The Rise Of LSD
The rise of LSD Liquid Staking Derivatives. The 1 to 100 moment.
When I’m not listening to a crypto-related podcast, I’m playing nice melodies from my oriamo speaker. I’m a music addict, this is something I haven’t shared before in any of my writings. In short, if I wasn’t writing about crypto, I’d be a songwriter, probably hustling for free gigs on Upwork. I used to write songs in the past as a hobby, during my spare time. As someone who’s into crypto, there’s no more spare time, even when you are sleeping, something is happening, and there’s always catching up to do. Since I started paying more attention to crypto, I have written songs less and less. While I’m not yet retired from songwriting, I haven’t written one in over a year now. I wrote last in September of 2021, a song that was supposed to be part of my sophomore album. An album, even friends and families haven’t even heard, I can count on my fingers, who have listened to it. Probably for my ears only, or would release for the world to hear, when $SHIB hits $1, happy waiting. The year prior was when I wrote my debut album, while my sophomore album is still in the works (but on hold for now) and doesn’t have a title yet, my debut was titled tales of broken hearts. It was an 11-track album, a genre of pop, adult pop, and adult contemporary. 2020 was a broken year, by any metric or standard, it only made sense for a title. The start to finish of the album was influenced by the happenings during the Covid lockdowns. Had a shit load of time to spare then, as we were all asked to stay in our various houses, and crypto prices were going through the roof, there was nothing to do than wire funds from your local bank to Binance, and buy anything CZ advertised on the app, sleep and awaken a millionaire. That’s how I at least thought of crypto then. That was also my first foray into crypto, I was still testing the waters then, hence wasn’t spending over 40 weeks on crypto (like I do), I still had a life then, unlike now.
While I listen to little rap, I’m more inclined to pop, adult pop, and adult contemporary. One of the numerous influences of tales of a broken heart was Sia. Have always listened to Sia growing up. Her voice is melancholic. She’s one of the best female artists out there. Would even say she’s better than the overhyped Rihanna. Yes, Sia is better, but that’s a comparison I won’t go into. My bias is part of it, but the numbers confirmed it too. Sia is known to be a solo artist, she hardly features or is hardly featured. Whenever she’s on a feature is probably with a DJ or a vocalist. Most of her major hits like Titanium, Chandelier, Unstoppable, and Elastic Heart are usually solo singles or features with a DJ.
2019 was the last normal year, this generation ever saw and would probably ever see, the world took a flip on the head when Covid struck. That same year, Sia did something she has never done before — she released an album as a part of a trio. The album was named LSD, an acronym for their various names L stands for Labrinth, S for my beloved Sia, and D for Diplo. The album was a good one, having accumulated over a billion streams on Spotify, peaked at no 70 on the US Billboard 200 and 44 on the UK Album Charts, and has been certified Platinum in Brazil and Gold in Norway, Poland, Mexico, and Singapore. While these numbers don’t match up to what Sia has had in the past or can achieve alone, it’s something new and of Joy for at least LSD as a group. This got Sia fans contemplating if she had abandoned a solo career and wanted to be part of a group. It’s been almost 4 years and we haven’t heard anything from LSD, not even a single. Well, we didn’t know LSD was in the works until it was released, the same way we don’t know if LSD 2.0 is in the works. LSD was recorded from 2018–2019, if we followed a similar timeline, we should have gotten LSD 2.0 way before now, even 3.0. But good music takes time, as they say. So let’s give LSD a little more time. Would LSD 2.0 be able to match the success of LSD 1.0? That’s a question we won’t have an answer till we get LSD 2.0.
Enter Liquid Staking Derivatives (LSD). They had their moment pre-merge, with the poster child being $LDO — rallying over 300%. Is that a flash in the proverbial pan like the 1 billion streams LSD has acquired on Spotify or is there more than meets the eye? Do we get LSD 2.0 in crypto? The next rally in LSD, would it transcend the pre-merge hype? Is LSD even a thing?
Before we dive into what liquid staking derivatives are, let’s back up a little and do a normie’s class as to where it originated from.
There are two major ways to achieve consensus on a public blockchain. Had to explicitly state major because there are less unpopular/untested/unreliable ways to achieve consensus, and public because a blockchain that isn’t public would be better referred to as a Distributed Ledger Technology (DLT). There are other blockchains like the ones that are private and controlled by a consortium, but none of that should concern you if you are into crypto, because that goes against the ethos of decentralization, which is the backbone of public blockchains (which is our concern). The most common form, and also the first, safest, and most decentralized form to achieve consensus on a public blockchain is via Proof-of-Work (PoW), while the next safest and less decentralized form is Proof-of-Stake (PoS). Decentralization is a spectrum, the debate of which is the most secure and decentralized, PoW or PoS? Is something that has been argued ad nauseam. Justice has been done to that topic, by folks way smarter than I am, so won’t re-hash that here.
While PoS is our major concern, you first need to have an idea of what PoW is to understand what gave rise to PoS. Proof of work is a method used to validate transactions and create new blocks in the chain, requiring computational power to solve complex mathematical problems. It’s like doing a difficult math problem to earn a reward. The more puzzles a computer solves, the more likely it is to be rewarded with new cryptocurrency coins. This process helps secure the blockchain network and makes it more difficult for bad actors to manipulate the system. These computers require a large swath of energy and specialized hardware to solve complex puzzles to verify and add new transactions to a blockchain. This process is termed mining, synonymous with gold mining. This way, there is a tie between the blockchain and the physical world.
PoS servers the connection between the blockchain and the physical realm. Instead of using a lot of energy and computing power like, in proof of work, proof of stake relies on users “staking” or locking up their cryptocurrency as collateral to validate transactions. The more cryptocurrency a user stakes, the more likely they are to be chosen to validate the next block of transactions and earn rewards. Think of it like having a lottery ticket — the more tickets you have, the better chance you have of winning.
There’s vanilla Proof-of-Stake which Ethereum uses, and there are other variants, such as:
— Delegated Proof of Stake.
— Leased Proof of Stake.
— Pure Proof of Stake.
— Liquid Proof of Stake
And a host of others, with Delegated Proof of Stake being the most popular of them all. Five out of the top 10 assets by market cap employ a form of Proof of Stake, either in its vanilla form or its variants. This goes to show how popular PoS is, even more than PoW. One major advantage of PoS is that it is much less energy-intensive than PoW. In a PoW system, nodes compete to solve complex mathematical problems to validate transactions and add blocks to the blockchain. This process requires significant computational power, which consumes a large amount of energy.
In contrast, PoS does not require the same level of computational power and energy consumption. Instead of miners competing to solve puzzles, validators are chosen based on their stake in the network (i.e. the amount of cryptocurrency they hold and have committed to “stake” in the network). Validators are incentivized to act honestly because they risk losing their stake if they are found to be acting maliciously.
Because PoS requires less energy, it is seen as a more sustainable alternative to PoW. It also allows for faster transaction times and lower transaction fees, since the validation process is not as resource-intensive. Additionally, PoS may be more resistant to centralization, as it is easier and more cost-effective for individuals to participate in the validation process compared to PoW.
Overall, the energy efficiency of PoS is considered one of its major advantages over PoW and has led to increased interest in the mechanism as a way to create more sustainable and scalable blockchain networks.
Three major drawbacks with staking on a Proof of Stake world as of today are;
1. A high barrier to entry.
Staking on PoS Ethereum requires users to have a certain amount of Ether (ETH) to participate. This is what I mean by a high barrier to entry — not everyone may have enough ETH to stake.
Think of it like this — imagine you’re going to a concert and you need a ticket to get in. But to get a ticket, you have to already have some money to buy it. If you don’t have enough money, you can’t get a ticket and therefore can’t go to the concert.
It’s kind of the same thing with staking on PoS Ethereum — you need a certain amount of ETH to participate. This can make it difficult for people who don’t have a lot of money to get started with staking. To stake your ETH and earn rewards, you need to have a minimum amount of ETH, and that amount is pretty high — around 32 ETH. For a lot of people, that’s a lot of money to spend just to get into the staking game. So, while staking can be a great way to earn more ETH, it’s not accessible to everyone.
2. The staked Eth can’t be withdrawn until the Shanghai upgrade.
If you’re not familiar with Ethereum, it’s a decentralized blockchain platform that enables developers to build and run decentralized applications or dApps. To ensure the security and reliability of the network, Ethereum uses a consensus mechanism called Proof of Stake (PoS), which allows users to stake their ETH to help validate transactions and earn rewards.
Now, here’s where things get a little tricky. When you stake your ETH on Ethereum, you’re essentially locking it up in a smart contract that’s responsible for validating transactions on the network. This process is known as “staking,” and it’s similar to mining in a Proof of Work (PoW) system like Bitcoin.
To incentivize users to stake their ETH, Ethereum offers rewards in the form of additional ETH. However, there’s a catch: once you’ve staked your ETH, you can’t withdraw it until the network undergoes a major upgrade known as the “Shanghai upgrade,” which is currently slated for March 2023.
So why can’t you withdraw your staked ETH until the Shanghai upgrade happens? Well, it has to do with how Ethereum’s PoS system works. To validate transactions, PoS systems require users to deposit a certain amount of cryptocurrency as collateral. This collateral is then “locked up” in a smart contract, and if the user fails to validate transactions honestly, they risk losing their collateral
On Ethereum, the amount of collateral required to participate in staking is 32 ETH. This means that if you want to stake on the network, you need to deposit at least 32 ETH into a staking contract. Once you’ve done so, your ETH is locked up and can’t be withdrawn until the Shanghai upgrade happens.
The Shanghai upgrade is an important update to the Ethereum network that’s designed to make staking more secure and reliable. The upgrade will introduce several changes to the network that will help to prevent attacks and ensure that stakers are incentivized to act honestly. These changes require a significant amount of testing and planning, which is why the upgrade won’t be implemented until March 2023.
Overall, while the delay in being able to withdraw staked ETH can be frustrating for users, it’s important to remember that the Shanghai upgrade is necessary to ensure the long-term security and stability of the Ethereum network. Once the upgrade is implemented, users will be able to withdraw their staked ETH and use it for other purposes.
3. It’s capital inefficient.
When it comes to staking on the Ethereum PoS (Proof of Stake) network, one of the main drawbacks is that it can be quite capital-inefficient. This means that if you want to stake a significant amount of Ethereum, you may end up tying up a lot of your funds, which can limit your ability to use them for other purposes.
Let me break it down for you. When you stake your Ethereum on the PoS network, you’re essentially locking it up in a smart contract for a certain period. This is necessary to help secure the network and earn rewards for doing so. However, during this time, you won’t be able to use your Ethereum for other things, like trading or investing in other assets.
Furthermore, the amount of rewards you can earn for staking your Ethereum is directly tied to the amount you stake. So if you want to maximize your rewards, you’ll need to stake a significant amount of Ethereum. This can be a good strategy if you’re planning to hold onto your Ethereum for the long term, but if you need access to your funds in the short term, it can be a problem.
So all in all, while staking on the Ethereum PoS network can be a great way to earn rewards and support the network, it’s important to understand the capital inefficiencies involved. Make sure to carefully consider your financial goals and needs before deciding to stake your Ethereum, and always do your research to ensure you’re making an informed decision.
Liquid Staking Derivatives solve all of the above.
What are Liquid Staking Derivative
Liquid staking is a process that allows people to earn rewards for staking their cryptocurrency while still being able to use it for other purposes. It works by creating a new asset that represents the staked cryptocurrency, which can be freely traded or used in other DeFi protocols, while the original cryptocurrency is locked in a smart contract to earn staking rewards. This allows people to earn passive income while maintaining liquidity and flexibility with their cryptocurrency holdings.
When you stake a cryptocurrency, you lock it up for a while to help secure the blockchain and earn rewards. However, during this time, you can’t use that cryptocurrency for anything else. Liquid staking solves this problem by creating a new asset, often called a staked token, that represents your staked cryptocurrency. This staked token can be freely traded or used in other DeFi protocols while your original cryptocurrency remains staked and earns rewards.
For example, let’s say you have 10 ETH and you want to stake it to earn rewards. Instead of locking up your 10 ETH, you could use a liquid staking protocol to create 10 staked ETH (stETH) tokens. These stETH tokens can be traded or used in other DeFi protocols while your original 10 ETH remains staked and earning rewards. When your staking period is over, you can redeem your stETH tokens for the original 10 ETH plus any rewards earned during the staking period.
This process is made possible through the use of complex algorithms and mathematical models that enable the creation of a fungible, liquid asset that represents the underlying staked asset. These models take into account factors such as staking rewards, volatility, and liquidity to determine the value of the liquid token.
Pros of Liquid Staking
1. Continued Access to Capital
Let’s say you have a cool toy that all your friends want to play with, but you don’t want to give it to them because you’re afraid they might break it. Instead, you come up with a solution where you let them play with the toy, but you still keep it safe and make sure it doesn’t get broken. In exchange for letting your friends play with the toy, they give you some of their allowance money.
Now, let’s apply that concept to liquid staking. When you own some cryptocurrency, like Ethereum, you can stake it to help keep the network secure and earn rewards for doing so. However, when you stake your crypto, you can’t use it for anything else until the staking period is over. That’s where liquid staking comes in.
With liquid staking, you can stake your crypto and still use it for other things at the same time. It’s like letting your friends play with your toy, but you’re still keeping it safe and making money at the same time. This way, you can earn rewards for staking your crypto and still have access to your capital if you need it for something else.
So, to sum it up, liquid staking allows you to earn rewards for staking your cryptocurrency while still having access to it if you need it for something else. It’s like letting your friends play with your toy while still keeping it safe and making money at the same time.
2. Promote Staking Activity
As I have explained above, staking is a process of holding and locking up a certain amount of cryptocurrency in a blockchain network to support its operations and earn rewards in return. However, staked assets are usually illiquid, meaning you cannot use them for other purposes until the staking period is over.
This is where liquid staking comes into play. It allows stakers to use their staked assets as collateral to borrow or lend other cryptocurrencies while still earning staking rewards. In other words, it enables stakers to participate in the broader DeFi ecosystem without losing out on staking rewards.
As a result, liquid staking promotes staking activity by making it more accessible and flexible to investors. It incentivizes stakers to hold their assets for a more extended period and participate in the blockchain network’s governance decisions, leading to a more robust and decentralized network.
Furthermore, liquid staking also allows smaller investors to participate in staking activities that were previously only available to large investors. This means more individuals can earn staking rewards and contribute to the network’s security and stability.
In conclusion, liquid staking promotes staking activity by providing stakers with more flexibility and accessibility to participate in the broader DeFi ecosystem while still earning staking rewards. It’s an excellent way to support the blockchain network’s operations and ensure its long-term sustainability.
Overall, liquid staking provides numerous benefits to stakers, including flexibility, accessibility, and participation in the DeFi ecosystem. However, like any other technology, it also has some drawbacks that need to be considered. Let’s dive into some of the cons associated with liquid staking and explore how they can impact stakers and the network’s overall health.
Cons of Liquid Staking
1. Slashing
In liquid staking, you can trade the staking rights to someone else and receive a token in exchange.
Sounds pretty good, right? But here’s the catch: if the person who’s staking your crypto messes up, you could lose some of your investment. This is what’s known as slashing, and it can happen if the staking provider tries to cheat the system or goes against the network’s rules.
So, let’s say you decide to try out liquid staking derivatives anyway. You choose a staking provider that seems trustworthy and start trading your staking rights for tokens. Everything is going smoothly, and you’re earning some nice rewards.
But then, out of nowhere, you hear that your staking provider has been caught cheating the system. The network decides to penalize them by slashing their staked crypto, and unfortunately, this means that you lose some of your investment too.
It’s a bummer, but that’s the risk you take when you use liquid staking derivatives. You’re relying on someone else to maintain the network’s security, and if they mess up, you could be in trouble.
That’s why it’s important to do your research and choose a reliable staking provider if you decide to use liquid staking derivatives. You want someone who’s trustworthy and has a good track record of following the network’s rules.
2. Lower Yield
In a scenario where you have a big bag of candy that you’re willing to share with your friends. You could just give each friend a piece of candy, but you decide to do something a little different. You tell your friends that if they give you their piece of candy, you’ll give them a ticket that they can redeem for a piece of candy at any time.
Now, some of your friends might not want to give up their candy right away. They might want to keep it for themselves or trade it with someone else. But some of your other friends might be happy to trade their candy for a ticket because they trust you to give them a piece of candy back whenever they want.
In this scenario, your bag of candy is like a proof-of-stake blockchain network. The candy pieces are like tokens that represent a share of the network’s value, and the tickets are like liquidity pool tokens that represent a share of the staked tokens in the network.
When you stake your tokens in a liquidity pool, you’re essentially giving them up temporarily in exchange for liquidity pool tokens. These tokens give you a claim on a portion of the staking rewards generated by the pool. However, because you’re no longer in direct control of your tokens, you may not be able to vote on governance decisions or transfer your tokens to another wallet without first redeeming your liquidity pool tokens.
The reason why the yields on liquid staking can be lower than on regular staking is because of the additional risks and fees involved. When you stake directly on a blockchain network, you don’t have to worry about impermanent loss (the loss of value that can occur when the price of the tokens in a liquidity pool fluctuates) or the fees associated with swapping tokens in and out of the pool. However, when you stake in a liquidity pool, you’re exposed to these risks and fees, which can eat into your returns.
Liquid staking can be thought of as trading candy for tickets. It can be a good way to access liquidity and earn staking rewards, but it comes with some trade-offs and risks that can result in lower yields compared to regular staking.
State of the Ethereum network
Before we look into the various liquid staking providers, let’s access the state of the Ethereum network. Ready for some chart porn? Let’s get into it.
Over 17 million eths are currently being staked, via over 500,000 validators. That’s ~15% of the total Eth supply. This is the crux of this piece — the amount of Eth staked would continue to grow, and most of that would be done via liquid staking.
Most Proofs of Stake networks have an average of 60% of their circulating supply staked, with Ethereum being the outlier here.
Also, most of the staking being carried out on other chains is through the vanilla staking staking form. But that has drawbacks as I explained above. This is market share up for grabs by LSD.
While LSD is most prominent in Ethereum because that’s where it originated from and Ethereum is the largest Proof of Stake network, Liquid Staking further branches out into other chains, like we are currently seeing (although not in a big way).
There’s a misconception that if most of the circulating supply of a coin is being staked, it’d reduce selling pressure. I beg to differ on such a narrative, the reason being the duration of staking (how long does it take to unstake).
If we access networks with over 60% of their circulating supply being staked, you’d find out that that doesn’t necessarily act as a hedge against selling pressure, due to how fast it is to unstake staked tokens. Solana for example typically takes 172,800 blocks, an average of 3 days to unstake. Unstaking on ICP varies depending on the canister being used, some take as short as 1–2 days, while some may have a longer unstaking period of up to 3 months. It also varies on the BNB chain too, depending on the protocol being used, for example, Venus has a 3-day unstaking period, while PancakeSwap (the leading DEX on the BNB chain via Total Value Locked — TVL), has a 7-day unstaking period.
While having a high percentage of their circulating supply being staked (although not up to 60%), Polygon, Avalanche, and Tron have an unstaking period of 7 days, 2 days, and 3 days respectively.
Networks with a high percentage of their circulating supply being staked and having the longest unstaking period are Polkadot and Cosmos, with a 28-day and 21-day unstaking period respectively. LSD would be a solution to this as users won’t have to wait that long before unstaking.
While LSD solves for a longer unstaking period, it also increases the likelihood of selling pressure. Currently, no Ether being staked can be withdrawn, but you can exit your staking position by selling the derivative — stEth on the open market. This still contributes to selling pressure.
There are speculations as to if the unlocking of withdrawals via the Shanghai upgrade would lead to selling pressure in Eth.
This claim is founded, as the bulk of the staking happened between $2,200 and $3,500. With the current price at ~$1,600, 80% of the total Eth staked is underwater (meaning they are currently in the red). Mind you, this is in dollar terms. In Eth terms, 60% are underwater, that’s still a lot though, but not as dire when you look at the USD value.
Liquid Staking Providers
We will discuss only the two largest Liquid Staking Providers, Lido Finance and Rocket Pool. There are others worth mentioning, Frax Finance, Stakewise, etcetera. You can read up on them in your spare time.
Lido Finance
Lido by a wide margin is the biggest liquid staking provider. 27% of all Eth staked is done via liquid staking providers.
Of the 27% of Eth staked via liquid staking providers, Lido accounts for 94% of that. Over 5 million Eth have been staked via Lido, and they offer a 4.2% APR. All in all, Lido accounts for 30% of Eth staked on the Ethereum network.
Despite Lido’s TVL taking a hit last year, due to the Terra-Luna fiasco, it’s still the protocol with the highest TVL on the Ethereum network. It commands a whopping $9B in TVL, which is 9x its closest competitor — RocketPool.
Lido’s governance token $LDO is up 300%+ in the last 90 days.
How does Lido work in practice
You first need to get your hands on Eth. There are various ways to do that, with swapping a stablecoin, USDC for example, for Eth on a DEX like Uniswap, being the most popular. Other popular ways to get access to Eth is by buying it on a Centralized Exchange, like Coinbase, or via Peer-2-Peer networks. Would refrain from mentioning any P2P network, so it doesn’t look like it’s a recommendation.
Here’s a simplified step-by-step process of how Lido works
- You send your ETH to Lido. When you send your ETH to Lido, it gets converted into a special type of ETH called stETH. This stETH represents your stake in the Ethereum 2.0 network and can be redeemed for ETH at any time.
- 2. Lido pools your stETH with other users’ stETH. By pooling everyone’s stETH together, Lido can create larger and more efficient validator nodes on the Ethereum 2.0 network. Validator nodes are responsible for validating transactions on the network and ensuring the security of the network.
- 3. Lido runs validator nodes on the Ethereum 2.0 network. These validator nodes are run by Lido and use the pooled stETH to participate in the staking process on the Ethereum 2.0 network. By participating in the staking process, Lido and its users earn rewards in the form of more stETH.
- 4. You earn rewards on your stETH. Every day, Lido distributes the rewards earned by its validator nodes to all the stETH holders in proportion to their stake. So the more stETH you have, the more rewards you’ll earn.
- You can redeem your stETH for ETH at any time. If you want to redeem your stETH for ETH, you can do so at any time on Lido’s platform. The conversion rate between stETH and ETH is always 1:1, so you’ll receive the same amount of ETH that you originally deposited.
Lido allows you to earn interest on your Ethereum by staking it on the Ethereum 2.0 network through a pooled staking approach. By participating in staking through Lido, you can earn rewards in the form of stETH, which can be redeemed for ETH at any time.
Lido charges a 10% fee for the Eth staking reward and splits it between node operators and DAO Treasury
The risk associated with Lido
1. Smart Contract risk
As with anything built-in crypto, smart contract risk is usually the biggest risk. Smart contract risk refers to the potential for errors or vulnerabilities in the code of these contracts that could lead to unexpected outcomes or losses for users. These risks can arise from various factors such as coding mistakes, malicious attacks, or unforeseen changes in the underlying blockchain technology.
For example, a coding mistake in the smart contract could cause it to malfunction, allowing an attacker to steal funds from the network. Similarly, a vulnerability in the smart contract’s code could be exploited by an attacker to manipulate the network’s operations and potentially steal funds or disrupt the system.
To mitigate these risks, Lido Finance and other DeFi protocols employ various security measures such as code audits, bug bounties, and decentralized governance processes to ensure the smart contracts are functioning correctly and securely.
As the saying goes, the longer it stays, the safer it gets. Lido has been around for over 2 years and hasn’t been hacked, despite being a honey pot and a potential victim for attack due to the large concentration of Eth. The fact that it hasn’t been hacked, testifies to the robustness with which the smart contract was built.
2. Centralization Risk
The next concern is centralization within the Ethereum network. As more and more people use Lido to stake their tokens, it’s possible that a small number of entities could end up controlling a large portion of the network’s staked tokens. This could give them a disproportionate amount of power and influence over the network, which goes against the principles of decentralization.
To put it simply, imagine if a group of people was playing a game and one person started to accumulate more and more points than everyone else. Eventually, that person could become so powerful that they could control the outcome of the game and everyone else’s ability to play fairly. In the same way, if a small number of entities control a large portion of Ethereum’s staked tokens through Lido, they could potentially control the network’s operations and decision-making, which could undermine its decentralized nature.
To maintain Ethereum’s decentralized nature, as many people as possible need to participate in the network and avoid the concentration of power in the hands of a few entities. They should also use more decentralized liquid staking providers like RocketPool.
There’s also been talk of a regulatory clampdown on Liquid Staking Providers, due to the recent actions of the SEC, which fined Kraken (a Centralized Exchange) $30M and asked them to stop offering staking services to US citizens. I think that claim is unfounded as there’s a stark difference between what Lido does and what Kraken used to do. The difference between a CEX and DEX offering staking services is clear as day.
In summarizing this section, it would help point out that smart contract risk isn’t peculiar to Lido and instead is a necessary demon all DeFi protocols would have to deal with, including RocketPool. On the centralization front, I think it’s all based on incentives. The operators are incentivized to act honestly. It is in their best interest to play by the books. With the recent happenstance with FTX in November last year. Wouldn’t put anybody above going against the decentralization ethos in crypto.
RocketPool
RocketPool is the second largest Eth liquid staking provider after Lido. The major difference between Lido and RocketPool is that Lido operates with a set of permissioned validators, while RocketPool’s validator set is permissionless, meaning anyone can join to become a validator.
RocketPool has a much smaller TVL when compared to Lido. In short, Lido is heads and shoulders above RocketPool, regardless of the metric you use. RocketPool, while relatively new, has a TVL of $1B. For comparison, Lido’s is $9B.
Over 340,000 Eth has been staked with RocketPool as of the time of writing, compared to Lido’s 5M+ Eth.
The $RPL token has seen a similar rise as the $LDO. $RPL is up ~200% in the past 90 days. Both tokens are one of the best-performing assets, on a 3-month basis.
How does RocketPool work in practice
RocketPool has a working mechanism different from that of Lido in the sense that it makes use of 16 Eth rather than 32 Eth. Generally speaking, their working principles don’t differ a lot. You need a minimum of 16 Eth and 1.6 Eth worth of RPL (the governance token of RocketPool) to become a node operator. There are plans to reduce the number of Eth required, as it decreases the barrier of entry and increases centralization.
The remaining 16 Eth will come from stakers joining the Ethereum network node. Upon depositing, stakers would receive rEth in return which would accrue value, similar to wstEth.
Node operators also receive additional RPL token rewards in addition to the staking rewards from the 16 Eth, which results in a higher yield than solo staking. RocketPool charges a 5–20% fee from the staking rewards and gives all of it to the node operators. Here’s how it works:
- Users deposit their ETH into a RocketPool smart contract.
- 2. The smart contract mints a new token called rETH, which represents the user’s share of the pool.
- 3. RocketPool runs a network of node operators who run validator nodes on behalf of the pool. Node operators must stake their own ETH as collateral and are responsible for maintaining the node and earning rewards for the pool.
- 4. The pool’s rewards are distributed proportionally to users based on their rETH holdings.
- 5. Users can withdraw their rETH at any time and exchange it for ETH, minus a small fee that is used to cover the costs of running the RocketPool network.
Risks associated with RocketPool
The smart contract risk outlined above in the case of Lido is also applicable to RocketPool. The centralization risk doesn’t pertain to RocketPool that much as it makes use of permissionless validators as opposed to Lido’s permissioned set of validators.
Due to its permissionless nature, anyone from around the world can join the set of RocketPool validators, which introduces the risk of malicious actors. Unlike Lido’s with a permissioned set of validators, it reduces the risk of malicious actors. To counteract this, RocketPool node operators are required to deposit anywhere between 10–150% of the Eth staked in the RPL token. This acts as insurance against slashing and any other form of misbehaving, which could attract penalties.
For node operators to post more RPL collateral, they are giving more RPL tokens as an incentive. RPL inflates at 5% per annum and doesn’t have a maximum supply. 70% of the emission goes to the RPL incentives. 15% is allocated to the Oracle DAO (famously called O-DAO), and the other 15% is sent to the protocol treasury.
RPL has a much weaker value accrual than LDO as a result of RocketPool giving 100% of the staking commission to the node operators and earning from the RPL token emission, which isn’t an efficient treasury management system, but it is attractive to validators due to its higher yield offering.
The death spiral kicks in when the value of RPL declines too much due to high inflationary rewards and no solid value accrual mechanism. Node operators would then be required to buy more RPL to meet the collateral target, which would be capital inefficient, and the losses in RPL may deter confidence in the protocol thereby driving potential node operators away.
Summary and Conclusion
This is by far, the longest piece I have ever written, and it’s worth it because being positioned at the beginning of a secular bull market is very crucial to success in investing.
Every bull market is characterized by normies finding new ways to issue tokens. 2013 was Bitcoin mining, and other PoW-aligned tokens (all of which are dead, except for Litecoin, which is a few meters away from its grave). Then, people found out that they could just run software on their computers, from the comfort of their homes and make a shit ton of money.
The ICO (Initial Coin Offerings) mania triggered the 2017 bull market, as folks found a much easier way. There wasn’t a need to run software on bespoke computers, make use of specialized hardware (ASICs), or consume that much energy. ICO was a 1 to 100 moment in terms of folks finding new ways to issue tokens. Most ICO ended up being scams though, but we got our beloved Ethereum as a result of that.
To counteract the scammy nature of ICOs, folks turned to IEO (Initial Exchange Offerings). Here, rather than anyone issuing tokens, trusted exchanges acted as gatemen. They helped vet whether it was genuine or not. This sparked the 2019 mini-bull run, as it wasn’t that much of an innovation over ICOs.
Liquidity mining gave way to the 2020–2021 bull market. In a simplified explanation, all you had to do was provide liquidity to a protocol, and earn fees as a result. DeFi summer in 2020 was a product of liquidity mining.
In mid-2021, we got the NFT craze. This time, Non-Fungible Tokens (NFTs) were issued rather than fungible tokens as we saw in the past. This caused the last run-up from mid-2021, climaxing in early 2022. In every instance, new ways to issue tokens were invented. I believe that LSD is the latest discovery. And it’d lead us into the 2024–2025 bull run.
There’s a saying “nothing hurts more than being in the right industry but betting on the wrong horse”. Here’s what I mean by that, being in the right industry isn’t enough, betting on the right horse matters more. Betting on eBay over Amazon turned out to be a terrible choice. So being in crypto (the right industry), isn’t enough. Betting on the right horse (protocol matters more).
The rule of thumb of betting on the right horse is usually going “with the leaders’’. If I’m right in the thesis that LSD would lead us into the next bull market, then I want my bets placed on both Lido and RocketPool, as they are the leaders.
There are three prongs to investing, the right industry, the right horse, and the right timing. It’s much easier to be in the right industry and on the right horse than at the right time. You can get the Industry and horse right, and still lose out if you get the timing wrong. The right timing is the hardest to discern, despite being the most important of them all.
When exactly does this thesis play out? How long does it last? When do I know it has started? When do I know it has ended? These are all timing-related questions I wish I had answers to, but I, unfortunately, don’t.
To make up for my lack of timing deficiency, I tend to Dollar Cost Average in both LDO and RPL. I already own some and would increase my exposure as time goes by.
But what if I’m wrong? What if this isn’t the right industry, what if LSDs aren’t the right horses, what if this isn’t the start of the bull market, what if the thesis doesn’t play out as I envision it to? For the thesis to fail, everything would have to go wrong at the same time — crypto fades into oblivion, LSDs end up being shit, and we remain in a multi-year bear market. This is a very unlikely scenario, as I’m overconfident that this is the right industry as crypto is here to stay. A more plausible scenario is the thesis failing in bits. Here are different scenarios in which this thesis may fail. If the thesis fails, the trade stops working.
Scenario 1
I get the horse right and the timing wrong. I would have to wait much longer for the thesis to play out. And that is something I am ready for.
Scenario 2
I get the horse wrong, but the timing is right. In the grand scheme of things, it wouldn’t matter because a rising tide lifts all boats. While they might not give phenomenal returns they’d give something worthwhile.
Scenario 3
I get both the horse and timing wrong. I would have to wait much longer like scenario 1 and probably take some loss, due to the wrong timing and horse. I excluded the possibility of this being the wrong industry from the plausible 3 scenarios. But never say never.
Scenario 4
So if this indeed turns out to be the wrong industry. I would pack my bags and leave, and would no longer be writing this. Would start creating content on AI alignment problems. At that point, what horse I’m on, or the timing wouldn’t matter. Just to reiterate, I think this is a very unlikely scenario. But there’s a non-zero chance that it happens though.
