The Ethereum community has anticipated Ethereum’s Shanghai and Capella upgrades for months, dubbed together as the “Shapella” upgrade. Many holders believed that the Ethereum Improvement Proposal would be short-term bearish for ether, as millions of tokens were unlocked alongside the upgrade.
With the price of ether rallying more than 5% following the upgrade, these bearish predictions have proven to be wrong. Fewer stakers have unstaked their ether than expected, and there’s a strong case to be made that Ethereum’s Shapella upgrade will in fact increase staking rates.
However, investors are looking at the wrong token. Ether is, of course, impacted by the upgrade, but not to the degree that liquid staking derivatives (LSDs) are. The LSD landscape is quickly changing, with new products taking advantage of liquid staking. Let’s explore why LSDs are impacted more than ETH itself, and how holders are taking advantage of these developments.
Liquid Staking, Explained
When Ethereum’s beacon chain launched in 2020, ETH holders were able to lock up their ether for an unspecified amount of time in exchange for staking rewards on the new proof-of-stake chain. Given the fast-pace developments on Ethereum, staking presented large opportunity costs for investors. Consequently, Lido emerged to offer an ETH Liquid Staking Derivative, allowing holders to keep their ether exposure liquid while earning validator rewards.
Lido Staked ETH (stETH) quickly dominated the LSD market. The protocol allows anyone to deposit ether without needing to run a validator node. Importantly, users who deposit on Lido receive stETH tokens, representing their staked ether and accrued rewards. stETH holders can sell stETH for ETH at any time, keeping their position liquid while earning rewards on the stETH tokens they hold.
Since the emergence of Lido, competitors have entered the scene with alternative LSDs with their own benefits. Among them are Rocket Pool ETH (rETH) and Coinbase Staked ETH (cbETH). In order to maintain validator nodes and earn revenue from these products, LSDs take a cut of yield from staked ether, typically ranging from 10% to 25%.
How LSDs Are Impacted by Ethereum’s Shapella Upgrade
According to a recent report from Delphi Digital, Ethereum staking is anticipated to double over the next 12 months. ETH staking rates currently pale in comparison to other chains, with many major layer 1s exceeding 50% of tokens staked to validator nodes. At Ethereum’s current staking rate of 15%, there’s a lot of room for growth. But why has Ethereum staking participation been so low up until now?
Lower staking rates can be largely attributed to unknowns around staking lock up times. With the successful upgrade to enable ETH staking withdrawals, this barrier has now been eliminated. Although, most users will need to gain exposure through LSDs, as running one’s own validator node requires a minimum of 32 ether, hardware requirements, and advanced technical knowledge.
Prior to the Shapella hard fork, LSDs had trouble maintaining a strict ether price peg. At times, the prices of LSDs compared to ETH were significantly discounted, as users did not know when accrued rewards would be able to be claimed. With staked ether now liquid, LSDs can maintain their pegs much easier, increasing investor confidence and boosting liquidity.
Liquid staking derivatives currently account for around 30% of all ether staked. With increased liquidity and stronger price pegs, it’s reasonable to anticipate that this number will continue to grow. As more liquidity enters the LSD market, more applications for these tokens will be feasible throughout DeFi. Making LSDs more accessible through these integrations, liquid staking tokens are poised for growth in 2023.
What’s Next for Liquid Staking Derivatives
There is a downside for those holding LSDs as more investors begin to stake ether. As staking participation increases, staking yields will compress. If staking participation reaches 30% of all ether in circulation, the rewards APY could fall to nearly 3%. At these rates, holding a liquid staking derivative outright is far less appealing.
This presents opportunities for yield aggregators denominated in ether and liquid staking derivatives. Origin Protocol is one of the teams working to solve validator yield compression in light of Ethreum’s Shapella upgrade. Acting as a yield aggregator for ETH, stETH, rETH, and frxETH, Origin Ether (OETH) optimizes yield between the best opportunities on Ethereum.
I anticipate DeFi yield opportunities for LSDs to increase as the sector grows, and it’s a core reason that Origin Protocol built OETH. By holding LSDs and providing liquidity to leading AMMs, OETH can earn substantially higher yield than holding any single liquid staking derivative.
Further down the line, liquid staking derivatives may earn higher yield by allowing holders to opt in to additional slashing conditions in exchange for higher rewards. One of the leading projects in this developing sector is EigenLayer. Restaking promises to validators to earn validator rewards across networks, boosting APYs for participants.
The Shapella upgrade was crucial to propel Ethereum into its next stages of development. It also boded well for ETH, which was unexpected by many investors. While everyone is now watching the price of ETH react to these recent developments, my eyes are glued to the LSD market. Over the course of the next 12-24 months, I expect many primitives in DeFi to emerge through the expansion of liquid staking derivatives and associated applications.
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