Ethereum Staking from a Lido Perspective Exploring Lido’s Dominance

Unveiling the Dominance of Lido in Ethereum Staking Insights from Lido's Perspective

Author: Tanay Ved, Author’s Blog; Translation: Song Xue, LianGuai

1. Introduction

The evolution of the Ethereum network towards the Proof-of-Stake (PoS) blockchain has brought significant changes to its main participants and underlying economic system. This transformative shift is often referred to as “changing the wheels of an airplane in flight” and has now positioned staking as the cornerstone of Ethereum consensus. The successful completion of “The Merge” and the subsequent “Shapella” upgrade have led to the rise of Stake in the entire industry. With approximately $40 billion in assets and a growing ecosystem of stakeholders, it is crucial to understand the current composition of this landscape and delve deep into the key players that have a significant impact on the industry.

We have conducted an in-depth study of Lido (the largest participant in the staking economy) and explored its state consisting of liquid staking tokens (stETH), governance tokens (LDO), and underlying node operators. Through this analysis, we attempt to address Lido’s prominent position in the field of liquid staking, which has become a topic of increasing controversy within the Ethereum community.

2. Ethereum Staking Status

However, before delving into Lido and stETH (ETH staking), it would be helpful to understand the current state of Ethereum staking, especially in the context of macroeconomic backdrop of monetary tightening and rising interest rates.

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ETH Staked vs Yearly APR (%); Data Source: Coin Metrics Formula Generator

As of October, approximately 27.9 million ETH (23% of the current supply) or $40 billion worth has been staked on the Beacon Chain, highlighting the rapid growth of staking since the Shapella hard fork. However, the current acceleration seems to have slowed down, as indicated by the clearing of the validator entry queue. This slowdown can also be attributed to the Ethereum staking yearly APR dropping from over 5.5% during the merger period to 3.5% in October due to the influx of a significant number of validators into the network and lower transaction fees. In comparison, the current yield on US 10-year Treasury bonds is 4.67%, introducing a substantial opportunity cost as safer and higher yield opportunities emerge. However, changes in these conditions could lead to a shift in this outlook and make on-chain yields attractive again.

3. Exploring Lido’s Dominance

Lido plays a crucial role in the staking economy, facilitating the democratization of staking. The core of this protocol is to bring together capital providers (i.e., ETH stakers/delegators) and infrastructure providers (i.e., node operators), allowing users to deposit any amount of ETH instead of the required 32 ETH to become a validator. When users deposit ETH into Lido’s smart contract, the funds are pooled and outsourced to a select group of node operators running the necessary software and hardware. As a result, delegators receive “stETH” – fungible claim on ETH deposits minted in a 1:1 ratio.

Among the 27.6 million ETH pledged, Lido has pledged 8.9 million ETH, with a total locked value of $16.8 billion, making it the largest liquidity staking and decentralized finance (DeFi) protocol. In percentage terms, this is equivalent to about 32% of all staked ETH – a metric that has been closely watched as Lido’s market share hovers around a third of all staked ETH, causing concerns about centralization to resurface.

Source: Coin Metrics Network Data

These concerns stem from the idea that if a liquidity staking protocol or its underlying node operators exceed a critical threshold of total staked ETH, it could increase the likelihood of adverse outcomes for the Ethereum network due to increased centralization. This could include censorship, maximization of extractable value (MEV) coordination or unfair slashing (penalties), and other forms of manipulation, such as time-bandit attacks motivated by personal gain. However, it is worth noting that Lido is not operated as a single entity. Instead, it is composed of 38 node operators, subject to a maximum stake threshold, with servers distributed geographically to maintain a decentralized governance of the validator set.

Stake distribution of Lido node operators; Source: mevboost.pics

It can be said that the (potential) risks brought by the governance process supervised by the Lido DAO (decentralized autonomous organization) outweigh the share of ETH it has staked. We will explore the role of governance in the subsequent sections below.

The debate over Lido’s dominance has recently intensified, with supporters arguing that Lido enhances the accessibility of staking while attributing its success to free-market dynamics and the strong network effect of stETH. On the other hand, its skeptics are concerned about the potential for centralization as its influence grows and urge Lido to self-restrain its growth while also exploring alternative solutions, such as directly embedding staking into the Ethereum network itself. Although the reality of this situation is more nuanced and may fall somewhere in between, it is clear that the balance between accessibility and decentralization is crucial for maintaining Ethereum’s core principles and long-term health.

4. The Network Effect of stETH

Lido’s first-mover advantage, coupled with the native yield introduced through its liquid staking token, stETH, has brought significant network effects to the protocol. These characteristics have led to winner-takes-all dynamics, forming an oligopolistic market structure around liquid staking. stETH is one of the most critical components of the Lido ecosystem, allowing users/stakers to “delegate” their Ether to secure the network (participate in consensus) in exchange for tokenized ownership of their underlying stake (derivatives). This token not only presents native yield but also unlocks additional utility as it can be traded, swapped, borrowed, or used for liquidity purposes while earning staking rewards – a key value proposition of liquidity staking.

stETH as collateral – Deposit share (%) on Aave v2; Source: DeFi balance sheet

stETH and its wrapped version (wstETH) have become the largest collateralized lending form on multiple decentralized finance (DeFi) platforms and their iterations (including Aave, Maker, and Compound). As shown in the above chart, stETH makes up 33% of the total deposit share on Aave v2, and this proportion has been growing rapidly since the platform’s launch. Meanwhile, the share of WETH has dropped from a high of 39% to the current 21%. This growth has been driven by the yield and capital efficiency of stETH, which brings about the opportunity cost compared to holding or using regular ETH.

These features have also given rise to a range of emerging products that utilize stETH as the underlying collateral base for overcollateralized or synth stablecoins. These products complement other offerings such as sDai, sFrax, and USDM, bringing yields from public securities such as US Treasuries onto the chain.

stETH on decentralized and centralized exchanges; Source: Coin Metrics market data and Coin Metrics Labs

stETH is also quoted on secondary markets such as decentralized and centralized exchanges, allowing users to access the token and its staking rewards. Additionally, automated market-makers (AMMs) like Curve Finance and Uniswap provide substantial liquidity, facilitating the trading of the asset. As mentioned above, stETH has historically benefited from its significant presence on Curve, with monthly trading volumes reaching nearly $3.5 billion in May 2022. However, this situation seems to be weakening as Uniswap captures more liquidity and trading volume. In contrast, liquidity on centralized exchanges is generally lower, but platforms like OKX and Huobi seem to be experiencing an increase.

5. stETH Token – Rebase Mechanism

The stETH token follows a “Rebase” mechanism. This has critical implications for Lido users and applications that work with the stETH token. Essentially, the design of Rebase tokens like stETH ensures that the token’s supply or the ETH balance staked by users increases proportionally to the underlying asset. In this case, when users provide ETH (the underlying asset) to Lido, stETH (the derived asset) increases synchronously with the earned staking rewards. As a result, users can see changes reflected in their staking balances without the need for any additional transactions.

Rebase function:

balanceOf(account) = shares[account] * totalPooledEther / totalShares

The stETH Rebase function can be visualized at a higher level, as shown below. For example, we can consider three hypothetical accounts with initial staked amounts of 50, 30, and 20 ETH, respectively. The oracle reports daily statistical data on the total amount of Ethereum pooled among validators from the beacon chain. The total Ethereum and the cumulative increase or decrease in accrued rewards (in case of validators being slashed) are reflected in the users’ account balances at the end of each daily adjustment, similar to the balance increases in traditional savings accounts.

stTEH Account Balance – Rebasing Token Network

Although this brings a user-friendly experience, it means that applications that do not support Rebasing tokens need to load non-Rebasing versions for compatibility. This has led to the launch of the packaged staked ETH token (wstETH), which is applicable to various protocols such as Maker, Aave v3, Compound v3, and Uniswap V3.

Six, Lido DAO Governance and LDO Token

As mentioned earlier, governance is a major part of the Lido protocol. Lido DAO is managed by LDO token holders and has “root” access to certain critical aspects of the protocol. This includes upgrading smart contracts, managing nodes and oracle operator registries, related withdrawal keys, and supervising the Lido treasury. These privileges and the high centralization of LDO token holders have raised concerns about Lido’s governance layer as a potential attack vector. Therefore, proposals for dual governance have been introduced to allow stETH holders to veto decisions made by LDO holders with the aim of creating a balance in the current power dynamics.

LDO Token Holder Concentration – HHI; Source: Coin Metrics ATLAS and address labeling

The graph shows the Herfindahl Hirschman Index (HHI) of LDO token holders. HHI measures the concentration of market participants in an industry, in this case, the concentration of accounts holding LDO tokens. HHI around 0 indicates even distribution, while an HHI value close to 1 indicates extreme concentration, with a few holders controlling a disproportionate supply. It is clear that concentration has significantly changed due to the daily fluctuations in the holder base. The peak above 1 in HHI seems to be temporary due to the initial token allocation in December 2020 and the sharp drop in LDO price, leading to increased concentration. However, in the long term, the concentration of LDO token holders appears to be declining (indicated in red), from 0.6 in early 2021 to 0.3 in October 2023.

Seven, Conclusion

Lido is an important component of Ethereum and its health is closely related to the health of the Ethereum network. Therefore, the current discussions surrounding Lido and its prominent position represent a positive development for Ethereum as a Proof-of-Stake (PoS) blockchain. Although the path forward may be delicate and not so clear, it demonstrates that stakeholders on both sides of the debate have taken into account Ethereum’s best interests – aligning with its principles of accessibility and decentralization.

Network Data Insights

Key Metrics

Source: Coin Metrics Network Data Pro

The number of active Bitcoin addresses increased by 3% this week, while active Ethereum addresses decreased by 2%. On November 5th, the number of active Bitcoin addresses reached 1.14 million, the highest single-day total since September 15th.

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