Messari Report: Lido Liquid Collateral

important point

  1. Lido removes the challenges and risks of maintaining staking infrastructure by allowing users to delegate any amount of assets to professional node operators.
  2. Stakers receive liquid, tokenized staking derivatives (st assets such as stETH) to represent their claims to the underlying staking pool and its earnings.
  3. st assets effectively release liquidity and eliminate the opportunity cost of staking, because st assets can be used on some DeFi protocols and gain additional benefits.
  4. Node operators vote to join Lido through the DAO and are responsible for the actual staking process.

01 The development status of Lido

PoS networks still have high barriers to entry and opportunity costs for potential users (e.g. Ethereum requires a minimum of 32 ETH), including huge capital investment, technical complexity of the verification process, and long lock-up periods (locked until after the merger). The “staking-as-a-service” track was born, and these platforms provide holders with simple, flexible and capital-efficient staking services. The industry leader is Lido.

Lido is a non-custodial liquid staking protocol for Ethereum, Solana, Kusama, Polygon and Polkadot. Lido not only makes the access conditions of Pos more democratic, but also realizes a more secure decentralized PoS network as the Lido roadmap is gradually realized. Lido currently ranks fourth among all protocol TVLs and accounts for nearly a third of all staked ETH.

Recently, the Lido DAO voted against deploying on Terra 2.0. Lido will also continue to include more node operators through governance to diversify its validator set.

02 How Lido works

Currently the Lido DAO manages 5 Lido Liquid Staking Protocols. While the five supported PoS networks (including Ethereum, Solana, Kusama, Polygon, and Polkadot) differ in design, the general mechanics of their liquid staking protocols are similar.

Source: @Leo_Glisic, Messari

Source: @Leo_Glisic, Messari

The two main parties involved are users (stakers) and node operators (validators). Key parts of the protocol are staking smart contracts, token-staking derivatives (st assets like stETH), and external DeFi integrations (like Curve).

Node operator

The first key component of a liquid staking protocol is the node operator, who is responsible for the actual staking work. As of now, node operators are added and removed through the Lido DAO.

Lido’s admission mechanism is initiated by the Node Operators Sub-Governance Group (LNOSG), which currently consists of representatives from Lido’s 21 Ethereum node operators. Node operator applications are opened when Lido is launched on a new network, or when the group believes it can handle a network and can benefit from additional node operators. Applicants are evaluated by the panel based on several factors, including reputation, past performance, and the safety, reliability, and novelty (irrelevant nature) of their setup. Once the team has evaluated a pool of applications, it submits a list of recommendations to the Lido DAO for token holders to vote on. A good set of validators is crucial for Lido, as staking rewards and slashing penalties affect all stakers through a liquid staking protocol.

Lido is also non-custodial, which means node operators do not have direct access to user funds. Instead, they must use a public verification key to verify transactions of pledged assets. To moderate the incentive mechanism, Lido node operators receive commission compensation from staking rewards generated from delegated funds.

pledge contract

Users delegate their pledge rights to node operators through Lido’s smart contracts. The 3 main smart contracts are:

1. Node Operators Registry

The node operator registration contract maintains a list of approved node operators.

The underlying mechanism of Lido's Ethereum pledge source: Lido Blog

The underlying mechanism of Lido’s Ethereum pledge source: Lido Blog

2. The staking pool

The staking pool is the most important smart contract in the protocol. Users can access encrypted assets, mint or burn st assets by interacting with the contract. The staking pool uses the node operator’s address and verification key to distribute deposits to node operators in a uniform rotation. The staking pool contract is also responsible for distributing fees to the Lido DAO treasury and node operators.

3、LidoOracle

A LidoOracle is a contract that sends the balance of an address controlled by a DAO to an ETH 2.0 party. LidoOracle is responsible for tracking pledge balances. The net staking reward (that is, the net profit of staking minus the reduction penalty) is sent to the staking pool contract on a daily basis. The staking pool distributes 10% of the net staking reward by minting proportional st assets: 5% to node operators and 5% to the Lido DAO treasury. The remaining 90% of the net staking reward goes to st asset owners (aka stakers). Depending on the network, the staking reward will appear as an increase in the balance of the st asset or an increase in the exchange rate.

How LidoOracle Interacts with Ethereum Staking Pool Source: Lido Blog

How LidoOracle Interacts with Ethereum Staking Pool Source: Lido Blog

03 st assets on Lido

When users deposit assets into Lido Liquidity Staking Agreement, they will receive corresponding pledge derivatives (for example, pledge ETH will receive stETH). Lido’s tokenization of the pledge pool effectively unlocks the liquidity of user assets, and st assets exist in two forms: elastic supply (rebase) and shares (shares).

The elastic supply form (such as stETH, stKSM, stDOT) means that st assets are minted 1:1 according to the deposited assets. To match the underlying asset, the pegged token balance changes daily with accumulated staking rewards. Whether the st asset is acquired from Lido staking, purchased from a decentralized exchange, or acquired through transfers from other holders, the daily st asset balance will change based on cumulative rewards.

The form of shares (stSOL, stMATIC) means that st assets capture pledge rewards through appreciation, and the rewards are reflected in the increase in the exchange rate between st assets and pledge assets (for example, stSOL: the exchange rate of SOL is 1.1, which means that the pledge reward of SOL is 10%). (Pegged tokens can be encapsulated as stake tokens.)

As of now, stETH accounts for more than 98% of the total asset value of st in circulation. stETH is currently a purely synthetic, closed-end derivative, as it can redeem its staked ETH after the Ethereum merger. Holders who want to exchange stETH for ETH must rely on exchanges such as Curve, Uniswap, and FTX for pricing and liquidity.

04 Lido’s DeFi integration

Lido and DEX integration

In order to maintain the liquidity of stETH, Lido DAO incentivizes Curve’s stETH:ETH pool, which is currently the deepest AMM pool in DeFi. Measures to incentivize Lido DAO Tokens (LDO) and CRV by increasing the APY (annualized rate of return) of the pool have attracted corresponding liquidity. Such pools on Curve, along with Uniswap and Balancer, give stETH holders the ability to withdraw before their staked ETH is unlocked.

Messari Report: Lido Liquid Collateral

The price of 1 stETH should not really exceed 1 ETH. This cap exists because 1 ETH can always be minted as stETH through the Lido staking protocol. However, the arbitrage mechanism of stETH is not as clear-cut as other arbitrage methods.

Since stETH cannot be burned on the Lido protocol in exchange for staked ETH, the current exchange rate is dependent on market price discovery within the cap. stETH is less liquid, less practical (eg, cannot be used to pay gas fees), and has more technical (smart contract) risks than ETH. However, the stETH price is usually not much lower than the 1:1 exchange ratio of ETH, because the too low price will attract arbitrageurs to buy and hold, and wait for the merger to unlock to obtain the spread.

Translator’s note: At present, this situation has changed. With the decline of ETH, the demand for holders to convert encrypted assets into stable coins has increased. Combined with the impact of events on the Celsius platform, the ratio of stETH/ETH pool assets has tilted, resulting in The ratio of stETH to ETH has dropped significantly. As of press time, the conversion ratio is about stETH: ETH = 0.95.

For other st assets, the liquidity of DEX is still useful, because it gives holders more choices: whether to exchange for liquidity or pledge to wait for unlocking.

Lido and Lending Integration

While Lido stakers can hold stETH or provide low-risk liquidity to DEXs (risk from impermanent losses), there are opportunities for higher returns if stakers use st assets as collateral. For example, Aava and MakerDAO can mortgage stETH, and Solend can mortgage stSOL for loans. For example, assets on Aava can be loaned up to 70% of the value of stETH. Some people use this method to recycle loans and then pledge, which can obtain relatively high returns, but also take greater risks.

Source @Leo_Glisic, Messari

Source @Leo_Glisic, Messari

More recent structured products such as Index Coop’s icETH have begun offering stETH leverage through Aava while reducing some of the risk associated with managing collateralized debt. Nonetheless, events such as hacks, governance attacks, slashing of staking by multiple node operators, or a liquidity crunch across the market could lead to continuous liquidations and a huge tilt in the stETH/ETH pair. But using leverage to borrow assets is the core capability of capital efficiency, and it is also the method Lido uses to try to solve the dilemma of illiquidity and pledge lock-up.

Messari Report: Lido Liquid Collateral

As shown in the chart above, since Aave’s integration at the end of February 2022, its stETH scale has grown considerably. As of press time, nearly 45% of the stETH in circulation is stored on Aave. The second largest stETH pool is Curve’s stETH:ETH trading pair. About 2/3 of the liquid stETH is divided between the two major protocols.

05 The competitive landscape of the pledge market

In early May, Lido briefly surpassed Curve as the DeFi protocol with the largest TVL amount. Lido’s overall TVL ranking has been around fourth since the UST de-coupling.

Messari Report: Lido Liquid Collateral

After entering May 2022, about 70% of the new ETH2 pledge deposits came from Lido. In general, the Lido pledge ratio accounts for 32.5% of the total network ETH pledge.

Messari Report: Lido Liquid Collateral

Lido has over 90% market share in the non-custodial, decentralized liquid staking circuit.

Messari Report: Lido Liquid Collateral

Lido’s first competitor in the market, Rocket pool, has gained some market presence and publicity since its launch in November 2021. Despite the 3x increase in ETH staked on Rocket Pool, the market share in this segment is still below 4%.

2 differences between Rocket Pool and Lido:

1. The biggest difference is the difference in validator settings . Whereas Lido’s approach is to centralize validators among professional, hand-picked node operators, Rocket Pool aims to build a no-approval validator set, secured by economic incentives rather than validators’ reputation/past performance Pledge security. While Rocket Pool’s system does enable wider participation in the validation process, it also leads to capital inefficiencies (like requiring node operators to provide 16/32 ETH to each validator), which makes scaling difficult.

2. The second major difference is liquidity . Lido DAO currently spends more than 4 million LDO per month to incentivize the liquidity of each chain and DEX on each chain, most of which is spent on the stETH:ETH trading pair. Rocket Pool has no liquidity incentive payouts. Lido’s incentive system promotes demand for stETH by reducing slippage and creating an inherent fundamental benefit for stETH holders.

Rocket Pool’s late start, relatively poor liquidity, and low rETH price (an asset acquired after staking on Rocket Pool) make it difficult for Pocket Pool to catch up with Lido. As a result, stETH has become a subconscious choice for users in the non-custodial liquid staking ETH market.

Another major player in liquidity staking ETH is Binance

The custodial nature of Binance makes it not a direct competitor to Lido. Also, while Binance does issue a liquid tokenized derivative (bETH), the token generates no additional value outside of the staker’s Binance wallet, which is much worse than stETH and rETH.

Overall, the three largest custodial staking solutions (Kraken, Coinbase, and Binance) collectively deposited nearly 2.7 million ETH, or about 60% of Lido’s staking. Going forward, this gap will grow, as Lido’s recent increase in staking accounts for the vast majority (70%) of ETH2’s new staking.

ETH staking rewards are undoubtedly the main source of income for Lido, and Solana staking reflects the multi-chain expansion aspect of Lido. First of all, Lido is not a subdivision winner of liquid staking on Solana, where Marinade is the ruler. SOL staking on Marinade is currently roughly 2.5x that of Lido. From a broader perspective, however, liquid staking on Solana is an easily overlooked small market, with the two largest protocols on the track taking only 2.5% of total staking. In ETH2, the two largest liquid staking protocols, Lido and Rocket Pool, account for 36% of the total staking amount.

The reason behind this may be due to Solana’s native delegation function and the higher liquidity brought by the 2-3 day staking cycle on the chain. While this complicates Lido’s multi-chain expansion prospects, Lido’s branding, cross-chain synergy, and dominance of the huge Ethereum market still make it promising overall in terms of competition and product market fit expected.

06 Risk

Given the Lido DAO’s heavy reliance on Ethereum, any setbacks in the merger’s timeline or execution could be disastrous. While this article does not delve into Ethereum 2.0 in depth, adverse events in the merger process could hit the ETH:stETH exchange ratio, such as a further extension of the transition period, or a crisis of confidence surrounding the transition itself.

Given the rehypothecation of stETH, continuous liquidations could put further downward pressure on the price of stETH. However, if the merger goes well, Lido will play a central role in the largest PoS chain.

The choice to gradually decentralize allows Lido to optimize for speed and scalability. While Lido has a first-mover advantage over competitors such as Rocket Pool, Lido’s smaller set of node operators has raised concerns about Ethereum’s centralization.

The LNOSG is a committee of insiders that controls the initial planning process for node operator selection. Even though the Lido DAO will vote on the finalized list, the LDO token centralizes insider ownership. This also resulted in 21 professional node operators controlling all ETH shares of Lido on the Ethereum beacon chain, which accounted for 32.5% of the total ETH pledged. In addition, the withdrawal certificate of ETH pledged before July 15, 2021 is controlled by a multi-signature of 11 people, and only 6 people can sign it to pass. If more than 5 signers lose their keys or act rogue, about 600,000 ETH (about 15% of the current Lido ETH2 total pledge amount) may be locked. The Lido DAO team plans to migrate this part of the pledged assets to the withdrawal certificate of 0x01 (upgradable smart contract) as soon as possible.

In addition, Lido has also developed related plans. Part of the plan involves adding permissionless verification. Distributed Validator Technology (DVT) will allow Lido to onboard new, unknown, untrusted node operators by simply pairing them with trusted whitelisted node providers. These new validator groups will work together to propose and prove blocks while maintaining mutual constraints.

The second part of the plan addresses the concentration of LDO ownership. This will give stETH holders the ability to monitor and veto DAO decisions.

Epilogue

Currently, only about 10% of ETH in circulation is pledged. After the merger, stakers will have the option to withdraw, and staking rewards may also be doubled. If the ETH pledge ratio reaches the average level of the current top PoS public chains, the overall ETH pledge may also increase by a factor of six. In addition to benefiting from an uptrend, Lido will allow stakers to avoid validator activation queues that can last for several months and start earning staking revenue immediately. Whether it’s offering lower yields or using some of its treasury assets to fill the gap, Lido has another huge opportunity to cement itself as the market leader in Ethereum’s liquid staking track.

Messari Report: Lido Liquid Collateral

However, with great power comes great responsibility. Lido will play a central role in securing the largest L1 blockchain, directly or indirectly impacting the security of billions of dollars worth of assets (as of press time). Contrary to what critics might say, it is not wrong in itself. The possible long-term impact of Lido’s dominance on the Ethereum network and the entire crypto ecosystem depends largely on how the Lido DAO will build a secure and truly decentralized protocol. Regardless, Lido lets the ecosystem’s stakers think in cycles of years, not days, weeks, or months, a testament to the protocol’s intended staying power. What it’s doing is combining a strong ecosystem with a strong flywheel effect.

END

Posted by:CoinYuppie,Reprinted with attribution to:https://coinyuppie.com/messari-report-lido-liquid-collateral/
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