Generating yield with liquid staking derivatives

As a liquidity management solution, Everbloom aims to provide an automated and optimised software framework that is able to capture sustainable yield on blue chip digital assets. We use Ethereum as our core infrastructure layer. As the most developed and mature Decentralized Finance ecosystem, Ethereum has the deepest liquidity, widest diversity of DeFi protocols and a native yield-generating process in the form of ETH 2.0 Proof-of-Stake Staking. 

What is ETH 2.0 Proof-of-Stake Staking?

In September 2022, the Ethereum blockchain switched from Proof-of-Work to Proof-of-Stake as a consensus model. In Proof-of-Work, specialised hardware operators (miners) run a software client that solves small mathematical puzzles in an attempt to find a valid solution which results in the appending of a new block to the blockchain. The miner is rewarded with new tokens as an incentive to participate honestly in this lottery. Proof-of-Work is very secure, especially once a certain size of computing power is reached. But it also has some significant drawbacks, most notably the fact that the process is very energy-intensive. For a system like Bitcoin, in which decentralisation, censorship-resilience, stability and security are of primal importance and where compromises can not be made, Proof-of-Work is most likely by far the best choice for its consensus algorithm. For Ethereum, which has different objectives than Bitcoin and which needs a more flexible consensus model if it wants to implement its scaling roadmap, the choice was made many years ago to switch to Proof-of-Stake. That change came into effect last September.

Proof-of-Stake is fundamentally different from Proof-of-Work as it doesn’t require computationally expensive calculations to participate. Instead of energy expenditure, Proof-of-Stake uses ETH token deposits as input for its process. Creating blocks is done by an ETH 2.0 Validator, which is a general purpose hardware system running validator software that requires a certain number of ETH to be pledged. The ETH locked up in the Validator is called the ‘Stake’. If the validator contributes to network operation in a constructive and positive way, he is rewarded with fees and block rewards not unlike what is given as an incentive in a Proof-of-Work model. But if the validator submits invalid blocks that are not compliant with the network rules or is not sufficiently available because of downtime, then the  ‘Stake’ can be ‘slashed’, resulting in a loss of ETH placed within the validator. Similarly to Proof-of-Work, positive contribution to a healthy network is encouraged and rewarded while undesirable behaviour is punished. Proof-of-Stake doesn’t require large amounts of energy but its security properties are less studied, tested and understood. While the jury is not completely out on which consensus model is the best, both can work and have different effects on the network they attempt to secure.

Another advantage of Proof-of-Stake as its being used right now in the Ethereum network is that it democratises block production. While Proof-of-Work has some centralising forces for miners, like economies of scale and geographical differences in energy prices, Proof-of-Stake enables the common user to participate in network security. This is partly theoretical, as in practice running a validator is non-trivial. The Ethereum blockchain size is multiple terabytes in size which needs to be stored on the hard drive of the validator. There is also quite a bit of network traffic and network latency needs to be low enough, so an expensive internet connection is required. Since slashing can occur if the system does not have sufficient uptime, monitoring the uptime of validators and intervening in case of hardware failures is needed.

Because of the complexities of running a validator and the severe penalties when it is done inadequately, professional entities are offering these services in the market in a very special manner.

Liquid Staking Derivatives

While the ETH 2.0 was being rolled out, a certain trend in DeFi was gaining traction: tokenisation. The idea is that blockchain-based tokens represent the state of capital and can be used in a composable way across DeFi applications. The companies offering professional validator services used this breakthrough in tokenisation technology to create a liquid staking derivative of the outside Ethereum that they were offering to manage. For every ETH that is sent to a staking provider, the provider issues a tokenised derivative to the sender. This tokenised derivative (LSD) represents ETH staked with the staking provider. ETH 2.0 is still being rolled out completely and currently there is no way to withdraw ETH placed in validators. When this upgrade is implemented, tokenised derivatives will be interchangeable again for ETH from suspending validators. In the meanwhile, there is a supply and demand driven market based on liquidity pools that support swapping back and forth between the staking derivative and real ETH. Owning the staking derivative gives the holder the rights to the majority of the staking rewards from that validator with a small fee going to the staking provider. It also allows participating in ETH 2.0 on a smaller scale as running a manual validator requires increments of 32 ETH. LSD’s allow multiple smaller entities to combine their ETH to participate by weight in staking process. The growth of LSD’s and staking providers has accelerated throughout 2022. There is now increased diversity in tokenised staking derivatives and their liquidity and price stability are improving. They are being integrated across DeFi protocols which make owning them more efficient and profitable. We will show the efficiency benefits of LSD’s in the next chapter as we explain how Everbloom capitalises on their properties.

Everbloom and LSD’s

Thanks to deepened liquidity and price stability compared to its underlying staked token, ETH in this case, LSD’s are becoming a replacement for native ETH. With the added benefit of being yield-bearing, LSD’s are a pristine form of collateral. Money markets such as Aave and Euler allow users to deposit yield-bearing LSD’s as collateral for borrowing. Since the collateral increases in value over time and its value is closely correlated to potential borrowing assets, this introduces plenty of opportunity for ingenious strategies.

Our flagship Ethereum strategy takes ETH deposits and swaps them to a yield-bearing LSD. It then deposits that LSD to a money market and borrows ETH against it. That ETH is again swapped for the LSD and deposited again. This has further increased our borrowing power which allows us to repeat the process. The result is a leveraged position with a low risk-profile since the collateral and debt are correlated assets. This allows for more aggressive borrowing. Besides the usual smart contract risk that is always present when using DeFi protocols, the main risk comes from the peg stability of the LSD. In order to make LSD’s liquid, the issuing protocol has to incentivise a liquidity pool that allows for low slippage token swaps between the LSD and its underlying token. If that pool becomes unbalanced by having too much of the LSD token in it, then the mechanism to swap between LSD and underlying token breaks down and becomes inefficient. The price of the LSD can then trade several percentage points below the price of the underlying token. Especially in scenario’s with high volatility, when market participants need liquidity at all costs, this has proven to be a challenge. When the value of the LSD decreases slightly, the value of our collateral would also decrease, potentially resulting in our position being unhealthy. This means its at risk of partial liquidation by an external liquidator. Getting liquidated used to be quite costly with penalties of 5 to 10 percent of the collateral but recent innovations like reverse Dutch auctions make a liquidation event not as harmful. Either way, it should be avoided by constantly monitoring the price of the LSD against the underlying token and reacting if a sudden change takes place. Thanks to monitoring and proper risk management, we can leverage the LSD for maximum efficiency and enjoy a yield on the underlying token that is double or triple the normal LSD staking yield.

The future of staking and LSD’s

Here we speculate on what the next year might hold for LSD’s and staking. At the time of writing, January 2023, we have just seen an explosive boom in demand for LSD’s. Besides the market leader Lido, we have seen Frax, Rocketpool and also Coinbase gain traction and market-share, decentralising and bringing competition to the DeFi vertical of LSD’s. We’ve seen deepening liquidity and an increased confidence in the price stability of these LSD’s. This has led to more adoption across DeFi protocols, with money markets at the forefront as the LSD is a great form of collateral. I suspect we see these trends continue with more exotic and innovative usage of LSD’s undoubtedly to follow.

A big change for ETH 2.0 staking is coming in the form of the Shanghai hard fork. The main purpose of this software upgrade to the Ethereum network is to enable withdrawals from validators. Up until now, you could only deposit ETH to validators but you could not withdraw your deposited ETH or any of your accumulated rewards. While a definitive date has not been set, the update is expected to arrive in March or April. An event like this always introduces some form of uncertainty in the market and we could see reactions in the price of ETH. After all, it is expected that significant numbers of ETH will become liquid again, which could lead to a sell-off. But markets are often forward-looking and since this is a well-known and anticipated event, the unlocking could be priced in already. One could argue that if Shanghai goes well, LSD’s will trade almost at 1 to 1 with ETH as the withdrawal process allows for arbitrage opportunities in case LSD’s trade at a discount. We should see LSD prices trade closer to ETH as we approach the Shanghai upgrade. This final step in the ETH PoS switch could lead to higher adoption of 2.0 staking. Currently, approximately 15% of all ETH is staked in validators and while this is a healthy chunk, there is much room for growth. When it is actually possible to withdraw, large players could feel a lot more comfortable dedicating ETH to 2.0 staking. This means higher demand for ETH as an increasing share is locked in validators. Since validator yield depends on usage of the Ethereum network as they earn fees from transactions, if that usage remains the same but more ETH is locked in validators, that could lead to a decrease of yield. At some point, a balance will be found, but it might not be as high as current yields we are seeing. All of this is speculation of course, but it should be clear that Shanghai is a significant event for ETH and LSD’s.

As usual, Everbloom is on top of any developments and is closely monitoring for risks and opportunities in the ever-evolving landscape of DeFi.