Blockworks Research Report: stETH - Ethereum's Outstanding Institutional Product

Author: Magicdhz, Blockworks; Compiler: Baishui, Golden Finance

Abstract

• The Lido Protocol, managed by Lido DAO, is an open source middleware that routes rewards for ETH, stETH, and Ethereum between a set of validators and ETH stakers.

• stETH is the most liquid LST and the most widely used form of on-chain collateral.

• stETH liquidity and stETH as collateral are also growing on CEXs, indicating that institutions are interested in trading and holding stETH as an alternative to ETH.

• stETH is staked in a strong set of validators, has lower risk, and provides higher probability-adjusted rewards.

• As TradFi seeks to stake ETH rewards, this may mean developing a "tradfiETH" product, with stETH serving as a coordination tool to combat centralization.

Introduction: stETH > tradfiETH (ETF)

On May 20, 2024, Eric Balchunas and James Seyffart revised the odds of approval of the spot ETH ETF from 25% to 75%. ETH rose by about 20% within hours. However, the issuer amended the S-1 registration statement to remove the ETF's staking rewards, as required by the SEC. As a result, investors holding the spot ETH ETF will not receive staking rewards for Ethereum, likely due to the regulatory clarity required to provide a staking ETH product. In any case, at current rates, investors who choose to receive the spot ETH ETF will lose out on the ~3-4% APR on consensus and execution layer rewards. Therefore, there is an incentive to add staking to the ETF product in order to mitigate dilution.

The Lido Protocol is an open source middleware that automatically routes ETH in a pool between validator sets based on delegation criteria. The Lido DAO is governed by LDO holders and is responsible for managing some of the parameters of the above delegation standards, such as protocol fees and node operator and security requirements. However, the protocol is non-custodial and the DAO has no direct control over the underlying validators. With ~29% of the total stake in the network (9.3M ETH, or $35.8B), stETH is critical infrastructure for the staking industry, holding high standards for performance, delegation, and other staking practices.

ETH ETFs may be the most convenient option for TradFi investors to gain exposure to ETH right now, but these products do not capture Ethereum issuance or cryptoeconomic activity. As more TradFi venues join the token themselves, holding Lido’s liquid staking token stETH is arguably the best product to gain exposure to ETH and Ethereum staking rewards, as it has key utility in the existing market structure:

• stETH is the most liquid and highest volume ETH staking asset on decentralized exchanges (DEXes).

• stETH is the most widely adopted form of collateral in DeFi, outstripping the largest stablecoin USDC and ETH itself.

• stETH is the most liquid, reward-based native L1 asset on centralized exchanges (CEXes) — both as an alternative to spot ETH trading and as a form of collateral.

stETH’s dominance is likely to continue as ETH ETFs emerge, investors learn more about Ethereum and seek additional returns from consensus and execution layer rewards — a helpful tailwind to solidify a stronger stETH market structure. Looking ahead, as TradFi institutions eventually add staking to their products (calling them “tradfiETH”), Lido DAO governance and the growth of stETH will be critical to maintaining a sufficiently decentralized validator set on Ethereum.

Thus, “stETH > tradfiETH” as it offers better returns, unlocks more utility than adjacent products, and acts as a coordination tool to combat centralization.

Source: FINMA, Taurus

Lido Protocol

The Lido Protocol's middleware is a set of smart contracts that programmatically allocates users' ETH to a group of vetted Ethereum validators. This Liquidity Staking Protocol (LSP) is designed to enhance Ethereum's native staking capabilities. It primarily serves two parties: node operators and ETH stakers, and solves two problems: the barrier to entry for validators, and the loss of liquidity caused by locking up ETH for staking.

Although the hardware requirements for running validators on Ethereum are not as high as other chains, in order to reach consensus, node operators need to stake increments of exactly 32 ETH in validators to receive rewards in ETH. Not only is raising so much money not easy for potential validators, but allocating ETH within the constraints of 32 ETH intervals can be very inefficient.

To simplify operations, Lido routes ETH from investors and delegates these ETH to the validator set, effectively lowering the high economic barrier to entry. In addition, Lido DAO reduces the risk of the validator set through strict evaluation, monitoring, and delegation strategies across node operators. Operator statistics and metrics containing data from the validator set can be found here.

In return for their ETH deposits, investors receive stETH, and the value proposition is simple. Running a validator or staking ETH requires locking up ETH in an account - in contrast, stETH is a liquid utility token that users can use in CeFi and DeFi.

stETH

stETH is a Liquid Staking Token (LST), a utility token that represents the total amount of ETH deposited to Lido plus staking rewards (minus fees) and validator penalties. Fees include staking commissions collected from validators, the DAO, and the protocol.

When a user deposits one ETH to Lido, one stETH is minted and issued to the user, and the protocol records the user's share of ETH in the protocol. This share is calculated daily. stETH is a receipt that users can redeem for their share of ETH in the pool. By holding stETH, users automatically earn Ethereum rewards through the rebasing mechanism - essentially, when ETH rewards accumulate to the validator set, the protocol mints and distributes stETH based on the account's ETH share in the protocol.

Rewards for stETH depend on ETH issuance, priority fees, and MEV rewards. ETH issuance is the reward validators receive for participating in consensus and correctly proposing blocks. Currently, the issuance rate is 917,000 ETH per year (and there are discussions about changing this monetary policy). Users pay priority fees to prioritize transaction inclusion. MEV rewards are an additional source of income for running MEV-Boost, which facilitates a market for validators to earn a portion of Ethereum's block rewards. This part of the reward depends on the demand for Ethereum block space. According to mevboost.pics, in 2023, validators realized about 308,649 ETH ($704.3 million based on the ETH price on January 1, 2024) through MEV-Boost. Taking these factors into account, investors can earn a variable annual interest rate of 3-4% throughout 2024 simply by holding stETH.

In summary, unlike the spot ETH ETF, stETH is a liquid product through which investors can own ETH assets and earn cash flow from Ethereum. In addition, stETH is also one of the most used assets in various environments in DeFi.

stETH Utility

stETH's main utilities make it an ideal asset, which include liquidity and the ability to use it as collateral. Typically, it takes days to withdraw staked ETH, as the amount of time a staker must wait depends on the size of the exit queue. This increases the potential for maturity mismatch, where the value of ETH changes dramatically between a withdrawal request and redemption.

The core value proposition of stETH is its liquidity. Instead of waiting in an exit queue, stakers can exit their staked position simply by selling stETH on the market on a DEX or CEX. Astute readers will appreciate that eliminating maturity mismatch risk shifts the risk to the willingness and ability of the secondary market to accept stETH inventory. That being said, given the approval of a spot ETH ETF and the properties and underlying market structure trends of stETH, there is greater precedent to predict further adoption and deeper liquidity for stETH.

stETH Liquidity

It is worth noting that stETH reserves in Ethereum and rollup pools have been declining throughout 2023. This is due to the DAO moderating its incentive payouts to on-chain stETH LPs, which means LPs have withdrawn their reserves from the pools. In 2024, reserves reach a stable level. Moving away from subsidized LPs (who are generally more inclined to withdraw reserves when they are most needed) to real, non-subsidized stETH LPs is much healthier for stETH's on-chain liquidity profile. Despite these market forces, stETH remains one of the most liquid assets in DeFi and is in the top ten by TVL on Uniswap.

During the same period, both stETH trading volume and stETH usage in these pools have increased. The trends in the chart below indicate that: (1) LPs are more sticky and consistent, (2) the market is approaching a more stable equilibrium for stETH liquidity, and (3) more and more participants are willing to trade stETH. These market structures are a stronger and more organic foundation for expansion than overinvesting in LDO incentives on seasonal LPs. As shown in the chart below, stETH's trading volume and liquidity are far ahead compared to other LSTs.

Liquidity Does Matter (ICYMI)

Liquidity is arguably the biggest determinant of risk management in financial markets. The liquidity profile of an asset greatly affects its risk-adjusted return, and in turn, its attractiveness to investors. This makes stETH a great choice for investors and traders looking to earn Ethereum rewards, as confirmed by Blockworks’ panel with large crypto-native institutions including Hashnote, Copper, Deribit, and Cumberland. The chart below shows the trend of crypto-native institutional adoption on CEX: more crypto-native institutions and market makers are more willing to hold and trade stETH. Note: Global bid data is incomplete during February and part of March because exchanges changed the exchange rate limits for order data.

stETH as collateral

stETH is also the preferred form of collateral in DeFi - it even surpasses ETH and popular stablecoins such as USDC, USDT, and DAI. The figure below shows that it has gradually climbed to this position since its inception, accounting for about 1/3 of the total market share.

Using stETH as a high-quality collateral option improves its capital efficiency and may help exchanges and lending platforms generate more trading volume. In February of this year, ByBit announced that it would increase the collateral value of stETH from 75% to 90%. Since then, the stETH trading volume on ByBit has increased nearly 10 times.

It seems that the on-chain market structure of stETH has reached a more stable equilibrium, which may lay a solid foundation for a long-term gradual growth trend. Off-chain, we can observe sparks of more institutional adoption as investors will prefer to stake ETH instead of ordinary ETH. While we also expect other LSTs (possibly including LRT) to gain market share, stETH's existing market structure and dominance, as well as its first-mover advantage, should maintain its strong position in the market. In addition, Lido and stETH have many favorable features compared to other staking options. Compared to other staking mechanisms, Lido's mechanism has three key features: non-custodial, decentralized, and transparent.

stETH vs. Other Staking

Compared to other staking mechanisms, Lido's mechanism has three key features: non-custodial, decentralized, and transparent.

• Non-custodial:Neither Lido nor node operators have custody of users' deposits. This feature mitigates counterparty risk - node operators never have custody of users' staked ETH.

• Decentralized:No single organization validates the protocol - technical risk is evenly distributed across a set of node operators, improving resilience, uptime, and returns.

• Open Source:Anyone can review, audit, and/or suggest improvements to the code that runs the protocol.

When comparing stETH to other LST and staking providers, the difference in rewards between the top node operators is small, ranging between 3.3-3.5% by total stake, according to Rated. However, small differences in rewards contain large risks when considering the factors that go into operating a node (including devops, cloud infrastructure, hardware, maintaining code, client types, geographic distribution, etc.).

stETH is less risky because it ensures exposure to a diverse set of operators running different machines, code, and clients in different locations across many teams. As a result, the likelihood of downtime is lower and risk is dispersed by default; other staking providers have more centralized operations and more potential central points of failure. For more information on this area, Blockworks Research analyst 0xpibblez wrote an in-depth research report.

The probability of stETH receiving excess rewards

Referring to the first graph below, we can observe that the execution layer rewards (priority fee + baseline MEV) are more variable than the consensus layer rewards (issuance). The second graph below shows a zoomed-in view of this variation over the past month. This is due to the cyclical nature of on-chain activity, whereby in certain periods, increased activity levels coincide with more valuable blocks, and thus higher execution layer rewards, whereas consensus layer rewards are constant. This means that realized staked ETH rewards are a function of the probability that a validator will propose the next block, capturing the variation in execution layer rewards.

Because stETH is staked in the hands of many different operators, accounting for 29% of the total staked ETH, stETH has a much higher probability of capturing changes in block rewards than a single validator, a smaller operator, or a validator set with less stake. This means that it continues to generate higher returns on average.

In other words, at one extreme, when a single validator proposes a very valuable block, even if the total reward is much higher (e.g., earning 10 ETH in a block by staking 32 ETH), the chance of this happening is very low, about 1 in a million (32/32,400,000). They will basically win the lottery. At the other extreme, Lido's validator set is more likely to capture valuable blocks about 29% of the time. Therefore, by holding stETH, users can choose and increase their chances of sharing more rewards.

In summary, another reason why stETH is a better choice for earning rewards for staking ETH is that it produces extremely competitive rewards on a probability and risk-adjusted basis.

Lido Governance: stETH's growing importance to decentralization

The approval of the spot ETH ETF has brought expectations for more products - most notably staking ETH products. During the bull cycle break, crypto native legend DegenSpartan wrote an article titled "How many Trojan horses can we launch? ". In this short blog post, DegenSpartan wrote: "After spot ETFs, there is still more access to be expected on the [TradFi] side. Options, Funds of Funds, Mutual Funds, Retirement Accounts, DCA Plans, Structured Products, Dual Currencies, Lombard Loans, etc."

While US capital markets will have more access to ETH, bringing more permanent (structural) tailwinds, it is unclear how TradFi will integrate other digital assets or derivatives, and what side effects they may have on decentralization.

tradfiETH vs stETH

Philosophically, we believe that LST is the best way to maintain a sufficiently decentralized, secure, and well-performing validator set. Grandjean et al calculated Ethereum's HHI (a metric used to assess market concentration and competition) and found that Lido has improved decentralization (lower HHI readings as shown in the figure below).

While treating Lido as a single entity results in a higher HHI (i.e., a lower degree of network decentralization), we do not believe that this description of Lido accurately reflects Lido's presence in the market, as the protocol is not managed or controlled by a single organization or entity, and the validator set is composed of a variety of different independent entities. While large LSPs are risky, implementing appropriate governance mechanisms and protocol oversight (e.g., dual governance) should reduce the severity of the risk. In addition, the inclusion of DVT is expected to further decentralize the operator set.

That being said, given the economic incentives to stake ETH (or the dilution of holding native ETH), it makes sense for TradFi to eventually launch a staking ETH product. Here are some possible (pure) hypothetical outcomes: (1) TradFi explicitly adopts stETH and all its benefits; (2) TradFi works closely with Coinbase or other large institutional staking providers to build this framework, in which case cbETH or tradfiETH becomes TradFi’s canonical staking ETH product; or (3) TradFi develops its own practices, invests in proprietary node operations, hosts its own staking ETH, and issues tradfiETH products.

“While this is great for BTC [and ETH], where it goes next is uncharted territory.” — DegenSpartan

We believe, and have evidence to suggest, that hypothesis (1) is the better solution for the network, because in either case, if staked ETH gravitates toward tradfiETH, the chain is at risk of staking centralization. Therefore, in a state where well-capitalized incumbents develop centralized staking products, as long as Lido remains sufficiently decentralized, stETH and the DAO are important components of maintaining the consistency of Ethereum, and more broadly, because the DAO manages the delegation of stETH and, in turn, has a significant impact on the performance, security, and decentralization of the network.

Risks

• Volatility and Liquidity:When ETH volatility spikes, investors will be more willing to sell stETH on the open market rather than wait in a withdrawal queue. In the absence of liquidity, periods of high volatility coinciding with high selling volume could cause the price of stETH to deviate from its 1:1 ETH price peg, which would pose follow-on risks until market conditions recover.

• Circulation Risk:A popular method of earning rewards (such as farming for airdrops or liquidity mining incentives) is for users to take a leveraged position, lend stETH, borrow ETH, buy stETH, lend additional stETH, and repeat the cycle until they fully leverage to capacity. In times of volatility, circulators are at risk of being liquidated, which can give rise to amplified risks associated with volatility and liquidity.

• Protocol and Governance:There are risks associated with LSPs taking a large market share. The protocol to which stETH is delegated is governed by a DAO. While the DAO is taking steps to achieve dual governance, which would mitigate these risks, if stETH accounts for a majority of staked ETH, then there is reason to worry about the concentration of ETH stake into LDO governance.

• Smart Contracts:The Lido protocol is executed by a set of smart contracts. This includes deposits, withdrawals, delegated staking, slashing, and key management. There are unforeseen bugs or malicious upgrades associated with smart contracts in these systems.

• Competitors:The LST market is large, and other re-hypothecation protocols are entering the space. TradFi has also been able to develop its own staking products, which may be more accessible to some investors given the current market structure.

• Regulation:While spot ETH ETF approval may make the average security for staking providers higher, staking ETH will still be subject to regulatory scrutiny. Public legal discussions include (but are not limited to) the role of staking providers, the distinction between "management" and "administration" (under the Howey test), and whether LSPs are "issuers" (the Reve test).

Summary

By today's standards, stETH is arguably the best product for gaining exposure to staked ETH. It is the most liquid LST on-chain; it is the most widely used form of collateral in DeFi; and these market structures are rapidly expanding off-chain, as evidenced by the growing volume on CEXs (most notably ByBit and OKX). While there are risks to holding stETH, these strong market structures are likely to continue and may even proliferate given the properties of stETH, Lido's protocol, the growing need to align with Ethereum, and upcoming catalysts. These catalysts on the roadmap include distributed validator technology (DVT), dual governance, support for pre-confirmation and allocation of additional resources for re-staking stETH, and an improved governance structure to facilitate Ethereum research. More importantly, if TradFi develops a staking ETH product, stETH and Lido DAO will play an increasingly important role in Ethereum.