Key Insights:
- Ethereum staking provides the best risk-free interest rate on the internet. And the DeFi sector growing around it is called LSDfi.
- LSDfi protocols can be divided into five major categories: DEXes, Lending markets, Stablecoins, Index LSDs, and Yield Strategies
- There are two major tailwinds for LSDfi narrative: massive growth of Ethereum staking, and the low penetration of LSDfi.
- Here are common risks facing LSDfi protocols: slashing risks, LSD price risks, smart contract risks, third-party risks, and regulatory risks.
The Internet now has a risk-free yield: Ethereum staking.
So, you know how TradFi has US Treasury Bills at its center? Well, DeFi has its own version of T-bills: Ethereum staking. It is now being integrated into DeFi in front of our eyes.
Essentially, people are getting ~5% APY in the most trusted protocol in the space. And an entire sector being built on Ethereum’s liquid staking tokens and their possibilities.
We’ll briefly go into what it is, the major categories, and some risks with it.
What are LSDs?
In short, Liquid Staking Derivatives or Tokens (LSDs or LSTs) are tokenized representations of staked assets. The LSDfi narrative is fueled by staked Ethereum.
Now, what’s the big deal about Ethereum staking? It’s like the hottest yield source on the internet right now. If you stake Ethereum by yourself (solo staking), you’ll get around a 5.77% return per year.
And it’s almost risk-free. (Many institutions will love these >4.5% guaranteed return.)
Where does this yield come from?
All blockchains need a consensus mechanism to protect their integrity. Ethereum is secured by Proof-of-stake (PoS). In this system, validators secure Ethereum by staking ETH and validating transactions. In return, they’ll get newly issued $ETH as reward..
All of this sounds good. But there are three problems with solo Ethereum staking.
- Technical difficulty. Many people find it technically challenging to stake.
- No liquidity. Once you stake, your ETH will be locked up. It will be unproductive.
- High barrier to entry. You need 32 ETH for solo staking, which is a lot of money.
Liquid Staking Derivatives (LSDs) are the solution to these problems.
They are super easy to use. You deposit ETH with a protocol, and they give you an “IOU” version in return, like stETH. You can then use this stETH to play around in DeFi while earning staked returns.
There are many LSD protocols: Lido, Coinbase, RocketPool, and Frax are the leading ones.
Source: DeFiLlama
Different LSDs (LSTs) provide different rates of return. Here’s a list of returns from leading protocols.
- Lido – 3.90%
- Coinbase cbETH – 3.23%
- RocketPool – 3.30%
- Frax Finance – 5.23%
Each of these protocols also has its differentiators.
- Lido – Most lindy LSD. It has the first-mover advantage.
- cbETH from Coinbase – The best LSD for retail users and institutions
- RocketPool – The most decentralized LSD protocol
- Frax Finance – LSD protocol with the highest yield
What is LSDfi?
We now understand what LSDs are. These LSDs are further used in DeFi. For example, they can be used to get additional yield. LSDfi protocols are those that provide further utilities for LSDs.
Technically, existing protocols that integrate LSDs are also part of LSDfi.
- OG stablecoins like $DAI can be minted with LSDs.
- DEXes like Curve are facilitating exchanges for them.
- Money markets like Aave are accepting LSDs as collateral.
These old protocols – well, they’re not exactly the most exciting thing out there. And many degens don’t include them under LSDfi. However, they are an important part of the sector.
I’ve classified LSDfi protocols into five different categories.
#1 DEXes
DEXes are protocols that allow users to exchange one token for another.
They are important for the LSDfi sector as a form of exit liquidity. If you want to withdraw staked Ethereum, you have to wait in a withdrawal queue. So protocols won’t always be able to immediately convert their LSTs into ETH.
Instead, protocols will create liquidity pools consisting of their LSD and ETH. Users will be able to immediately exit their positions using these pools. Hence, LSDfi needs DEXes to facilitate the immediate exchange of staked tokens for native Ether.
Curve, Balancer, Uniswap, and Maverick are the leading DEXes. Below is a bar graph showing the volume handled by each DEX in 2023.
Below is an Area chart showing the percentage of volume handled by each DEX in 2023.
Takeaway from these charts:
- Curve is where most of the LSD volume is handled.
- Uniswap is a close second that attracts significant volume.
- Maverick Protocol, a newcomer, did manage to attract some volume, but it is dying down.
When evaluating DEXes, volume isn’t the only metric you should pay attention to. Capital efficiency is another important metric. It refers to the effectiveness of DEXes in using the capital deposited by Liquidity Providers.
Why does capital efficiency matter? It means Liquidity providers will get more profits. And there’ll be better liquidity for users as well. The following chart shows the capital efficiency of the four major DEXes.
Key takeaway: Maverick and Uniswap are much more capital efficient than Balancer and Curve.
#2 Lending Markets
LSDs are taking over the role of ETH in the previous ecosystem. Their percentage share of total deposits is increasing day-by-day.
Aave is the leading lending protocol. Let us focus on Aave to illustrate this point. The following graph shows the percentage share of each token in the total deposits on Aave.
Key point: 33.21% of total deposits on Aave are LSDs. This percentage will only increase as LSD penetration increases.
Compound, Morpho, Silo, & FraxLend are a few other important lending protocols.
We will see similar trends in other protocols as well.
#3 Stablecoins
Stablecoin is probably the most successful application of crypto. They are everywhere.
The most successful crypto-backed stablecoin model is the Collateral Debt Position (CDP) stablecoin. CDP stablecoins are created by depositing crypto as collateral and minting stablecoins.
The entry of LSDs meant that stablecoins could be minted using LSDs as collateral. And that’s what happened.
The following table compares different LSD-backed stablecoins.
The key takeaway is that the OG stablecoin MakerDAO is still the market leader. Most of the LSD-backed stablecoins are $DAI, Maker’s stablecoin.
However, that doesn’t mean there aren’t any innovations.
eUSD from Lybra Finance is a notable innovation.
It is an interest-bearing stablecoin. You can hold eUSD in your wallet, and interest will be paid directly to your wallet. They claim they can give up to 8% APY.
How do they do it?
- eUSD is created by depositing ETH.
- This ETH is instantly converted to stETH.
- The interest is paid out by selling stETH rewards.
This crypto-native interest-bearing stablecoin was only possible because of Liquid Staking Tokens. And for the average DeFi user, this stablecoin is superior to other established alternatives. Others don’t give them money to hold it.
Numbers tell the same story. The protocol was launched in April only. But it already has around $158.17 million in TVL. It is the largest among the new LSDfi protocols.
$R from Raft is another example. It has two unique features.
- Flash mint. You can create $R without any collateral and have to pay it back in the same transaction.
- One-step leverage. Get up to 6x leverage on your staking rewards.
This is a highly competitive sector. There are many more stablecoins like crvUSD from Curve and GHO from Aave.
#4 Index LSDs
Some protocols issue tokens representing a basket of LSDs. For example,
- $dsETH from Index Coop represents three LSDs: rETH, stETH, & sETH2.
- $yETH from Yearn Finance represents a basket of tokens that include rETH, wstETH, & sfrxETH.
Why do we need such tokens? Here are some reasons.
- Spread your risks
- Boosted yields (sometimes)
- Exposure to a basket of LSDs.
Depending on the design of the Index protocol, they can incentivize liquid staking protocols to be more efficient and decentralized. The Index Coop claims to do so.
Essentially, all these protocols are selling their own synthetic-Ether in return for Liquid Staking Tokens from other LSD protocols. Index protocols; control over these underlying Liquid Staking Tokens gives them several ways to innovate.
unshETH is an example of an innovative Index LSD.
Since they already have a bunch of LSDs, they also created a swap market for LSDs. Its users will be able to swap between different LSDs. This gives them an additional revenue source: swap fees.
unshETH Real Yield APR = ETH Staking APR + Swap Fee APR + Mint/Redeem Fee APR
#5 Yield Strategies
This category includes all protocols which make use of yield from staked Ether.
It is a very diverse category of protocols. There are many different ways to generate yield using LSDs. Most of the innovative protocols you see on Crypto Twitter will fall under this category.
Here’s an example.
Pendle is a DeFi protocol for trading yields.
Using SY (Standardized Yield tokens), they can split any yield-bearing asset into two tokens: the Principal token (PT) and the Yield token (YT).
And guess what? You can trade those PT & YT tokens. This unlocks advanced yield strategies, such as:
- Earn fixed yield on stETH.
- bet on stETH yield going up by purchasing more yield.
- Provide liquidity with your stETH for additional yield.
- Any mix of the above strategies.
They are essentially building the interest derivative market for DeFi. In TradFi, the interest derivative market is worth over $400 trillion.
With their vePENDLE system, they also have a killer tokenomics model.
They have been growing at lightning speed. At the beginning of the year, their TVL was only 16.883 million. But as of July 25th, their TVL is around 180.17 million.
Flashstake gives users instant upfront yield.
Assume John has $10,000 that earns $1 in interest per day. Using Flashstake, he can redeem $365 today. He just has to lock up the $10,000 for 365 days.
He will also be able to withdraw his $10,000 early by paying back a decreasing percentage of his $365.
However, Flashstake wasn’t able to attract the same level of success Pendle managed to do. On July 25th, it only had $6.48 in Total Value Locked.
The Restaking Protocol: EigenLayer
The above five categories don’t necessarily exhaust all the possible LSDfi protocols. EigenLayer is an example. It is a protocol for restaking.
Restaking is a simple concept. You take the staked ETH, and stake it again on a new protocol. You’ll get additional yields as a reward.
EigenLayer acts as a market between protocols and restakers. Protocols need trustless actors to fulfill specific conditions. And restakers will provide that for yield.
If everything goes well, users will get additional yield from protocols. But if users fail to meet the conditions set while restaking, they’ll lose their staked ETH.
This is an excellent example of an LSDfi protocol. It creates additional yield opportunities for Liquid staking tokens. (EigenLayer can function without LSDs as well.)
Oh, and there’s no token for it yet, but it’s already launched on the mainnet with some safety measures.
Does this mean we should start accumulating them? A recent Binance report gave a future outlook for the sector. It showed both positive trends and risks. Let’s get into that.
Why I’m Bullish on LSDfi
Tailwind #1: Growth of Staked ETH.
As of July 25th, only 17.99% of the available ETH was being staked. Let’s compare this to other decentralized PoS chains.
- Cardano : 63.04%
- Solana : 61.34%
- Avalanche : 61.34%
- Cosmos : 72.47%
So, we can expect Ethereum staking to keep growing. And it is already happening. Ethereum has a validator queue. And right now, to be a new validator, you have to wait more than 34 days.
Ethereum staking is the foundation of LSDfi protocols. And as it grows, we can expect the LSDfi sector to grow.
Tailwind #2: Low penetration of LSDfi.
The total market cap of all LSDs combined is around $18.55 billion. However, the combined TVL of the top new LSDfi protocols is only around $461.48 million. This means that only a small percentage of LSDs are further used in DeFi.
This is cuz this sector is in its infancy. As this sector matures, people will want more yield on their LSDs. And as a result, LSDfi protocols will obviously grow more.
However, all this hopium shouldn’t tempt you into blindly aping.
The Risks of LSDfi
Not all of the new LSDfi protocols are worth investing in. There could be project-specific risks, such as shady teams or leaky tokenomics.
And there are many risks associated with liquid staking in general.
#1 Slashing risks: Validators will get slashed if they fail to meet some conditions. Holders of LSDs are indirectly exposed to these risks.
#2 LSD price risks: Market forces can cause the LSD price to fluctuate. If LSDs were used as collateral, this volatility could cause liquidation.
#3 Smart contract risks: The protocol’s code might have vulnerabilities. Users have to take that into account.
#4 Third-party risks: Users are exposed to additional risks if a protocol builds on top of other protocols. Other protocols can get hacked or rug pulled.
#5 Regulatory risks. I mean, your government can always ban your stETH or declare it as a security. Stay informed about the regulatory landscape.
Is LSDfi Summer here?
In short, yes. There are strong structural forces in favor of LSDfi summer. Crypto is always hungry for more yield, and there is strong growth in Ethereum staking.
But don’t let the narrative confuse you. This isn’t just another narrative. This is the birth of a new ecosystem, and we’re just scratching the tip of the iceberg.
So buckle up and get ready for the ride, cuz things are about to get wild in the world of LSDfi!
Additional Resources:
- Twitter list of LSDfi protocols.
- Notion Dashboard of LSDfi protocols.
- Binance LSDfi report (June).
- Binance LSDfi Data report (July).
