「Trend Research by LD Capital」 Stability and High Growth of LSD

Guide:

Due to the imminent Shanghai upgrade, we believe it is necessary to reassess the future development of the LSD track and its impact on the entire on-chain ecosystem in light of recent data changes. This article overviews the LSD track in four parts: the overall growth space of the industry after the Shanghai upgrade, the selection of 4 types of staking solutions and different LSD protocols, the positioning of the DVT track, and the impact of LSD assets on other on-chain ecosystems.

Summary:

The increase in Ethereum’s staking rate will lead to an overall increase in protocol fees on the LSD track. In the long run, the David double-click on the LSD track is not over. The current Ethereum staking rate is 14.56%. Since the staking rates of other POS public chains are mostly over 60%, there is a large growth expectation for the increase in Ethereum’s staking rate.

Assuming the cost situation on the LSD track remains unchanged, we estimate that when the Ethereum staking rate rises to 29%, 44%, and 58%, the corresponding increases in LSD protocol fees will be 1.31 times, 1.55 times, and 1.76 times respectively. From a P/F valuation perspective, the current LSD track leader LDO has a 3.89 times P/F, which still has a large room for improvement compared to the valuation levels of old Defi protocols such as UNI with 7.12 times and AAVV with 10.35 times.

After the Shanghai upgrade, the relative market share of LSD protocols may change. In the medium term, pay attention to the track leader Lido and high-yield LSD protocols represented by Frax, and focus on Rocket Pool’s Atlas upgrade in the short term.

After the Shanghai upgrade, the exit of early nodes and the strengthening of user staking intentions will provide conditions for the competition between LSD protocols.

• Lido has been tested in terms of popularity, fund scale, security, yield, liquidity, and composability, and its leading position is unshakable.
• However, newcomers like Frax have achieved a combination with the Curve ecosystem through their self-holding CVX and dual-currency model design, which gives them a staking yield rate far higher than similar staking products, successfully completing the cold start and early growth of the product. In the future, with the popularization of yield aggregation products, the growth of high-yield products like Frax is expected to accelerate further. It should be pointed out that Frax’s high yield will decrease as its TVL increases. Based on current estimates, when its ETH staking reaches 200,000 coins, the staking yield will drop to 6%.
• The recent Atlas upgrade of Rocket Pool is worth paying attention to. It reduces the minimum staking quantity of node operators’ ETH from 16 to 8, increases the protocol capacity while enhancing node incentives, and is expected to bring a large increase to its TVL.”

DVT products represented by SSV, Obol, and Diva are currently positioned as important basic infrastructure for Ethereum staking.

DVT products aim to ensure the stability of Ethereum block validation while improving the network’s degree of decentralization. They can reduce the operational costs of node maintenance teams and minimize security risks.

The development of SSV focuses on the construction of the operator network, with its token serving as a means of payment and governance certificate to capture protocol value.

Obol’s development emphasizes middleware adaptability, while Diva’s goal is to combine LSD and DVT modes to create a one-stop product, currently in the early stages of development.

Ethereum staking may spawn LSD assets (lsdETH) of the hundred-billion scale. As they reshape or impact traditional DeFi protocol income structures, second-layer products built around this new asset class may become the new α in the market.

The construction of liquidity for lsdETH/ETH could bring new business increments for DEXes like Curve and Balancer. Compared to Curve, Balancer currently sees more significant marginal changes. However, Ethereum staking yield can be seen as the on-chain, risk-free yield rate in coin terms. The emergence of this yield rate will increase the liquidity cost on-chain and bearish for deposit pool-type lending products, while CDP model lending is relatively less affected. At the same time, future re-staking, yield aggregation, principal-interest separation, and leverage protocol products built around this interest-bearing asset will benefit from the large scale of the underlying asset and achieve a higher business ceiling, making them worthy of continuous tracking and research.

Risks:

Regulatory risks, macroeconomic risks, risks of technology upgrades not meeting expectations

1. Overall Space of LSD Track

The growth in Ethereum’s staking rate drives an increase in miner income, leading to an overall rise in LSD track income. In the long run, track income valuation remains in a double growth range. The current Ethereum staking rate is 14.56%. Since the staking rates of other POS public chains are mostly over 60%, there is a large growth expectation for the increase in Ethereum’s staking rate. The following graph estimates that when Ethereum’s staking rate doubles, triples, and quadruples, rising to 29.12%, 43.68%, and 58.24% respectively, the corresponding increases in LSD protocol fees will be 1.31 times, 1.55 times, and 1.76 times. The calculation method, assumptions, and process are as follows:

• Execution layer rewards are determined by the Priority fee. Due to the balanced setting of Ethereum’s fee mechanism, it is assumed that execution layer rewards remain unchanged (a conservative estimate, when network Gas fluctuates, execution layer rewards will rise sharply, such as the USDC de-pegging event on March 10 that led to a surge in on-chain transactions, Ethereum’s execution layer reward increased 4–6 times of the usual).
• Consensus layer rewards are determined by Ethereum’s block rewards. The total block rewards are proportional to the square root of the total staking amount, and the consensus layer APR is inversely proportional to the square root of the total staking amount. The specific calculation formula is base_reward = effective_balance * (base_reward_factor / (base_rewards_per_epoch * sqrt(sum(active_balance)))).

With the current 14.56% staking rate corresponding to consensus layer rewards and execution layer rewards as the benchmark, the miner income situation when the staking rate reaches 2–4 times the current level is estimated based on the above two conditions. At the same time, assuming that the LSD protocol fee standard remains unchanged, the multiple of miner income growth with the increase in the staking rate is the LSD protocol fee growth multiple as follows:

Figure 1: Changes in Miner Income with the Staking Rate

Source： LD Capital Research

It’s important to note that the increase in Ethereum’s staking rate is a gradual process, and a decrease might even be observed in the 1–2 months following the Shanghai upgrade. Due to the restrictions on Ethereum validator node entry and exit, it can be inferred that the change in Ethereum’s staking rate is a slow process. Currently, the total number of Ethereum network validators is approximately 556,800, with 1,800 validator nodes admitted daily.

After the Shanghai upgrade, validator nodes are allowed to exit, and the daily exit quantity equals the entry quantity. Due to the early validator’s exit, there might be a slight decrease in Ethereum’s staking rate after the Shanghai upgrade.

The basis for this judgment is: currently, about 10.87 million ETH in the beacon chain participate in staking via the lsd protocol with centralized exchanges, providing secondary market liquidity. Since there is virtually no discount for various types of lsdeth/eth, the redemption scale based on the primary market’s pegging or profit requirements will not be large after the Shanghai upgrade.

The remaining approximately 6.95 million ETH are staked through Staking pools or individual staking, which lacks secondary market liquidity. Assuming that half choose to redeem after the Shanghai upgrade, a maximum of 57,600 ETH can be redeemed daily. Ethereum will face a full-load redemption situation within 60 days after the Shanghai upgrade.

Observing the current data on staking entry, the daily new staking ratio is generally one-third of the maximum possible staking ratio. Therefore, if the new staking ratio cannot reach the maximum load after the Shanghai upgrade, based on the above assumption, Ethereum’s staking rate may experience a slight drop within 1–2 months. After the redemption requirements based on pegging and profit are cleared, the growth will resume, and it may take 1–2 years for Ethereum’s staking rate to double.

source: https://ethereum.org/zh/developers/docs/consensus-mechanisms/pos/rewards-and-penalties/

2. The Complete Landscape of LSD Track

The LSD track can be expanded to Ethereum staking solutions and their derivatives, which include four types of Ethereum staking solutions competing for market share, DTV technology ensuring security while extending decentralization, and second-layer yield enhancement products and leverage protocols and index products born around the LSD staking certificate.

Figure 2: The Complete Landscape of LSD Track

Source: LD Capital Research

2.1 Among the Four Staking Solutions, LSD Holds the Highest Market Share and is Expected to Expand Further

Ethereum staking solutions are divided into four types, including individual staking, custodial staking, Liquid Staking Derivatives (LSD), and centralized exchange staking. Both LSD and centralized exchange staking have gained the majority of the market share due to their advantages, such as allowing participation with small capital, not requiring hardware infrastructure, and the ability to release liquidity again through staking certificates. From the perspective of the number of nodes, currently, LSD holds a market share of 33.4%, CEX holds 27.5%, custodial staking (Staking pool) holds 16.6%, and individual staking holds 22.5%.

Figure 3: Current Market Share of Various Staking Solutions

Source: beacon-chain， LD Capital Research

Let’s look at the basics of the four staking solutions:

• Individual Staking: Requires at least 32 ETH and a dedicated computer, as well as the network and power conditions and methods to operate nodes. Users can obtain all the staking rewards and full asset control. Funds cannot be withdrawn before the Shanghai upgrade, but they can be withdrawn with restrictions after the upgrade.
• Custodial Staking: Requires at least 32 ETH but no hardware infrastructure. Users obtain staking rewards by delegating their ETH to a node operator. During this process, users need to upload their signing key, allowing the service provider to validate on their behalf. Funds cannot be withdrawn before the Shanghai upgrade, but they can be withdrawn with restrictions after the upgrade.
• Liquid Staking Derivatives (LSD): This does not require 32 ETH or hardware infrastructure. Users delegate their custom Ethereum to the LSD protocol, which pairs the user’s delegated Ethereum and chooses a node operator to stake it to earn staking rewards. Users typically need to distribute part of their earnings to the LSD protocol and the node operator. Funds can usually be withdrawn at any time on the secondary market through the liquidity of lsdETH, or leverage can be added to enhance returns. This solution currently has a high degree of centralization.
• Centralized Exchange Staking: This does not require 32 ETH or hardware infrastructure, and even a chain wallet is not necessary. Users can obtain most of the staking rewards through staking services provided by centralized exchanges like Coinbase, with a small portion of the benefits being collected by the exchange. This solution has the lowest operation difficulty for users. Staking can usually be promptly withdrawn or exited on the secondary market through staking certificates, and leverage can be added through lending protocols to enhance returns. This solution currently faces significant regulatory risks and is the most centralized.

Figure 4: Comparison of 4 Staking Solutions

Source: LD Capital Research

However, it’s important to note that centralized exchange staking and LSD staking solutions are facing unresolved regulatory issues from the U.S. Securities and Exchange Commission (SEC). The question of whether staking operations are considered securities has yet to be definitively answered. The SEC previously targeted Kraken’s staking operations, but it has not yet materially affected Coinbase, Lido, and other key LSD protocols. The main reason for this is that Kraken did not disclose the destination of user funds at that time, operating in a ‘black box’ manner, while also promising returns far exceeding those of Ethereum staking, which led to regulatory crackdowns. However, from the perspective of the Howey Test, Kraken, Coinbase, Lido, and other LSD protocols are all participating in staking by managing user funds, with no essential differences. Therefore, the development of LSD operations currently faces uncertainty due to U.S. regulations.

From a product perspective, although staked Ethereum can be redeemed and withdrawn in the primary market after the Shanghai upgrade, the quantity is limited. Based on the current staking scale, up to 1800 nodes, corresponding to 57,600 ETH, can be withdrawn daily. Due to the LSD protocol’s solutions for small fund participation in staking, releasing liquidity of staking certificates, and enhancing returns through protocol combinations, it is still likely to occupy a major market share after the Shanghai upgrade. There may be a passive increase in the overall market share of the LSD protocol shortly after the Shanghai upgrade, due to the early redemption and profit exit of ETH from individual or custodial staking.

From the perspective of competition in the LSD protocol, current factors influencing the development of each LSD protocol include popularity, return rate, fund security, anchoring status, degree of decentralization, and combinability. These dimensions can be combined to analyze the similarities and differences between the mainstream LSD protocols on the market.

Lido is currently the largest Total Value Locked (TVL) LSD protocol, 13 times larger than the second-ranked Rocket Pool. Lido currently uses a whitelist mechanism to select operators, ensuring the smooth operation of staked nodes to avoid affecting the rate of return or causing fund penalties. At the same time, Lido achieves an annualized return rate of 4.5%-5% for its users through compounding at the execution layer, maintaining this relatively high level even after a 10% fee. This rate is second only to Frax among mainstream LSD protocols, surpassing Rocket Pool, StakeWise, Ankr, and others. It’s noteworthy that Lido will upgrade to version V2 in mid-May, introducing a staking routing module, allowing anyone to create staking nodes and connect to DVT, aiming to ensure network stability and security while increasing the degree of decentralization.

Rocket Pool’s uniqueness lies in its lack of entry permissions for staking nodes; anyone can become a node operator on this network by creating a Minipool. Currently, node operators need to deposit 16 ETH (with the remaining 16 ETH coming from user deposits) and also stake a minimum of 1.6 ETH worth of RPL Token as secondary funds subject to penalties. Rocket Pool currently provides RPL subsidies to node operators on the platform to encourage node deployment. Rocket Pool will undergo the Atlas upgrade within a month, the most significant upgrade since its launch, which will have a significant impact on its business development. The main content of the upgrade includes:

1. LEB16 — LEB8: The minimum stake for node operators will be reduced from 16 ETH to 8 ETH, greatly improving the current situation where Rocket Pool’s scalability is restricted by the node side. Theoretically, this improvement could double the protocol’s TVL and triple its deposit capacity. Once the scalability of the node side is opened up, the number of deposits in the dynamic deposit pool will become a leading indicator of Rocket Pool TVL growth.
2. Node incentives will further increase, excluding RPL incentives, LEB8 node rewards will be 25% higher than LEB16.
3. Tools will be introduced to allow Solo Stakers to migrate to the Rocket Pool platform without having to exit the validator.
4. The dynamic deposit pool will be optimized; when the ETH required by the Minipool queue exceeds the 5000 ETH limit, the deposit pool’s upper limit will also increase.

Frax Ether’s characteristic is its current high staking return rate. The staking yield of sfrxETH has been maintained at 7%-10% due to Frax’s dual currency model of frxETH and sfrxETH. frxETH and ETH form LP in the Curve pool to gain CRV returns using Frax’s own CRV governance resources, and all staking returns are distributed to sfrxETH. Overall, the high yield of Frax Ether compared to other liquidity staking products comes from an additional layer of CRV rewards. This CRV reward contributes to the overall system’s return enhancement and depends on the proportion of the frxETH/ETH gauge pool, the TVL of the Frax Ether system, and the CRV/ETH price ratio. According to current estimates, when the staked amount of Frax Ether reaches 200,000 ETH, the staking return of sfrxETH will drop to around 6%.

The aforementioned three mainstream LSD protocols have established three main ETH staking models. The remaining smaller LSD protocols mainly aim to improve and tweak some user pain points of these three major protocols. For instance, Stafi and Stader address the issue that currently Rocket Pool node operators need to stake 16ETH, resulting in low capital utilization efficiency and operators being forced to increase their RPL risk exposure. These two only require node operators to stake 4 ETH, and they provide a solution that doesn’t increase the risk exposure of protocol tokens for node operators. However, it’s important to note that blindly reducing the proportion of ETH staked by node operators could potentially increase the risk of user fund loss. Moreover, unlike Rocket Pool, Stafi is currently facing pressure to grow its user funds.

Chart 5: Comparison of the 3 Major LSD Protocols

Source: LD Capital Research

Currently, from the perspective of protocol valuation, whether it’s FDV/Revenue or FDV/TVL, Lido is at a relatively low level. However, LDO currently only has governance rights while RPL and FXS both have corresponding token empowerments, so they should enjoy a corresponding valuation premium.

Frax currently holds about 3.5 million CVX, making it the largest holder in the CVXDAO.

Chart 6: Valuation Comparison of Different LSD Protocols

Source: LD Capital Research, Token Terminal

Decentralization and security assurance are the core tenets of Ethereum, and on this basis, Distributed Verification Technology (DVT) emerged. Current Ethereum staking solutions are all faced with the contradiction between decentralization and stable node operation. Represented by Lido and Rocket Pool:

Lido currently selects qualified operators through a whitelist to ensure the effectiveness of block generation and the traceability and safety of funds, to avoid losses caused by node downtime or failure. However, this approach makes Lido somewhat centralized.

Rocket Pool, on the other hand, binds the interests of both the node and the user through joint staking and further ensures user’s funds safety by pledging RPL tokens as collateral. This undoubtedly increases the cost of operating nodes on the Rocket Pool platform. At present, Rocket Pool is trying to balance this by using RPL to incentivize nodes, but this undeniably increases protocol expenditure and limits its scalability.

DVT products, through technical solutions such as fragmenting verification private keys and rotating leadership nodes, transform the one-to-one relationship between operator and node to a many-to-one state, enhancing system security and robustness from a network architecture perspective and allowing a higher degree of decentralization.

The specific principle is as follows:

DVT consists of four key parts: Distributed Key Generation (DKG), Shamir’s Key Sharing for BLS signatures, Multi-Party Secure Computation, and the IBFT consensus layer:

• Distributed Key Generation (DKG) is the first step in implementing DVT. It fragments a validator’s private key into 3n+1 parts, with multiple fragments corresponding to multiple operators. DKG technology is the cornerstone of DVT products.
• Shamir’s Key Sharing for BLS signatures complements DKG, aiming to achieve multi-party aggregate signatures, that is, combining fragmented block signatures into a single signature. Since DKG allows the fragmented private key to be held by multiple parties, when a signature is needed, the signatures of multiple people are aggregated into one. The fragmented private key and multi-party aggregate signature form the backbone of the entire DVT product.
• Multi-Party Secure Computation (MPC) distributes the split keys securely among the nodes to perform validator duties and verify network information, without having to reconstruct the validator key on a single device, thus eliminating the risk of centralizing private keys during computation. The Istanbul Byzantine Fault Tolerance (IBFT) consensus algorithm randomly selects a validator from the DVT nodes as the leading node, responsible for block proposals and other tasks. If the majority of nodes in a single cluster agree that the block is valid, it is added to the blockchain. If the leading node goes offline, the algorithm will reselect a leader within 12 seconds to ensure system stability.

In summary, DVT fragments verification keys through DKG, distributing them to different operators, achieves multi-party aggregate signatures through BLS private key sharing, ensures data security through Multi-Party Secure Computation, and ensures nodes will not maliciously block or affect overall profits due to offline through IBFT leadership node rotation. Ultimately, it allows multiple operators to run a single validator node, rather than the current industry standard of individual operation, greatly enhancing the overall system robustness.

3.1 Comparison of DVT Products on the Market: SSV.Network, Obol Labs, and Diva

• SSV.Network has built an operator network based on DVT and is the fastest developing product in the DVT sector. It has received a donation of $188,000 from the Ethereum Foundation and a donation of $100,000 in LDO tokens from Lido. SSV.Network is the only entity to have issued tokens at this time, with its token, SSV, mainly used as a means of payment in the network and for governance. Stakers in the SSV network need to pay operational fees to the node operators, with the specific fees determined by each operator based on operational costs and market competition. At the same time, operators currently need to pay a quarter of their network income to the SSV treasury (the fee standard is determined by the DAO), and all the aforementioned payment processes require the use of SSV tokens. SSV plans to hold a community meeting on March 30 to discuss the timing of the mainnet launch.
• Obol Labs is committed to building a staking middleware, Charon, that allows any node to participate in the operation of the distributed validator cluster (DV cluster). Obol has also received a donation of 100,000 USD worth of LDO tokens from Lido DAO and has completed a series A financing of 12.5 million USD, led by Pantera Capital and Archetype, with participation from Coinbase, Nascent, Block Tower, and others. In terms of development progress, Obol is currently in the Bia public testnet stage, and is expected to launch the Circe testnet in June of this year, followed by the mainnet launch; in terms of development progress, it is slightly behind SSV.
• Diva is a new product in the DVT track, which has completed a seed round of 3.5 million USD, led by A&T Capital, with participation from Gnosis, Bankless, OKX, and others. It aims to combine LSD and DVT modes to create a one-stop product for liquidity staking and distributed validation.

4. Development trends of the LSD track and its impact on the current mainstream tracks

Following the Shanghai upgrade, Ethereum staked on the Beacon Chain can be withdrawn, which enhances users’ willingness to participate in staking and promotes an increase in the staking rate, thereby expanding the scale of the interest-bearing asset, lsdETH. Therefore, in the future, not only might there be an increasing number of liquidity staking protocols, but DeFi products revolving around the lsdETH asset will also embark on a new growth curve.

• Decentralized exchanges: The construction of lsdETH liquidity is the most important part of the LSD protocol. lsdETH/ETH, as similar assets, have their best choice for liquidity construction being Curve and similar products. If more and more LSD protocols emerge in the future, issues surrounding the construction of different types of lsdETH liquidity might trigger a new round of Curve war. It is worth pointing out that currently, the cost of constructing liquidity in the Balancer ecosystem is lower than Curve, and since Balancer’s base is smaller, from the perspective of marginal changes, the prosperity of lsdETH will have a greater impact on the Balancer ecosystem than Curve (relevant protocols include Aura, Convex, Balancer, Curve).
• Lending protocols: The market demand for using lsdETH to leverage will drive lending businesses based on this asset category. Currently, there are two main types of leverage demands:

1. Yield enhancement through revolving loans, represented by AAVE, where stETH is used as collateral to borrow ETH, with a maximum LTV of 90%, and a maximum of 10x leverage without considering intermediate costs. However, this model faces the issue of high ETH borrowing rates (after the Shanghai upgrade, the interest rate of AAVE’s ETH deposit pool may equalize with the ETH staking interest rate, making the borrowing rate of ETH in AAVE higher than the staking rate, which would make the current demand for revolving loans disappear). The core reason is that the ETH borrowing rate needs to cover the depositors’ cost. In the future, stablecoins pegged to ETH may be minted in the form of CDPs, replacing the depositor’s cost with a more efficient liquidity cost, enhancing protocol composability while better meeting users’ demands for leverage-enhanced returns (relevant protocols include AAVE, Compound).
2. Increase the overall risk exposure of the investment portfolio by borrowing stablecoins against lsdETH, which can operate through both normal lending and CDP models (relevant protocols include Fraxlend, MakerDao).

• Principal and interest separation and other derivatives: As an interest-bearing asset with a floating interest rate, lsdETH can give birth to financial derivatives such as principal and interest separation and interest rate swaps. Principal and interest separation products can enable shorting future interest rates (selling interest tokens and buying principal tokens, low leverage, typically used to lock in returns in advance), longing future interest rates (selling principal tokens and buying interest tokens, high leverage, typically to satisfy speculative demand), and yield enhancement. Before the outbreak of LSD, the underlying interest-bearing assets of derivatives such as principal and interest separation were mainly concentrated on stablecoin LPs. Since these assets are smaller in scale compared to lsdETH and have lower yields, there is also the issue of liquidity splitting. Thus, the emergence of lsdETH as an asset will greatly promote the business development of principal and interest separation products (relevant protocols include Pendle, Element, Sense).
• Re-staking: The concept of re-staking was proposed by Eigenlayer. Eigenlayer is a protocol that modifies the Ethereum client at the base level, allowing validators to re-stake their ETH rights and verify other protocols, such as oracles and data availability modules. It is worth noting that while Eigenlayer gives staked ETH a second layer of yield, it sacrifices some of the token’s liquidity and requires users to bear additional AVS (Actively Validated Services) security, adding a layer of slashing risk to Restaked ETH.

Figure 7: Overview of downstream products based on lsdETH.

Source: LD Capital Research

LD Capital is a leading crypto fund who is active in primary and secondary markets, whose sub-funds include dedicated eco fund, FoF, hedge fund and Meta Fund.

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