The Ethereum Shanghai Upgrade and the Future of Liquid Staking Derivatives (LSD)

Author: Newman Capital

The Ethereum 2.0 upgrade last September, also known as The Merge, witnessed Ethereum's transition from proof-of-work to proof-of-stake. This transition has seen improvements in the scalability and sustainability of the Ethereum network—breaking it down, proof-of-work (PoW) uses miners to solve complex mathematical problems to validate the Ethereum network, while proof-of-stake (PoS) relies on validators who "stake" or lock up Ether (ETH) as collateral to secure the network. The following chart reviews the two different consensus mechanisms:

After transitioning to proof-of-stake, Ethereum allows anyone to become a validator. By participating in validating transactions, creating new blocks, and maintaining the security of the chain, stakeholders earn rewards from the Ethereum network. While PoS is more energy-efficient than PoW, this process requires a significant amount of initial capital, up to 32 ETH. For the average ETH holder, this is a costly investment—its entry barrier is high, and the returns are minimal.

However, everything changed with the introduction of Liquid Staking protocols. Liquid Staking Protocols are emerging platforms like Lido and Rocketpool that allow anonymous users to "pool" their ETH together to act as validators for the network. Therefore, even ordinary ETH holders can participate in validating the network without needing to stake at least 32 ETH.

Liquid Staking Protocols and the Shanghai Upgrade

The development of Liquid Staking Protocols aims to increase the accessibility of Ethereum network validation and democratize the staking market. In this article, we will not compare products on an individual level, but rather revisit the topic of Liquid Staking Protocols from a broader perspective.

In a recent report, JPMorgan stated that they believe staking expenditures could surge from the current $9 billion per year to $20 billion in the few quarters following the launch of Ethereum 2.0, reaching $40 billion by 2025. Since the Merge, the amount of ETH staked in Liquid Staking Protocols has been on the rise. Although withdrawals from the Beacon Chain have not yet been enabled, the staking rate of ETH is impressive. We can see from the Nansen chart below that ETH staking has been increasing steadily, with approximately 16.3 million ETH staked at the time of writing.

Figure 1: ETH Deposited Over Time, Nansen

The following Dune Analytics chart provides us with a broader picture of the staking rate, with weekly staking amounts ranging from 80,000 to 600,000 ETH.

Figure 2: ETH Deposited to the Beacon Chain, Dune from Hildobby

Figure 3 from Dune Analytics breaks down the types of depositors on the Beacon Chain. While whales and CEXs initially became the largest ETH stakers, Liquid Staking Protocols have far surpassed them in market share.

Figure 3: Breakdown of Beacon Chain Depositors Over Time, Dune from Hildobby

The three data descriptions above clearly illustrate how current market participants view staking. Although withdrawals from the Beacon Chain are currently not possible, the data shows that stakers are still locking their ETH at high rates. This provides a bullish case for staking, as it indicates that users believe in the continued use of Ethereum and are willing to support their confidence by locking up funds to validate the network.

With the Shanghai upgrade approaching, EIP-4895 will be introduced, allowing validators to withdraw ETH that has been staked since December 2020. The Shanghai fork includes multiple EIPs, among which EIP-4895 is considered one of the most important proposals. Although ETH prices may experience some short-term downward pressure and volatility during the unlocking period, we remain optimistic about the future of Liquid Staking in the long term and do not expect any significant pullbacks.

We believe this because data shows that Liquid Stakers and long-term Ethereum network validators are not easily affected by short-term price fluctuations. First, addressing the issue of Liquid Stakers. Liquid Staking Protocols not only provide users with a CEX alternative for Liquid Staking (which, as mentioned, occupies 33.28% of the market share), but some protocols can also offer capital efficiency through products like Liquid Staking Derivatives (LSD). One example in this area is Alchemix, which allows users to borrow against staked ETH as collateral, enabling them to take out loans while still earning staking rewards. This indicates that once the ability to unstake from the Beacon Chain is enabled, there may not be a large-scale sell-off, as Liquid Stakers already have solutions to sell their LSD at any time, but they choose not to do so and should not be affected by short-term price fluctuations.

Figure 4: Alchemix Fi Vaults

When we look again at the analysis of stETH tokens regarding the last movement time, this argument is reinforced by the tendency of stakers to deploy long-term. The table below illustrates that the highest proportion of stETH holders have held their stETH for 90 days or longer.

Figure 5: stETH Token Tenure Distribution, Nansen

As for existing Ethereum before the Shanghai upgrade, many validators have already staked over 32 ETH in the previous system for months, some even for years, so the upcoming changes should not trigger a large outflow.

The Future of Liquid Staking

Overall, we believe that the staking market will continue to grow due to the ongoing improvements in Ethereum's economic model. As more transactions occur on-chain and ETH becomes more deflationary due to the burn rate compared to the issuance rate, Ether has the opportunity to become a more valuable asset, while all other assets remain unchanged. Coupled with the fact that the Ethereum network serves as the foundational layer for all DeFi activities, including but not limited to swaps, lending, and NFT financialization, ETH becomes an extremely attractive asset due to its various use cases.

In summary, we believe that there will only be more use cases developed for staked ETH in the future, leading to an upward trend in users staking ETH and using Liquid Staking Protocols. One example is Eigenlayer, a platform that reuses staked capital to secure intermediate layer networks, but an analysis of what their team is building and the more advanced applications of staked ETH could be split into a separate article. For now, we will leave the discussion here. Unlike other first-layer networks, ETH remains the most attractive due to its cost-effectiveness, accessibility, and positive sentiment, as users wish to earn fiat returns by staking ETH.

Figure 6: Blockchain Revenue and Market Share, Bloomberg