions as a governance token enabling holders to vote on future changes. The LDO market cap is $1.6 billion compared to the ~$7.8 billion staked ETH managed by the protocol.9 The recent price increase may indicate that investors are acquiring a stake in LSD protocol tokens to have a say in an important and growing part of the Ethereum ecosystem.


What Does This Mean for ETH?


The Shanghai upgrade has the potential to be a catalyst for the Ethereum network by reducing risk and uncertainty associated with one of the more sustainable yields in crypto. While many crypto projects create and distribute tokens to subsidize yield, Ethereum staking yield is generated from the transaction fees paid to the network. Therefore, stakers may earn more rewards as network activity increases. The staking yield for ETH currently ranges from 4%-9%, primarily generated by transaction fees. The removal of withdrawal restrictions may also lead to an increase in risk-adjusted exposure to ETH.


The impact of the upgrade on the price of ETH is uncertain. Major network upgrades have historically had a positive long-term effect on the price of the blockchain’s native asset. Bitcoin halvings, for example, are largely considered to be a catalyst for a new BTC price cycle. However, in the short-term, market sentiment and news headlines tend to drive price action. It is possible that the current market conditions may present an opportunity for upside in ETH, as the asset is currently down nearly 75% from its all-time high.10 The successful implementation of the Shanghai upgrade could potentially break the trend of ‘selling the news’ and attract investors looking to acquire and stake ETH.

1. https://dune.com/arch1111/eth-staking-dashboard

2. Year-to-date as of 1/23/2023

3.  Liquid staking protocols are the applications that allow users to stake ETH and issue

4. Proof of Stake (PoS) – a consensus mechanism in which validators (known as miners in Proof of Work) risk or “stake” coins in order to be randomly selected to validate transactions and are rewarded coins in proportion to the amount of coins staked

5. Peg – A dollar peg is when an asset intends to maintain a fixed 1:1 exchange rate to the U.S. Dollar.

6. The 1% close in the stETH to ETH discount is as of 1/1/2023 to 1/18/2023 https://dune.com/queries/829834/1450267

7.  Rankings based on the Proof of Stake platforms tracked by Staking Rewards. https://www.stakingrewards.com/proof-of-stake/

8. As of 1/20/2023. https://defillama.com/lsd

https://dune.com/Marcov/coinbase-wrapped-staked-eth

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