Can Lido still dominate the Ethereum staking market?

Author: Momir, IOSG Ventures

Market Opportunity

Is Liquid Staking a Winner-Takes-All Market?

If centralized exchanges dominate the ETH staking market, it would contradict Ethereum's goal of building a decentralized network. As shown in the figure below, Lido is the leading project in the ETH staking space, holding about 30% of the market share.

Nevertheless, there are voices in the community that seek to limit Lido's market share. For example, Vitalik believes that staking projects (both centralized and decentralized) should self-limit the amount of staking they control, suggesting a cap of 15%.

Without ideological (decentralization) concerns, this could be a winner-takes-all type of market due to liquidity, composability, network effects, specialization, and yield maximization.

How Much Market Share Can Lido Capture?

The main arguments for and against limiting the market share of individual projects are summarized as follows:

Summary:

1: Lido will not impose any self-limiting measures.

2: IMO believes that a Lido fork is inevitable, but it is difficult to predict how much market share such a fork could capture, as it depends on many factors, such as LDO governance actions, timing, governance innovations from the fork, etc.

3: Due to competition from decentralized and centralized players, as well as community pressure, it is expected that Lido could capture up to 50% of the staking market in the best-case scenario.

4: The most realistic situation is that Lido maintains its current status, occupying about 30% of the market share. Many Lido depositors choose Lido partly for mining rewards, and there may also be a significant portion of ETH staked on leverage, which may prioritize withdrawals once the withdrawal feature is enabled.

5: At the same time, when the withdrawal feature is enabled, we also expect new depositors to flow in. The reason is that in this case, ETH LSD (liquid staking derivatives) trading should be closer to anchored value, and concerns about the market liquidity of LSD will also decrease, as users can convert back to ETH within 27 hours.

Therefore, the withdrawal feature will:

• Allow speculators (yield farmers, leveraged users) to withdraw their deposits while increasing overall market confidence, making staking more attractive.
• Cause the dominant LSD to lose some advantages compared to other solutions due to lower opportunity costs of staking.
• CEX may offer products that allow instant withdrawals (without waiting 27 hours), thus winning users on convenience.
  Using the following formula, we can roughly calculate the market's implied expectations.
  *（1/aaveearn * stETHdiscount）365
  The current pricing of stETH indicates that withdrawals will be enabled in about 460 days.

Rapidly Growing Market

Among various POS chains, Ethereum currently has the lowest staking rate. This is likely due to the following reasons:

• Users cannot stake directly at the protocol level and must accept the additional risks of smart contracts or custodial solutions.

• Staked Ethereum cannot be redeemed.

• Ethereum is a more mainstream asset, with a more decentralized community than any other POS token, but also attracts more speculation from entities like hedge funds.

Over time, as new smart contracts are battle-tested and the certainty of withdrawals increases, we can expect a larger share of ETH to be staked. However, I would be surprised to see more than 50% of ETH staked.

The decision-making thought process of ETH holders is as follows: Should I invest? If so, should I use a validator node pool? If so, should I choose a decentralized version? If so, should I choose Lido?

The Importance of Liquidity in LSD

Some point out that the network effects generated by the integration of the most liquid staking derivative—stETH—with major DeFi protocols could allow Lido to capture the entire market.

For example, if you want to obtain liquid staking derivatives, you might choose:

• The one with the best market liquidity and ease of exit.
• The deepest liquidity makes LSD a collateral in many DeFi protocols, providing more use cases for its holders.
• More use cases will make such tokens more liquid.

As mentioned earlier, due to the high opportunity cost, liquidity is even more important at this moment when withdrawals are not possible.
But overall, how interested are users in participating in re-staking? Or more simply, are users interested in using ETH in on-chain applications?

We have experienced a major bull market driven by DeFi, NFTs, and gaming projects, which distributed a large number of incentives to attract new users. However, despite all these use cases and incentives, only a small portion of ETH is used in smart contracts.

According to Nansen, in October 2021, the usage was about 4.5 million wETH (to participate in the on-chain economy, users must wrap their ETH), which is less than 4% of the total ETH supply.

Another thing, while not as concerning, is worth noting: not all DeFi protocols support rebase tokens, which is why Lido essentially has two standards: stETH and wrapped stETH (the latter is usually priced higher because it generates rewards that can be unlocked upon unwrapping).

The chart below shows that some of the largest DeFi protocols do not support the stETH standard, which is why we see wrapped stETH being used in MakerDAO, Balancer, Euler, etc. Although wrapping and unwrapping is not a significant barrier, it does affect user experience.

On the other hand, most stETH tokens are on AAVE and Curve.fi.

LDO vs ETH

• LDO's price is largely influenced by Ethereum activity and ETH prices.

• Ethereum is Lido's target market. Over 99% of Lido's locked assets are on Ethereum.

• Lido's fees come from Ethereum's inflation rewards and transaction fees (Priority Fees).

• Lido's yield equals 5% of the total staking rewards collected on Lido (90% allocated to stETH providers, 5% to node operators).

• Ethereum distributes 1700 ETH daily as staking rewards (about 0.5% of ETH supply), of which about 30% flows to Lido (based on their market share, assuming other conditions are the same).

While Lido is highly dependent on Ethereum fundamentals, we can see that even with ETH supporting its value, Lido has experienced significant volatility. This may be due to the market re-evaluating Lido's positioning within the Ethereum ecosystem and the estimated market size of the LSD vertical.

Ethereum Inflation Rewards

Since ETH inflation typically accounts for a large portion of Lido's revenue, it is also important to understand its dynamics.

Using data points from https://ultrasound.money/, we estimate that a 1% increase in TVL results in a 0.41% decrease in base reward APY.

Lido 30-Day Staking Reward APY %

Benchmarking Competitors

Quantitative comparison: To have a more mature competitor as a benchmark, we also added MakerDAO to the table, as LSD is essentially most similar to synthetic assets, where stETH is a synthetic asset. If one day Lido decides to support the minting of synthetic stablecoins backed by staked ETH, I would not be surprised.

Token Health (Behavioral Finance/Market Psychology) Note: This data lacks insight into the use of LDO tokens on centralized exchanges. How to interpret this data?

• Honest answer: Unclear.
• Possible intuition - Disposition effect, referring to the phenomenon where investors tend to sell profitable tokens too early while holding onto losing tokens for a long time.

Directional Comparison

Summary

• We estimate that staked ETH could account for up to 50% of the total ETH supply.

• Due to challenges from the community and the emergence of competitors, we reasonably estimate that Lido's market share in liquid staking will be around 35%.

• After Lido opens liquid withdrawals, we estimate that leveraged traders and mining participants will withdraw ETH, although withdrawals should generally create an environment that boosts staking interest. Smooth withdrawals will also reduce the value proposition of LSD.

• Open withdrawals may occur about a year from now.

Lido Advantages

• The number one project in ETH liquid staking, with first-mover advantage and a solid moat.

• Compared to competing projects, Lido has advantages in security, liquidity, composability, network effects, specialization/efficiency. Lido is likely to maintain its position as the primary decentralized liquid staking platform.

• Historically has a record of no censorship.

• A publicly transparent roadmap, with a track record of implementing and developing according to the roadmap.

Lido Disadvantages

• If Lido does not introduce certain restrictions, the cost of governance attacks will not be very high.

• There is a risk of validators manipulating the reward-sharing mechanism by participating in the LDO token war.

• LDO tokens are not sufficiently decentralized.

• A prolonged bear market will lead to low staking yields and a small portion of staked ETH.

• The significance of liquidity may be overestimated: many ETH holders are simply not interested in re-staking and using on-chain assets; once withdrawals are enabled, LSD will lose some of its value proposition.

• A Lido fork is inevitable, and it is still uncertain how significant its threat is.

• The target market size for Lido is largely determined by ETH's market capitalization. Lido is an indirect bet on ETH; however, on a risk-adjusted basis, ETH may be a better investment choice than Lido.