In-depth Analysis of Lido Finance: What is the Future Value of Decentralized Staking?

Original Title: "Hot Topics | How Valuable is Decentralized Staking? ------ In-depth Analysis of Lido Finance"

Written by: Ben Giove, President of Chapman Crypto

Translated by: Vivian

Dear Bankless Community,

Currently, becoming an Eth2 validator requires an investment of about $100,000.

This is absolutely insane. The 32 ETH threshold has deterred many people. (Who remembers when it was 1,000 ETH?)

This is a problem—current requirements contradict the ideals of Ethereum and the concept of open, democratized financial services. Furthermore, running an Eth2 validator requires quite a bit of technical knowledge. You need hardware, you must run software, maintain it, so you won’t get slashed, and so on.

This could be a significant issue.

So how can we expect ordinary people to stake ETH?

Fortunately, there are currently two main options.

The first is to stake ETH through centralized exchanges like Coinbase and Kraken. This is the most beginner-friendly method, as they abstract away all the complex logic and allow you to stake any amount of ETH (not just the fixed requirement of 32 ETH), while still earning decent returns.

The problem is, it is centralized. You have to trust the exchange to hold your ETH, and they usually take a hefty commission from the rewards you earn. Clearly, this is not an ideal solution for those who adhere to Bankless values.

The other main option is decentralized staking providers. This is the holy grail of staking ETH, and it’s something we love to advocate for.

These open protocols democratize the use of staking, providing you with a simple UI to stake any amount of ETH while also giving you a token that represents your deposit for use elsewhere. Most importantly, these protocols are designed to hold deposits in a non-custodial manner—you don’t have to trust anyone!

Lido and Rocket Pool are the two main competitors in this space. While Rocket Pool has not launched yet, Lido has been live on the mainnet for some time now. And its growth has been astonishing.

They have accumulated hundreds of thousands of ETH in deposits, with a total valuation of outstanding stETH (the protocol's tokenized staking ETH derivative) exceeding $2.3 billion.

Therefore, we have to take a look to answer a key question.

Is Lido undervalued?

Lucas

Analysis of Lido Finance

Image Source: Logan Craig

Lido is a non-custodial, liquid staking service.

The protocol provides liquidity for staked assets by issuing tokenized derivatives. For Lido's Ethereum implementation, this includes stETH. This token allows users to earn staking rewards while still holding a fungible token, enabling holders to deploy their assets across the DeFi ecosystem.

How Lido Works

Before we dive into the LDO token, let’s take a moment to understand how Lido works—especially regarding ETH and stETH.

When users click "Deposit" on Lido's interface, their tokens are sent to the protocol's staking contract.

These contracts pool all users' funds and then allocate them to node operators chosen by the DAO, currently totaling 9, with increments of 32 ETH. These node operators are the entities responsible for managing and maintaining the validators, meaning they are the ones actually doing the staking.

There are a few important things to note about this system. First, since users' funds are pooled together, slashing can lead to losses for all depositors. The second key point is that node operators cannot access user funds; instead, they have a public validation key that allows them to verify transactions related to another user's stake. This means Lido is non-custodial.

In addition to distributing tokens to node operators, the staking contract is also responsible for minting and burning stETH, which is Lido's staking derivative. stETH represents the underlying staked ETH and all future earnings. Notably, it is minted on a 1:1 basis according to the amount of user deposits.

The protocol uses oracles chosen by the DAO to monitor validator balances and recalibrate users' stETH balances to account for rewards.

Currently, 90% of staking rewards go to depositors, while the DAO takes a 10% reward share. This fee is currently split 50/50 between node operators and slashing insurance.

Lido's Value Proposition

Now that we understand how the protocol operates, we can see the value Lido provides to users.

For beginners, it significantly increases the accessibility of non-custodial staking. As we know, self-custody staking is quite challenging for non-technical users. It also comes with real risks (pun intended), as failing to run a validator correctly can lead to losses through slashing.

Lido simplifies staking ETH, making it as easy as using any other DeFi protocol, transferring the technical and slashing risks to world-class operators. Importantly, due to the pooling of user funds, holders with less than 32 ETH can now stake and earn passive income.

The stETH token—Lido's staking derivative—also provides users with an important benefit, allowing them to gain liquidity on their underlying Ether. Traditionally, staked assets are locked and cannot be used for other purposes. This is particularly true at present, as the Beacon Chain will not allow withdrawals until after the PoS merge.

With stETH, Lido users can earn staking rewards, maintain their share in the network, and unlock the value of their tokens. In other words, stETH can serve as collateral in other DeFi protocols, greatly enhancing the utility of their staking positions.

Competitive Advantages

Now that we understand how Lido works, let’s explore several reasons for its success and factors that can help it maintain its competitive position.

Liquidity Network Effects

Due to the "liquidity begets liquidity" nature of staking derivatives, Lido benefits from strong network effects.

As we know, liquidity is a trump card within DeFi. The stronger the liquidity of an asset or protocol, the more likely it is to attract future liquidity, creating a network effect where "liquidity hosts" continuously increase their economic bandwidth, thereby enhancing their utility and solidifying their position within the DeFi stack.

This is a dynamic we see with stablecoins. Despite concerns about its reputation, Tether's USDT has maintained dominance in this market due to its massive liquidity, even though it has recently declined.

Source: The Block

This concept may also apply to staking derivatives like stETH, as the stronger the liquidity of stETH, the more useful it becomes, and thus the more likely it is to attract future liquidity funds.

Integration of stETH

The integration of stETH within DeFi is crucial to Lido's success and helps strengthen its network effects.

Lido has managed to secure several key partnerships in this area to bolster the adoption of stETH. Most notably, Curve and the ETH-stETH pool, incentivized by Lido through LDO rewards. This pool utilizes Curve's low-slippage trading between like assets, allowing stETH holders to easily swap between staking derivatives and "regular" ETH. This liquidity pool currently holds over $3 billion in deposits, with over 505,000 stETH, accounting for approximately 66% of the circulating supply of stETH.

In addition to Curve, the protocol has also partnered with DiversiFi, ARCX, and 1inch.

While establishing liquidity for exchanges, Lido has also begun making progress in making stETH a widely accepted collateral. stETH can be used as collateral in smaller money markets, such as Inverse Finance's Anchor and Rari Capital's Fuse, which has two different active pools.

However, the "wheels" are in motion to list stETH on Aave and make it collateral for Maker.

Barriers to Entry for Staking Services

New staking protocols face incredibly high barriers to entry.

Between the complexities of interacting with the Beacon Chain, slashing risks, and the inability to fork staked assets to ensure orderly governance required for the system to function, running and maintaining staking services is quite challenging.

Due to their scale, incumbents like Lido can enhance their products in ways that new players cannot. One example in this regard is obtaining slashing insurance, as Lido has been able to partner with Unslashed Finance to purchase insurance for 196,479 ETH, approximately 26.5% of the total stake.

Additionally, due to their vast resources, Lido will also have the potential to adopt advanced MEV strategies to increase returns for depositors, thereby enhancing their competitiveness against potential challengers.

Smart Capital

Lido benefits from a strong team of smart capital. In addition to a highly skilled and capable core team, Lido has several prominent members from various sectors of cryptocurrency as contributors and community members, including UpOnly host Crypto Cobain, Tim Beiko, and Hasu. Furthermore, the protocol is supported by many top investors in the field, such as Paradigm, Three Arrows Capital, and ParaFi Capital.

Total Addressable Market (TAM)

When discussing Lido, it would be remiss not to mention its addressable market.

The staking industry is expected to experience explosive growth in the coming years, with even TradFi institutions like JPMorgan predicting that staking revenues will grow to $40 billion by 2025.

We don’t need trendsetters to tell us why this is likely. Given the returns offered by staking and the incentives for users to maintain their network shares, a significant portion of the supply in PoS networks is likely to end up being staked.

While post-merge Ethereum will almost certainly become the largest market for staking providers by a wide margin, Lido's TAM includes all PoS networks. In addition to providing liquid ETH staking, Lido currently offers the same service for LUNA holders on Terra and plans to expand to Solana, as well as potentially Polkadot.

These other chains not only represent growth opportunities for Lido but also position the LDO token as a cross-chain diversification in investors' portfolios.

LDO Token Economics

Let’s take a look at the LDO token itself.

The sole purpose of LDO, although very important, is governance of the protocol. Currently, there are no direct mechanisms to drive the token's value, such as buybacks or staking mechanisms that lock supply, which means LDO is more akin to a traditional, growth-stage stock.

Nevertheless, the token economics can still play a significant role in influencing its price movements.

Token Distribution

Lido's total supply is 1 billion tokens. At launch, 36% was allocated to the DAO treasury, 35% to team members (including founders, initial protocol developers, and future employees), 22% to investors, and 6.5% to deposit validators and withdrawal key signers.

The latter three groups of tokens have a one-year lock-up period, followed by a one-year vesting period.

We can see that this means 63.5% of the total supply is allocated to insiders of the protocol. For this reason, we have reason to say that control over Lido remains highly centralized. Additionally, with the lock-up period nearing its end, there is a risk of downward pressure on the price of LDO due to sales from these individuals. While this impact may not be as pronounced during a bull market, it could exacerbate declines if the market turns bearish.

Token Release

Like distribution, release plays a crucial role in determining the level of sell pressure a token may face. This is an uncertain area for LDO holders, as the token does not have a predefined issuance schedule. Instead, decisions regarding the issuance or distribution of tokens, such as through liquidity mining programs, are determined by the DAO. Currently, there are active liquidity mining programs on Curve, ARCx, 1inch, and DiversiFi.

While this means there may not necessarily be ongoing sell pressure based on releases, it has already led to some interesting dynamics. For instance, only 2.8% of the total supply of LDO is circulating in the open market.

In addition to creating a significant disparity between quoted market cap and fully diluted valuation, this also means the token may be more susceptible to wild price fluctuations or release sensitivity.

Governance

As mentioned earlier, governance is crucial to the operation of Lido, perhaps more so than for other protocols. This is because, in addition to voting on standard project matters, such as treasury allocations, LDO holders are responsible for selecting node operators to handle user stake validation, as well as oracle providers to help ensure proper rebalancing and allocation of stETH.

Lido governance has not failed to meet this need for active management, as there have been 83 proposals submitted for on-chain voting via Aragon (the platform used for DAO operations) since December 2020.

Of these proposals, 70 have passed, while 13 either did not reach quorum or were directly rejected. By DeFi standards, Lido's voter participation is also quite high, with an average voting rate of 55.9 million tokens, accounting for 5.59% of the total supply.

However, a deeper dive into some voting metrics suggests that concerns around centralized governance may be warranted.

For example, out of the 83 votes, 79 were unanimous, meaning all tokens cast the same vote. Additionally, 22 proposals received the same voting rate. As an example, the total vote count for seven proposals was exactly 52.718 billion. This indicates that, despite nominally high participation, a small subset of holders may be participating in governance and could exert significant influence over the protocol's direction.

On-Chain Operations and Financial Metrics

Let’s take a look at some on-chain metrics to assess Lido's performance and competitive positioning.

Deposits and Market Share

Since its launch in 2020, Lido has experienced tremendous growth. The protocol currently holds over 738,000 ETH, accounting for 11.11% of all ETH on the Beacon Chain.

This makes Lido the largest non-custodial staking entity and the second largest overall, behind Kraken.

Source: Dune Analytics

In recent months, the protocol's share has also increased dramatically. Since April 2021, it has more than doubled from 5.2%. This suggests that Lido may be seeing signs of product-market fit.

Source: Dune Analytics

In addition to its share of the overall staking pie, Lido is also rapidly eating into the share of other non-custodial solutions. Since April 2021, the protocol's share of these deposits has increased from 52% to 80.5%. This further demonstrates that Lido is quickly becoming the clear market leader in non-custodial staking.

Source: Dune Analytics

Contract Revenue

As mentioned earlier, Lido generates revenue by charging fees on the staking rewards earned by depositors. This fee currently stands at 10%, which is evenly distributed between paying node operators and slashing insurance. This means the protocol's revenue is driven by the fees collected, the amount of staked assets, the yield earned by validators, and, if denominated in USD, the price of ETH.

Source: Token Terminal

Since its launch in December 2020, Lido has generated $3.02 million in protocol revenue, annualizing to about $4.53 million. While this may seem low compared to other DeFi protocols, it’s worth noting that the staking yield on the Beacon Chain, Lido's revenue only includes issuance, not also trading fees and MEV returns. Finally, despite being active, Lido has not yet generated any revenue from Terra staking.

Source: Token Terminal

Upon closer inspection, we can see that Lido's daily revenue has reached an all-time high, now exceeding $40,000. Interestingly, we can also observe that during the recent market sell-off in cryptocurrency, Lido's revenue did not experience as severe a decline compared to some other projects. For example, while protocols like Uniswap and Compound saw their revenues drop by 92% and 86% respectively from peak to trough during this period, Lido's revenue "only" fell by 40%.

These data suggest that, compared to other projects, Lido's revenue may be less susceptible to market and DeFi activity fluctuations. This also illustrates how Lido benefits from the secular nature of staking: regardless of market conditions, holders will want to stake their Ether, meaning Lido will be able to grow in any context.

Users

Since going live, over 9,500 addresses have deposited funds into Lido. Despite strong overall growth, a deeper dive into user metrics reveals some areas of concern.

Source: Dune Analytics

A significant portion of the staked funds comes from a small number of large holders. Over 325,000 ETH (44%) can be attributed to 14 users with deposits exceeding 10,000 ETH, while another 231,000 (35%) can be attributed to another 67 users with deposits between 1,000 and 10,000 ETH.

Source: Dune Analytics

This means that 0.69% of depositors account for 79% of the deposits, indicating that Lido's customer base, and thus its revenue source, is highly concentrated and reliant on this small subset of holders. While a "Lido run" is unlikely in the short term due to the lack of withdrawals from the Beacon Chain, this is certainly something to keep an eye on.

Discounted Cash Flow Valuation

Next, we will analyze the discounted cash flow model for Lido and the LDO token.

Assumptions

This model makes key assumptions and uses conservative parameters. Its purpose is more to reflect that Lido may be undervalued relative to its growth potential rather than to make a universal claim about its value.

The model uses a 40% discount rate, a figure consistent with the discount rates used by venture capitalists to reflect the high risks associated with early-stage investments. Additionally, it uses a 2% terminal growth rate, which aligns with global GDP growth.

For growth estimates, the model assumes that the total ETH staked will increase by 30% annually, rising from the current 7.3 million stakes to 20.9 million by 2025. It also assumes that the price of ETH will increase by 30% each year, meaning it will rise from around $3,000 now to $8,568 by 2025.

Finally, the model uses Justin Drake's predictions for long-term ETH staking yields and assumes that Lido DAO's acquisition rate will remain at 10%.

Valuation

Using these parameters, we can calculate that the intrinsic value of LDO is $13.96, which would give it a circulating market cap of $396 million, with an FDV of $13.9 billion.

LDO is currently trading at $4.74, meaning there could be a 194% upside if it trades at its modeled intrinsic value.

Relative Valuation

Now, let’s take a look at Lido's valuation relative to some peers.

This is a tricky issue, as its most direct competitors, such as centralized exchanges and other liquid staking services like Rocket Pool, are either companies (mostly private) or the latter has not yet launched. For this reason, we will use other leading DeFi projects that generate protocol-level revenue in different areas, such as money markets, stablecoins, and perpetual swaps.

Price / TVL

Based on price / TVL, Lido's trading price appears to be higher than other DeFi protocols, with a ratio of 1.41, significantly above the next closest protocol, SushiSwap. This may indicate that either Lido is overvalued relative to these other protocols, or the market may be valuing its liquidity at a higher ratio.

Price / Earnings and Price / Earnings / Growth

When looking at PE, Lido's value appears astonishingly high compared to this group. The protocol's trading price is 870 times its earnings (based on the annualized protocol revenue over the past 180 days), meaning its trading price is more than three times higher than the closest token AAVE and nearly 25 times higher than SUSHI and MKR.

However, looking at Lido's price / earnings relative to its growth tells a different story. With its incredible growth rate of 1918%, LDO's PEG is only 0.45, aligning it with the PEGs of PERP and AAVE.

This means that despite the high PE, Lido's valuation is in line with market prices relative to its growth rate.

Risk Factors to Consider

Like other cryptocurrency assets, Lido carries significant risks. Let’s highlight the main risks we’ve discussed throughout the article, as well as some other potential areas of concern.

Assumptions of Protocol Trust

While Lido is non-custodial, the protocol is not entirely trustless. Before July 15, the limited functionality of ETH 2.0 deposits entering the protocol meant that approximately 81% of deposits were not non-custodial. Instead, the withdrawal keys for these assets (the private keys controlling the ability to withdraw staked funds) are controlled by a 6/11 multi-signature scheme, with well-known DeFi community members and entities as signers. If these signers are compromised, collude, or mishandle their keys, a significant portion of user funds could be at risk, potentially adversely affecting the price of LDO.

Concentration of Users / Revenue

Most of Lido's deposits, and thus its revenue source, are concentrated among a small number of depositors.

Centralization of Governance

The supply of LDO tokens, and thus governance power, is concentrated in the hands of a small number of stakeholders.

Token Release

LDO has undefined token releases and very low circulating float relative to the total supply of tokens.

Regulatory Risks

Provisions in the U.S. Infrastructure Bill may lead to disorderly regulation of proof-of-stake validators, which could increase the difficulty of finding quality node operators.

Conclusion

While there are serious centralization issues, Lido boasts stellar fundamentals with its useful product, extensive and diverse moats, massive TAM, strong competitive positioning, and potentially undervalued token. The former issues can be addressed over time and are intentional design choices made for the mainnet launch.

That said, as more infrastructure around Eth2 comes online, and with the merge, the market for decentralized staking providers has not yet solidified. But now we must ask:

Can LDO help steal the spotlight from the JPEG frenzy?