Basics Capital: Why will LSD be a trillion-dollar business opportunity?

Author: TIM, Basics Capital

In March 2015, during a tumultuous bear market, Bitcoin had fallen from its peak of $1,100 for over a year and was gradually bottoming out in the $200 range. At that time, the Northern Hemisphere was still experiencing a chilly spring, and the Ethereum mainnet had yet to launch. After nearly a year of discussion and development, the early Ethereum team divided the development of Ethereum into four major phases, codenamed Frontier, Homestead, Metropolis, and Serenity.

Thus began the Ethereum symphony, which narrates the story of American West gold miners expanding territories, building homes, and developing cities. Little did anyone know that this plan from that year would foresightedly dominate Ethereum's development for the next eight years. Now, with the Shanghai upgrade approaching, the final step of Serenity will conclude in March 2023, returning to tranquility.

Under the macro cycle of global monetary tightening, the shadow of a bear market looms over the venture capital market. Recently, the LSD (Liquid Staking Derivatives) sector has shown early signs of movement, with the overall track averaging over 40% growth in the past week. The leading project in this sector, Lido, has seen a growth of over 60% in seven days, with its peak even doubling, adding some green to the sluggish crypto market.

1. Current Staking Status of ETH2.0 Market

The LSD protocol has grown alongside the ETH2.0 upgrade as a DeFi derivative sector that had not formally entered the mainstream DeFi landscape. With Lido's TVL surpassing MakerDAO to become the top DeFi project, the asset scales of products like RocketPool and Stakewise are also continuously expanding, indicating that LSD has become a thriving sector, still in its early stages.

Since the launch of ETH Beacon Chain staking on December 1, 2020, over 16 million ETH have been staked, locking in assets exceeding $22 billion, with nearly 500,000 validating nodes. It has become the largest PoS public chain in terms of locked assets and validating nodes. However, when compared to the staking rates of the top five PoS chains by market capitalization, ETH's 13.28% staking rate is still very early.

Apart from ETH, the top five PoS public chains have staking rates of over 60%-70%. The level of staking affects the stability and security of public chains, and Ethereum has never lacked narratives in this regard. It is believed that after the Shanghai upgrade, with the release of ETH tokens, the drive for arbitrage, and the development of LSD protocols, the staking rate of ETH will continue to rise.

Assuming the ETH staking rate can reach 60%-70%, there is still nearly five times the potential. Currently, the staking asset scale of the ETH Beacon Chain is about $22 billion. Without considering the price of ETH, LSD could grow into a sector with a trillion-dollar business scale.

2. Working Principle of LSD Protocol

Independent node validators need at least 32 ETH, and they cannot retrieve it before the Shanghai upgrade. The validators are responsible for adding new blocks to the blockchain, processing transactions, and storing data, which involves certain risks. Technical issues can easily lead to the loss of staked assets or rewards, and the high threshold keeps many ordinary users out.

The LSD protocol allows ordinary users to participate in staking and earn rewards without maintaining staking infrastructure. Additionally, the design of ticket assets releases the liquidity of ETH during the staking period, quickly attracting a large number of users and assets, developing into an independent sector.

The business logic of LSD includes three roles: ETH Stakers, Pools, and Node Operators.

Stakers provide ETH, Pools collect, manage, and distribute rewards, and Nodes execute the signing, validation, and block creation for the Beacon Chain.

Ordinary users deposit ETH into the Staking Pool, and the LSD protocol hands over the collected ETH to node operators, who perform signing and validation to earn rewards. In this process, operators need the validator's private key to complete the validation. However, if the validator's private key is directly handed over to the nodes, various malicious risks may arise. Therefore, DVT (Distributed Validator Technology) solutions like SSV Network and Obol Network, which fragment the validator's private key, have gradually developed.

3. Development of the LSD Sector

Currently, in the ETH2.0 staking market, the number of ETH participating in Beacon Chain staking has reached 16,006,711 (data as of 2023/1/12). The ETH captured by LSD protocols accounts for 32.8% of the share, while the ETH staked on CEXs accounts for 28.7%, and the ETH staked by Whales accounts for 23.5%. Staking Pools' DeFi protocols have staked 10.1%, and other individual staking nodes account for 4.9%. CEXs inherently have advantages, allowing one-click staking on centralized exchanges, yet the LSD protocol has surpassed CEXs to become the leader, highlighting its future development potential.

In the LSD protocol sector, there are currently nine projects that can be counted, including Lido, Rocket Pool, Stkr (Ankr), Stakewise, StakeHound, Cream, SharedStake, Staked Finance, and Frax Finance. Lido alone has captured 465,000 ETH tokens, accounting for 88.41% of the LSD sector's market share and 29% of the entire Beacon Chain staking market, surpassing the total amount of ETH staked on all CEXs.

Comparing the yields of various LSD protocols, Staking Pools, and CEXs, based on the yield backtesting data from the past 30 days, the performance of each platform in this regard has not shown significant differences, with average levels between 5%-5.5%. Therefore, APR is not a significant factor causing business disparities.

Recently, Frax Finance launched its liquid staking business, where Frax uses part of the protocol revenue to purchase FXS tokens, which are then distributed to staking users, translating to an APR of 7.69%. The higher yield quickly attracted a large number of users to participate in staking, with the staked ETH now exceeding 50,000, ranking fifth in the LSD sector.

4. Ecological Opportunities in the LSD Sector

As mentioned earlier, node operators need the validator's private key to complete the validation work. However, directly handing over the validator's private key to the nodes poses various malicious risks, leading to the emergence of Distributed Validator Technology (DVT).

1. DVT Sector

DVT splits the validator's key into multiple fragments and distributes them across different nodes. The validation work is completed collaboratively by multiple node operators, and no single node operator has the authority to independently complete the signing validation. This not only reduces the risk of malicious behavior by nodes but also addresses the single point of failure issue, thereby enhancing the system's robustness. Currently, the main solutions in the market are Obol and SSV.

SSV Network
SSV (ssv.network) uses Secret Shared Validator technology to encrypt and splits the validator key into four KeyShares among non-trusted nodes. If one of them goes down or fails, the other three can operate that node, solving the centralization issue of the validator key, making the Ethereum network more decentralized.

Obol Network
Obol (obol.tech) is a trust-minimized staking ecosystem focused on expanding consensus by providing permissionless access to distributed validators, enabling users to create, test, run, and coordinate distributed validators. It creates distributed validator clusters, allowing different validating nodes to come together as a single entity for staking. Individual stakers joining the cluster do not need to worry about single points of failure, making the normal operation of validators more competitive while minimizing the risk of centralized malicious behavior.

2. Re-Staking Sector

EigenLayer is a Re-Staking protocol built on Ethereum, allowing users to stake not directly on Ethereum but within Eigenlayer's smart contracts, which can then be re-staked to other protocols, such as sidechains, cross-chain bridges, and oracles. This enhances the security of applications, as many different entities within the ETH ecosystem have their own trust networks. The collapse of some of these trust layers could lead to vulnerabilities and hacking attacks, while attacking the network security shared through Eigenlayer would require greater costs.

Additionally, when users provide Re-Staking, they can also earn staking rewards from application layer projects, improving network security while enhancing the efficiency of capital use. EigenLayer will support Re-Staking for three types of assets: ETH, ETH LP tokens, and stETH LP tokens.

Through re-staking, utilizing existing trust networks to protect other infrastructure and middleware layers presents a broad prospect and is expected to become the consensus security hub of the LSD sector.

5. Conclusion

LSD is set to grow into a trillion-dollar sector, but this is only in terms of its business asset scale. The trading opportunities in the secondary market need to be analyzed in conjunction with the token's market capitalization and application scenarios. Furthermore, as the liquid staking sector explodes, there will also be Alpha opportunities in the derivative ecosystem related to LSD, as well as in the DVT and Re-Staking sectors serving components related to LSD protocols.

References:

https://dune.com/hildobby/ETH2-Deposits

https://ethereum.org/en/staking/pools

https://twitter.com/MaiaZhao/status/1595983351671795713?s=20\&t=ktcTIA6eVAjbFO5psbvXA

https://docs.ssv.network/

https://docs.obol.tech/

https://www.eigenlayer.com/research

https://www.panewslab.com/zh/articledetails/lj7plnf0.html