Introduction: stETH > tradfiETH (ETFs)

On May 20, 2024 Eric Balchunas and James Seyffart revised their odds of the spot ETH ETF approval to 75% from 25%. ETH rallied roughly 20% within hours. However, per the SEC’s request, issuers amended S-1 registration statements, removing staking rewards from the ETFs. As a result, investors holding the spot ETH ETFs will not gain exposure to Ethereum’s staking reward, probably due to the necessary regulatory clarity for offering staked ETH products. In any case, at current rates investors who choose to gain exposure to the spot ETH ETF will leave roughly 3-4% APR from consensus and execution layer rewards on the table. Thus, in order to mitigate dilution, there is an incentive to add staking to ETF offerings.

Lido protocol is an open-source middleware that autonomously routes pooled ETH across a validator set according to delegation criteria. Lido DAO, managed by LDO holders, governs some parameters of the aforementioned delegation criteria, such as protocol fees, as well as node operator and security requirements. However, the protocol is non-custodial and the DAO cannot directly control the underlying validators. With ~29% of the network’s total stake (9.3M ETH i.e. $35.8B), stETH is a critical piece of infrastructure in the staking industry, held to high standards in performance, delegation, and other staking practices.

ETH ETFs might be the most convenient option for TradFi investors to access ETH exposure today, but these products do not capture Ethereum’s issuance or cryptoeconomic activity. As more TradFi venues onboard tokens themselves, holding Lido’s liquid staking token–stETH–is arguably the best product for gaining exposure to both ETH and Ethereum’s staking reward because of its key utilities within existing market structures: 

1. stETH is the most liquid and highly traded ETH staking asset across decentralized exchanges (DEXes).
2. stETH is the most widely adopted form of collateral in DeFi, greater than the largest stable coins, USDC, and ETH itself.  
3. stETH is the most liquid reward-bearing native L1 asset on centralized exchanges (CEXes)–growing as both an alternative for spot ETH trading and a form of collateral. 

With the advent of the ETH ETF, stETH’s dominance is likely here to stay as investors learn more about Ethereum and seek additional returns from both consensus and execution layer rewards–fruitful tailwinds for solidifying even stronger stETH market structures. Looking even further ahead, as TradFi institutions eventually add staking to their products (call them “tradfiETH”), Lido DAO governance and stETH’s growth become essential for maintaining a sufficiently decentralized validator set on Ethereum.

Therefore, “stETH > tradfiETH” because it offers better reward, unlocks more utility than adjacent products, and serves as a coordination tool against centralization.

 

Sources: FINMA, Taurus

The Lido Protocol

The Lido protocol’s middleware is a set of smart contracts that programmatically assigns ETH from users to a vetted set of Ethereum validators. This liquid staking protocol (LSP) is designed to enhance Ethereum’s native staking capabilities. It primarily serves two parties: node operators and ETH stakers, and it solves two problems: the barrier to entry for validators, and the loss of liquidity from locking ETH in order to stake it.

Even though the hardware requirements to run a validator on Ethereum are not as high as other chains, in order to contribute to consensus, a node operator is required to have increments of exactly 32 ETH staked in a validator to earn Ethereum’s rewards. Not only is raising this amount of capital non-trivial for prospective validators, but it can be highly capital inefficient to allocate ETH within the constraint of 32 ETH intervals.

To make it easier, Lido routes ETH from investors and delegates this ETH across a validator set, effectively lowering the high economic barrier. Further, Lido DAO mitigates risks of the validator set, through rigorous assessment, monitoring, and a delegation strategy 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 ETH in an account–instead, stETH is a liquid utility token that users can utilize across both CeFi and DeFi.

stETH

stETH is a liquid staking token (LST), a type of utility token, and it represents the total amount of ETH deposited into Lido combined with staking rewards (minus fees) and validator penalties. Fees include staking commissions taken from validators, the DAO, and the protocol. 

When a user deposits one ETH into 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. The stETH is a receipt that the user can redeem for their share of the amount of ETH in the pool. By holding stETH, users automatically earn Ethereum rewards via a rebasing mechanism–essentially as rewards in ETH accrue to the validator set, the protocol mints and distributes stETH according to the accounts’ share of ETH in the protocol. 

The reward from stETH is a function of ETH issuance, priority fees, and MEV rewards. ETH issuance is the reward validators earn for participating in consensus and correctly proposing blocks. Currently, the issuance rate is 917k ETH per year (and there is conversation regarding changing this monetary policy). Priority fees are paid by users to prioritize transaction inclusion. MEV rewards are an additional revenue stream for running MEV-Boost, which facilitates a market by which validators earn a portion of Ethereum’s block rewards. This portion of reward is a function of demand for Ethereum blockspace. In 2023, according to mevboost.pics, validators realized roughly 308,649 ETH through MEV-Boost ($704.3M using the ETH price from 1/1/24). Accounting for these factors, by simply holding stETH, investors have earned a variable 3-4% APR throughout 2024.

In summary, unlike the spot ETH ETF, stETH is a liquid product by which investors can own ETH the asset and earn Ethereum’s cash flows. Furthermore, stETH is also one of the most utilized assets across various contexts in DeFi. 

stETH utility

Key utilities of stETH that make it an ideal asset are liquidity and the ability to use it as collateral. Normally, staked ETH withdrawals take a number of days because the amount of time that stakers must wait to unstake their ETH depends on the size of the exit queue. This raises the potential for duration mismatches in which the value of ETH drastically shifts between the time of the withdrawal request and redemption.

A core value proposition of stETH is its liquidity. Rather than having to sit in an exit queue, stakers can simply exit their staked position by selling stETH in the market on a DEX or CEX. An astute reader would realize eliminating duration mismatch risk pushes the risk onto the secondary market’s willingness and ability to take stETH inventory. That said, given the spot ETH ETF approval in addition to stETH’s properties and trends in underlying market structures, there is greater precedent to anticipate further stETH adoption and even deeper liquidity.

stETH Liquidity

It is worth noting stETH reserves in pools across Ethereum and rollups declined throughout 2023. This is due to the DAO moderating incentives spending for onchain stETH LPs, which means LPs who were primarily farming LDO rewards have withdrawn their reserves from pools. In 2024, reserves plateaued. This shift from subsidized LPs (who are typically much more inclined to withdraw reserves when they are needed most) to real, non-subsidized stETH LPs is much healthier for stETH’s onchain liquidity profile. In spite of these market correcting forces, stETH is still one of DeFi’s most liquid assets, and sits in the top 10 in TVL on Uniswap. 

Over the same period of time, both trade volume in stETH and stETH’s utilization in these pools increased. These trends in the image below suggest: (1) LPs are much stickier and aligned, (2) markets have approached a more stable equilibrium for stETH liquidity, and (3) a growing number of participants are more comfortable trading stETH. These market structures are a much stronger and organic foundation for expansion than overspending LDO incentives on seasonal LPs. As shown in the following image, compared to other LSTs, stETH volume and liquidity is the most dominant by a wide margin. 

Liquidity is really important (ICYMI)

Liquidity is arguably the biggest determinant of risk management in financial markets. An asset’s liquidity profile greatly contributes to its risk-adjusted return, which in turn affects how attractive it is to investors. This makes stETH a superior option for investors and traders who want Ethereum rewards, made evident on a Blockworks panel with large crypto-native institutions including Hashnote, Copper, Deribit, and Cumberland. The images below show this trend toward crypto-native institutional adoption on CEXes: more crypto-native institutions and market-makers prefer to hold and trade stETH. Note: during parts of February and March, the global bid data is incomplete because exchanges changed rate limits for orderbook data.

stETH as Collateral

stETH is also the top form of collateral in DeFi–it even outranks ETH and popular stablecoins such as USDC, USDT, and DAI. The image below shows, since inception, it has gradually climbed to this position, at roughly ⅓ of the total market share. 

 

Enabling stETH as a high-quality collateral option increases its capital efficiency and may help exchanges and lending platforms generate additional volumes. In February this year, ByBit announced increasing the collateral value of stETH to 90% from 75%. Since then, stETH volume on ByBit has increased by almost 10x.

It appears stETH’s onchain market structures have reached a more stable equilibrium, which could potentially serve as a strong foundation for a gradual long term growth trend. Offchain, we can observe the kindling for more institutional adoption, as investors will prefer staked ETH exposure over regular ETH. And while we also expect other LSTs (including possibly LRTs) to gain market share, stETH’s existing market structures and dominance and first mover advantages should maintain its strong position in the market. In addition, Lido and stETH possess a number of favorable properties over other staking options. Compared to other staking mechanisms, Lido’s mechanism benefits from three key properties: it is non-custodial, decentralized, and transparent.

stETH vs the field

Compared to other staking mechanisms, Lido’s mechanism benefits from three key properties: it is non-custodial, decentralized, and transparent.

• Non-Custodial:  Neither Lido nor the node operators take custody of users’ deposits. This feature mitigates counterparty risks–node operators never have custody over users’ staked ETH. 
• Decentralized: There isn’t one single organization validating for the protocol–technical risks are evenly distributed across a group of node operators, improving resiliency, uptime, and rewards.
• Open-Source: Anyone can review, audit, and/or suggest improvements to the code running the protocol.

When comparing stETH vs other LSTs and staking providers, the difference in reward between the top node operators by total stake is marginal, ranging from 3.3-3.5% according to Rated. However, considering the factors of operating a node–which include devops, cloud infrastructure, hardware, maintaining code, client types, geographic distribution, and more–marginal differences in reward contain a lot of risk.

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. Thus, there’s a lower chance of downtime, and risks are by default more spread; whereas, other staking providers have more concentrated operations and potential central points of failure. For more information on the field, Blockworks Research analyst 0xpibblez wrote an in-depth research report.

stETH’s probability of outsized rewards

Referencing the first image below, we can observe that execution layer rewards (priority fees + baseline MEV) are more variable than consensus layer rewards (issuance). The second image below displays a zoomed in view of this variability over the last month. This is due to the cyclical nature of onchain activity i.e. there are periods in which elevated levels of activity coincide with more valuable blocks and therefore higher execution layer rewards; whereas, consensus layer rewards are constant. This implies realized staked ETH reward is a function of the probability that a validator will propose the next block, capturing the variability in execution layer rewards.

Because stETH is staked across an expansive diverse set of operators and represents 29% of total ETH staked, the probability that stETH captures the variability in block rewards is much higher than that of a solo validator, a smaller operator, or a validator set with less stake. This means it consistently generates a higher reward rate, on average.
 

In other words, at one extreme, when a solo validator proposes an extremely valuable block, even though the total return profile is much higher (for example, stake 32 ETH to make 10 ETH in one block), the chances of that happening are very low, at about one in 1 million (32/32,400,000). They’d basically win a lottery. At the other extreme, Lido’s validator set is much more likely to capture valuable blocks, at about 29% of the time. Therefore, by holding stETH, users are opting into and also strengthening the chances of sharing more rewards, in aggregate.

In sum, another reason that stETH is a superior option for gaining exposure to staked ETH reward is it generates an extremely competitive reward on both a probability and risk-adjusted basis.

Lido Governance: stETH’s Growing Importance for Decentralization

The spot ETH ETF approval brings expectations of additional products–the first most obvious one being a staked ETH product. During his bull cycle hiatus, crypto-native legend DegenSpartan wrote a note called HOW MANY TROJAN HORSES CAN WE LAUNCH? In this short blog post, DegenSpartan writes, “After spot ETFs, there are still more gains in access on the [TradFi] side that can be expected. Options, inclusion into funds of funds, mutual funds, retirement accounts, DCA plans, structured products, dual currency, lombard loans, etc etc.”

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

tradfiETH vs stETH

Philosophically, we believe LSTs are the best way to maintain a sufficiently decentralized, secure, and performant validator set. Grandjean et al calculated Ethereum’s HHI–a measurement for assessing the concentration and competition in a marketplace–and found Lido already improves decentralization (as seen in the lower HHI reading in the image below).

While considering Lido as one entity leads to higher HHI (i.e. the network is less decentralized), we do not believe this characterization of Lido is an accurate representation of Lido’s presence in the market because the protocol is not managed or controlled by one organization or entity and the validator set is composed of various distinct, separate entities. While large LSPs present risks, implementing proper governance mechanisms and protocol oversight, such as dual governance, should reduce their severity. Furthermore, the addition of DVT is expected to decentralize the operator set even more. 

With that said, given the economic incentive to stake ETH–or otherwise be diluted holding native ETH– it is plausible TradFi eventually offers a staked ETH product. A few possible (purely) hypothetical outcomes are: (1) TradFi explicitly adopts stETH and all of its benefits, (2) TradFi works closely with Coinbase or other large institutional staking providers to build out this framework in which case cbETH or tradfiETH becomes the canonical staked ETH product for TradFi, or (3) TradFi develops its own practices, invests in proprietary node operations, custodies their own staked ETH, and issues tradfiETH products.

“While this is all fine and dandy for BTC [and ETH], where it goes from here is somewhat uncharted territory.” - DegenSpartan

We believe, and there is evidence that suggests, hypothetically (1) is the better solution for the network because, regardless of the scenario, if staked ETH trends toward tradfiETH, the chain risks centralizing stake. Therefore, in a state where highly capitalized incumbents develop centralizing staking products, as long as Lido remains sufficiently decentralized, stETH and the DAO are essential pieces for maintaining Ethereum alignment, more broadly–because the DAO administers stETH’s delegation and by extension meaningfully impacts the performance, security, and decentralization of the network.

Risks

Volatility and liquidity: When ETH volatility spikes, investors will prefer to sell stETH in the open market rather than wait in the withdrawal queue. Highly volatile periods in parallel with high sell volume without sufficient liquidity can cause the price of stETH to deviate from its 1:1 ETH price peg, which poses subsequent risks, until market conditions recover.

Looping risks: A popular method of earning reward (such as farming for airdrops or liquidity mining incentives), users take leveraged positions in which they lend stETH, borrow ETH, buy stETH, lend the additional stETH, and repeat the loop until they are fully leveraged to max capacity. In times of volatility, loopers are at risk of getting liquidated which can trigger amplified risks related to volatility and liquidity.  

Protocol and Governance: There are risks associated with an LSP capturing significant market share. The protocol for stETH delegation is administered by the DAO. While the DAO is taking steps toward dual governance, which will reduce these risks, if stETH makes up the majority of staked ETH, then there is reason to be concerned about the centralization of ETH stake to LDO governance.

Smart contract: The Lido protocol is executed by a set of smart contracts. This includes deposits, withdrawals, delegating stake, slashing, and key management. Unforeseen bugs or malicious upgrades related to smart contracts are present in these systems.

Competitors: The LST market is large, and additional restaking protocols are entering the arena. TradFi is also capable of developing their own staking products, which, given the current market structures, could be more accessible for some investors.

Regulatory: While the spot ETH ETF approval probably makes it safer, on average, for staking providers, there will still be regulatory scrutiny over staked ETH. Open legal discussions include (and may not be limited to) a staking provider’s role, the distinction between “managerial” and “administrative” (per the Howey test), and whether or not LSPs are “issuers” (the Reve’s test). 

Final Thoughts

By today’s standards, stETH is arguably the best product for gaining exposure to staked ETH. It is the most liquid LST onchain; it is the most widely used form of collateral in DeFi; and these market structures are rapidly expanding offchain, made evident by growing trading volumes on CEXes (most notably, ByBit and OKX). And while there are risks to holding stETH, these strong market structures will likely continue to persist and possibly proliferate given stETH’s properties, Lido’s protocol, the growing necessity for Ethereum alignment, and upcoming catalysts. These catalysts on the roadmap include distributed validator technology (DVT), dual governance, supporting preconfirmations and allocating additional resources to restaking stETH, and a revamped governance structure that will contribute to Ethereum research. More importantly, if TradFi develops staked ETH products, stETH and Lido DAO are positioned to serve an increasingly important role in Ethereum, more broadly.
 

Resources

Dual Governance: design and implementation proposal

Ethereum Proof-of-Stake Consensus Layer: Participation and Decentralization

HOW MANY TROJAN HORSES CAN WE LAUNCH?

Issuance Issues — Initial Issue

Lido docs

Magnitude and Direction

Operator Statistics and Metrics

Rated Explorer

ReGOOSE

stETH Utility

Scorecard

Lido Operator Set Strategy 

This research report has been funded by Steakhouse Financial. By providing this disclosure, we aim to ensure that the research reported in this document is conducted with objectivity and transparency. Blockworks Research makes the following disclosures: 1) Research Funding: The research reported in this document has been funded by Steakhouse Financial. The sponsor may have input on the content of the report, but Blockworks Research maintains editorial control over the final report to retain data accuracy and objectivity. All published reports by Blockworks Research are reviewed by internal independent parties to prevent bias. 2) Researchers submit financial conflict of interest (FCOI) disclosures on a monthly basis that are reviewed by appropriate internal parties. Readers are advised to conduct their own independent research and seek the advice of a qualified financial advisor before making any investment decisions.

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