Liquid Staking: How to Evaluate LSD Projects

Liquid Staking: How to Evaluate LSD Projects

Liquid Staking Derivatives (LSDs) is a crucial sector, ranking third in Total Value Locked (TVL) within the DeFi market. Currently, there are over 60 active LSD projects, with notable ones including Lido Finance and RocketPool. This article provides an overview and criteria to help users evaluate the most suitable LSD projects.

What is Liquid Staking?

Liquid Staking Derivatives (LSDs) are protocols that allow users to stake blockchain coins and generate synthetic assets representing the amount and value of the staked coins on Proof of Stake (PoS) blockchains.

How Liquid Staking Works

Liquid Staking falls under the category of derivatives, enabling investors to trade various products based on their price without owning the underlying assets. Liquid Staking Derivatives protocols unlock staked assets by converting them into synthetic assets. This allows users to buy, sell, or participate in other activities within the DeFi market.

Example of Liquid Staking

For instance, Lido Finance allows users to stake ETH and receive stETH in return. In addition to earning staking rewards from the staked ETH, users can also utilize stETH in other DeFi protocols to generate additional profits, such as lending on Aave or participating in liquidity mining on Automated Market Makers (AMMs).

Importance of Liquid Staking

Liquid Staking Derivatives is a vital segment in the DeFi space, ranking third in Total Value Locked (TVL). With over 60 active LSD projects, including prominent ones like Lido Finance and RocketPool, these protocols provide users with increased flexibility and opportunities to maximize their returns on staked assets.

Why Are Liquid Staking Derivatives Growing Rapidly?

First, let's understand the consensus mechanisms of Proof of Work (PoW) and Proof of Stake (PoS).

Proof of Work vs. Proof of Stake

Proof of Work (PoW) is a consensus mechanism that requires validators to use powerful mining rigs to compete for the right to validate blocks. Validators do not need to hold the blockchain's coins. Operating mining rigs is costly and consumes significant resources, such as electricity. The mined coins are often sold to cover the operational expenses of mining farms.

On the other hand, Proof of Stake (PoS) blockchains require validators to stake a certain amount of coins on the network. If validators act dishonestly, they are penalized and lose a portion of their staked coins. This mechanism ensures that validators remain honest and helps reduce the circulating supply of coins in the market.

PoS has proven to have several advantages over PoW, including faster block creation times, lower operational costs, higher throughput, and a smaller ecological footprint.

The Rise of PoS Blockchains

Since 2020, there has been an increase in the number of PoS blockchains, a key factor contributing to the rapid growth of Liquid Staking Derivatives (LSDs). LSDs operate exclusively on PoS blockchains and do not function on PoW blockchains.

Ethereum's Transition to PoS

One notable example is Ethereum, which transitioned from PoW to PoS. As of now, Ether (ETH) is the largest staked asset in Liquid Staking Derivatives protocols. This transition has significantly impacted the adoption and growth of LSDs.

The development of PoS blockchains has fueled the growth of Liquid Staking Derivatives. As PoS continues to demonstrate its benefits over PoW, the demand for LSDs is expected to increase. These protocols provide a more efficient and environmentally friendly way to stake and manage digital assets, offering users greater flexibility and potential for higher returns.

Benefits of Liquid Staking Derivatives

Liquid Staking Derivatives (LSDs) provide various advantages for different stakeholders involved in the blockchain ecosystem. Here are the key benefits:

Benefits for Participants

  • Users: LSD protocols enable users to earn additional profits from two sources: block rewards and incentives from DeFi protocols. This dual earning potential increases capital efficiency.
  • Blockchain Networks: As more users stake their tokens in LSD protocols, they indirectly contribute to the network's security and decentralization. This participation helps strengthen the overall blockchain ecosystem.
  • Node Operators: Node operators receive a portion of the fees for supporting stakers by managing the hardware and software required to stake coins on the network. This creates an additional revenue stream for operators.
  • Projects on the Network: The use of tokens from LSD protocols increases the Total Value Locked (TVL) and transaction volumes for projects built on the network. This, in turn, boosts the project's visibility and attractiveness.
  • Token Holders of LSD Projects: Holders of tokens from LSD projects benefit from revenue sharing and have the opportunity to participate in the project's governance. This involvement allows them to influence the direction and decisions of the project.

Positive Network Effect

As user demand for LSDs grows, the benefits for all involved parties increase, creating a positive network effect. This interconnected growth enhances the overall value and functionality of the blockchain ecosystem.

Liquid Staking Derivatives provide significant advantages by improving capital efficiency, enhancing network security, generating additional revenue streams for node operators, boosting project visibility, and involving token holders in governance. As the adoption of LSDs continues to rise, these benefits will further amplify, driving the growth and development of the blockchain industry.


Benefits for Token Holders

Investing in and holding tokens from Liquid Staking Derivatives (LSD) projects typically provides two main benefits: revenue sharing and governance rights.

Governance - Participation in Project Ecosystem Management

Governance is a fundamental feature present in almost all DeFi protocols today. It allows token holders to propose or vote on changes that affect the project's operations.

For builders or large investors, this is a significant benefit as it enables them to influence project decisions and secure their interests. However, for smaller traders, governance may not hold as much value.

Revenue Sharing from the Protocol

Most LSD projects generate protocol fees by charging a percentage of the profits users earn. This fee structure ensures a mutually beneficial relationship between the project and its users.

Projects may distribute all or part of these protocol fees to token holders or stakers using various formulas.

Example: Lido Finance

Consider a user who stakes 1,000 ETH in Lido with an Annual Percentage Rate (APR) of 9%. After one year, the user withdraws their stake, and Lido charges a protocol fee of 10%. The user would receive their initial capital plus block reward profits, calculated as:

1,000 + 1,000 * 9% * 90% = 1,081 ETH

Lido, on the other hand, would earn a protocol fee of:

1,000 * 9% * 10% = 9 ETH

Assuming the current value of ETH staked in Lido is around $5.7 billion with an APR of 9% (assuming TVL and APR remain constant), Lido would generate annual protocol fees of approximately $51.3 million.

However, Lido Finance does not share this revenue directly with token holders. Instead, 10% of the protocol fee is split, with 5% going to Node Operators and the remaining 5% allocated to the Treasury for further development. As a result, LDO token holders do not receive direct financial benefits from holding the token.

In conclusion, while governance and revenue sharing are key benefits for token holders in LSD projects, the specific advantages can vary significantly based on the project's fee distribution model and governance structure.

Risks Associated with Liquid Staking Derivatives

Liquid Staking Derivatives (LSDs) come with their own set of risks for both protocols and users. Here’s a detailed look at these risks:

Risks for the Protocol

Unlike lending protocols that can encounter bad debts, Liquid Staking Derivatives protocols face minimal risk as long as they avoid security issues within the DeFi ecosystem. However, security remains a significant concern, as any vulnerability can lead to substantial losses.

Risks for Users (Stakers)

Users face several risks related to Liquid Staking Derivatives assets, such as stETH, rETH, and ankrETH. A common risk is the liquidity of these tokens, which is often low. If sold in large volumes over a short period, these tokens can lose their peg.

Example: In June 2022, during a significant market downturn in the crypto space, Alameda Research sold a large portion of stETH to mitigate risks associated with illiquid assets. They exchanged stETH for ETH on Curve Finance, accepting a minor loss. However, the large volume of stETH sold caused its price to drop to 0.94 ETH instead of the usual 1:1 peg.

Token Liquidity Issues: stETH, created by Lido Finance, has a market cap of approximately $5 billion with a 24-hour trading volume of $26 million. Other tokens, like ankrETH, have much lower market caps (around $50 million) and daily trading volumes (about $100,000), posing significant de-pegging risks for users.

Chain Reaction Risk: LSD tokens used across various DeFi platforms can trigger cascading risks. For instance, if you use stETH as collateral on Aave to borrow other assets, a sudden drop in stETH’s price could jeopardize your loan position and lead to bad debt for the lending protocol.

Potential for De-pegging and Collapse

Many stakers worry about the de-pegging risks of LSD tokens, fearing a collapse similar to UST. To understand this risk, it’s crucial to differentiate the mechanics behind UST’s collapse from those of LSD tokens.

UST vs. LSD Tokens:

UST was an algorithmic stablecoin backed 1:1 by the value of LUNA. When LUNA’s price plummeted during a market downturn, UST lacked sufficient backing assets, leading to a loss of confidence and massive sell-offs, resulting in the collapse of both UST and LUNA.

In contrast, LSD tokens like stETH have clear backing assets locked in smart contracts. Although de-pegging can occur due to low liquidity, they are unlikely to collapse as they are secured by the staked assets.

Advice for Stakers

For those who stake and hold LSD tokens, it’s crucial not to panic-sell without understanding the underlying reasons for de-pegging. Selling LSD tokens means forfeiting both the staked tokens and the accrued interest.

Notable Liquid Staking Derivatives Projects

As of June 2024, according to DefiLlama, there are over 60 different DeFi Liquid Staking Derivatives (LSD) projects in the market. Here are four prominent projects you can consider:

  • Lido Finance: Lido Finance is considered the most robust LSD protocol in the DeFi market, dominating in Total Value Locked (TVL) compared to other projects. Lido supports five networks: Ethereum, Solana, Polygon, Polkadot, and Kusama. In the future, Lido plans to expand to Layer 2 solutions like Optimism and Arbitrum. Backers of Lido Finance include a16z, Coinbase, Paradigm, and Dragonfly. One of the reasons for Lido Finance's strong growth is its powerful partners who accept the synthetic tokens it creates, particularly stETH. These tokens are used on platforms like Uniswap, Balancer, Curve, and Convex.
  • Rocket Pool: Rocket Pool is the second-largest DeFi Liquid Staking Derivatives project. However, it focuses exclusively on ETH and has no plans to support other assets. Rocket Pool allows Node Operators to start with 16 ETH instead of the usual 32 ETH required by other projects. Backers of Rocket Pool include ConsenSys Ventures and KR1.
  • Stader Labs:  Stader Labs supports seven networks, including Ethereum, BNB Chain, Near, Terra 2.0, Fantom, Hedera, and Polygon. In the future, they plan to add support for Avalanche and Solana. Backers of Stader Labs include Pantera, Coinbase, Jump Capital, and
  • Ankr Liquid Staking: Initially, Ankr was not a Liquid Staking Derivatives project but a platform providing tools for developers to build products in the DeFi market. Ankr has since expanded into various areas, including AppChain, Gaming SDK, API, and Liquid Staking Derivatives. Currently, Ankr supports eight blockchains, including Ankr, Gnosis, Ethereum, Polygon, BNB Chain, Fantom, Avalanche, and Polkadot. Backers of Ankr include Binance Labs, NGC Ventures, OK Blockchain Capital, and JD Capital.

Evaluation Criteria for Liquid Staking Derivatives Projects

For Stakers

The market offers various LSD projects, each providing different interest rates for the same type of asset. However, the highest interest rate is not always the best. Stakers should balance risk and reward when choosing these protocols.

Key Factors to Consider:

  • Total Value Locked (TVL): Indicates the total value of tokens staked in the protocol. Higher TVL reflects a larger project scale.
  • APY & APR: Represents the interest rate stakers earn and the net return after fees.
  • Service Fees: The fees generated for the protocol. Typically, this fee is 10% of the user's earned rewards (e.g., Lido and Stader Labs).
  • Liquidity and Market Cap of LSD Tokens: Important for reducing de-pegging risks and increasing profit opportunities across different protocols.

For Protocols

While the above factors are also important for protocols, the following are more critical:

  • Focus on growing and expanding in future-proof ecosystems like Ethereum, BNB Chain, and Polygon.
  • Sustainable revenue generation and revenue-sharing mechanisms with native token holders.
  • Collaboration to enhance the utility of LSD tokens in DeFi protocols, thereby increasing liquidity and market cap to reduce de-pegging risks.

For Investors

Investors should consider the following factors alongside those mentioned above:

  • Market Cap of the Project: Use TVL/Market Cap ratio to evaluate the project’s valuation.
  • Token Inflation: Projects with low market cap and low inflation are ideal as they offer hidden gem potential without the drawback of high inflation.
  • Value and Benefits for Token Holders: While most projects do not directly share revenue with token holders, tokens can still appreciate if the project develops correctly.

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