How To Unlock The Potential Of Liquid Staking Derivatives (LSDs)

ntroduction to Liquid Staking Derivatives (LSDs)

What Are LSDs?

Liquid staking derivatives (LSDs) are tokens issued by liquid staking protocols or platforms, enabling users to unlock their illiquid staked assets to earn higher yields. The price of the derivative token is pegged to its underlying asset, which is locked when staked on a Proof-of-Stake (PoS) network.

In both traditional finance and crypto, derivatives are contracts that derive value from an underlying asset, primarily used for hedging and speculating. The difference in crypto is that the underlying asset is a token. The LSD mechanism was pioneered by Lido in December 2020 and was built for the Ethereum chain. Lido remains the largest liquid staking protocol by total value locked (TVL).

Why LSDs?

With regular staking, users help to secure PoS networks by locking their assets through a protocol or platform, receiving staking rewards in return. However, this brings about the problem of capital inefficiency as stakers lose out on the opportunity to earn additional yield when their assets are illiquid and locked up.

Solves Capital Inefficiency

LSDs solve this problem by providing users with a liquid and usable token representing their staked asset. This way, stakers can use their LSDs to further participate in DeFi, such as through liquidity provision or using them as collateral, while still receiving network staking rewards.

Lowers Barriers to Entry for Staking

LSDs also use pooled staking, which lowers the barriers to entry for users to stake on a network as it is usually costly to run a validator node. This is especially useful for Ethereum, where 32 Ether (ETH) is the minimum amount needed to run a validator node to stake on the network.

Increases Network Security and Stability

By lowering the barriers to entry for staking and incentivizing staking by mitigating capital inefficiencies, LSDs encourage user staking on the network. The stability and security of PoS networks increase with the number of stakers on the network because greater decentralization is achieved.

Drawbacks of LSDs

Despite its benefits, there are also disadvantages and risks associated with LSDs.

Small Market Size

Compared to their underlying assets, LSDs might be limited by their small market size and thus, may not always have deep liquidity. This makes it more difficult for users to enter or exit their positions, resulting in risks of wider bid-ask spreads and slippages, which can cause significant losses.

Counterparty Risks

LSDs are typically traded on centralized exchanges (CEXs) or decentralized protocols involving a counterparty. This comes with counterparty risks, such as the counterparty’s potential insolvency or inability to fulfill its obligations. Further, there has been a recent crackdown on staking by the SEC on platforms such as Kraken. This may impact the liquid staking space in the future, contributing to uncertainties around the future of LSDs on CEXs.

Depegging Risks

The price of LSDs is typically pegged to that of the underlying token. However, most LSD prices are dependent on their secondary market. There have been instances where the price of the LSD token fell below that of the underlying token, creating a liquidity crunch. During the 2022 crypto contagion, there was a stETH/ETH depeg with stETH trading at around 0.93 ETH at its bottom in June 2022. As a result, liquidity providers started withdrawing their funds and draining market liquidity. The resultant volatility could be a risk faced by any LSD.

A Rise in Popularity

Although there are risks associated with LSDs, they have been growing in traction and could emerge as one of the main 2023 crypto narratives, as mentioned in our Insights piece, “Treehouse’s 2022 Wrap-up and 2023 Outlook”. There was a significant increase in interest in liquid staking, especially after Ethereum’s successful Merge as it shifted from Proof-of-Work (PoW) to PoS.

Staking rewards are probably the key driving factor for user adoption. The table below shows some decentralized liquid staking platforms’ Annual Percentage Rates (APRs).

Despite the rise in LSDs, up till the end of 2022, Ethereum’s stake rate was only 13%, compared to the average stake rate of other PoS networks at 60%. Stake rate refers to the total percentage of an asset staked out of the total supply of the underlying asset.

Ethereum Shanghai Upgrade

There is also anticipation for Ethereum’s Shanghai network upgrade, slated for March 2023. The upgrade will finally allow users to withdraw their staked ETH on the Beacon Chain, de-risking staking and potentially encouraging more users to stake ETH on the network. This could mean greater liquidity for the Ethereum LSD market, contributing to a flywheel for the adoption of LSDs.

It is important to note that there might be a spike in volatility once the Shanghai upgrade happens. A sudden wave of user withdrawals could occur, especially with stakers who have had their ETH locked since late 2020.

How Do LSDs Work?

LSDs allow individuals to gain exposure to DeFi yield in addition to staking rewards by retaining the liquidity of their assets. These liquid tokens represent a claim on the underlying, illiquid staking position. They can be used in various ways, such as for lending, trading, and as collateral, within DeFi…