Ethereum Shanghai upgrade, how can established DeFi applications enter the LSD track to share the pie?

Author: Grapefruit, ChainCatcher

Ethereum will officially launch the Shanghai Upgrade on April 12 at 22:27:35 UTC (approximately 06:27:35 on April 13 Beijing time), at block height 6209536. At that time, ETH2.0 will support users in withdrawing staked ETH and rewards from the mainnet. Compared to the previous locked state, stakers will have more options, which will encourage more users to stake ETH on-chain.

According to Beaconscan, as of April 12, there are approximately 563,000 active validators, with over 18.17 million ETH staked, valued at about $34.5 billion, accounting for about 15% of the total circulating supply.

The StakingReward platform shows that the staking rates of other mainstream POS networks in the same category are mostly around 50%, such as Solana with a staking rate of about 70%, Avalanche at 66%, Polygon at 39%, and Near at 46%. Compared to these POS networks, Ethereum's current 15% staking rate has significant room for growth.

StakingReward platform staking rates

Many believe that the ETH staking rate could reach 50%-60% in the future, indicating that there is more than three times the current staking amount left to grow. LSD has a high potential to become a trillion-dollar business segment. This is also why the market for crypto assets related to the LSD sector has been leading up to the Shanghai Upgrade.

Currently, the LSD product sector can be divided into three main categories:

First, Ethereum staking infrastructure. This mainly includes DVT (Distributed Validator Technology) products represented by SSV, Obol, and Diva. DVT products aim to ensure the stability of Ethereum's block production while enhancing the decentralization of the network, diversifying validator nodes through techniques such as fragmented validation private keys and leader node rotation, thereby reducing single points of failure.

Second, liquid staking platforms. These primarily help users stake Ethereum more easily and with higher capital efficiency, which can be divided into centralized exchanges and decentralized liquid staking platforms. Common decentralized staking platforms like Lido, Rocket Pool, and Stakewise lower the staking threshold, providing opportunities for small funds and users unfamiliar with on-chain operations to participate in staking, while also releasing the liquidity of staked assets through staking receipt tokens.

Third, DeFi application products built around liquid staking tokens (also known as LSTs, referring to LSD assets like Lido's stETH). These will enhance the yield and liquidity of related LSD liquid staking tokens like stETH through various DeFi Lego combinations. For example, MakerDAO is about to launch a synthetic asset ETHD corresponding to LST (staking receipt), and Yearn is set to launch yETH covering a basket of LSD assets, among others.

After the Ethereum Shanghai Upgrade, staking receipt LST can be directly exchanged back for ETH, eliminating the previous decoupling risks. The price of LST anchored to ETH will become more stable, making it a high-quality asset like ETH. LST can be used as collateral in lending applications like AAVE or as leverage, and even serve as trading targets in some derivatives applications.

Ethereum staking may give rise to a trillion-dollar scale of LST, and this new asset is reconstructing and changing the income structure of traditional DeFi applications. DeFi products built around this new asset class may become new investment opportunities in the market.

In fact, these LSTs have already become important targets for established DeFi applications. Many of these applications are facing sluggish on-chain user growth, and ETH2.0 staking will prompt the outflow of ETH locked in their applications. Therefore, to maintain their TVL or find new growth opportunities, established DeFi needs to embrace LST assets and tap into the LSD sector to share in the benefits.

Currently, many DeFi applications have already benefited from these businesses. For instance, the liquidity building of LST/ETH may bring new business increments to DEXs like Curve and Balancer; in the lending platform Aave v3, users can borrow over 90% of ETH using LST assets (like stETH) through e-Mode.

So, how are established DeFi applications entering the LSD sector? They can be mainly divided into two categories: one helps improve staking-related yields and LST asset utilization, while the other helps enhance the liquidity of LST tokens.

1. MakerDAO, Frax, and Yearn are committed to enhancing LST token-related yields.

Currently, improving staking yields can be achieved in two ways: one is to enhance the capital utilization and yield of LST tokens, and the other is to directly increase the yield of LSD Ethereum staking.

1. MakerDAO launches the synthetic asset ETHD for LST tokens, collateralizing to mint DAI to improve capital utilization.

On February 9, MakerDAO co-founder Sam announced on Twitter the launch of the first lending application product of the Spark protocol, Spark Lend, and plans to introduce the synthetic asset EtherDAI (ETHD) to enter the LSD sector.

According to the MakerDAO community proposal, the Spark protocol is the first product developed by Phoenix Labs, a company founded by core members of the MakerDAO community, dedicated to developing new decentralized products to integrate into MakerDAO and help expand its ecosystem. All products developed will be owned by MakerDAO.

Spark Lend is the first product launched by the Spark protocol, a decentralized lending market built on AAVE V3 open-source code, allowing users to collateralize stablecoin DAI and other mainstream crypto assets (ETH, WBTC) for over-collateralized borrowing. Spark Lend is expected to complete product development in April this year.

Spark Lend product image

In the LSD space, MakerDAO enters the LSD market through EtherDAI (ETHD) and guides the use of ETHD through the Spark protocol, supporting ETHD as collateral to borrow DAI.

ETHD is a liquid staking product launched by MakerDAO, a synthetic asset of an LST token that aggregates various LST staking receipt tokens, aiming to keep all ETH tokens participating in staking under the control of MakerDAO applications. Here, users can wrap LST into ETHD or exchange ETHD for LST.

According to documentation, there are mainly two ways to participate in ETHD: one is for users to directly stake ETH to obtain sETHD with staking rewards, and the other is for users to mint or wrap their staking receipt tokens (LST) into regular ETHD at a 1:1 ratio.

In this mechanism, users can either stake ETH directly on the platform to obtain sETHD with staking rewards or mint LST into ETHD, then use sETHD or ETHD as collateral to borrow DAI, enhancing the capital utilization of LST tokens. For example, users of Lido's stETH or Rocket Pool's rETH can wrap stETH or rETH into ETHD to use as collateral to borrow DAI.

Two forms of EtherDAI

MakerDAO will have backdoor access to the collateral of ETHD and the ability to set the minting and burning permissions of ETHD.

To generate a large amount of DAI from the ETHD treasury, creating economies of scale and promoting user use of the ETHD treasury, the Spark protocol can guide demand for ETHD by adjusting the stability fee for minting DAI from ETHD. For example, the stability fee for minting DAI from ETHD can be temporarily set to 0 to incentivize users to use the ETHD treasury to generate DAI. Additionally, to enhance the liquidity of ETHD assets, a liquidity pool for ETHD/DAI can be created on Uniswap, and liquidity mining reward policies can be implemented to improve the liquidity and use cases of ETHD, attracting users to utilize ETHD.

Moreover, since Spark Lend is built on AAVE V3 open-source code, it also incorporates Aave V3's e-Mode module, allowing LST assets to be borrowed against ETH at a collateralization rate (LTV) of up to 98%. For instance, staking wstETH can allow borrowing up to 98% of ETH, increasing capital efficiency.

This means that whenever MakerDAO generates DAI from staked ETH in the form of the synthetic asset ETHD or accumulates staked ETH into its treasury in the form of ETHD, MakerDAO is guiding and promoting the growth of its TVL. In the long run, ETHD is as important as DAI.

After the Shanghai Upgrade, there will inevitably be a large-scale migration of ETH assets. MakerDAO's support for wrapping LST tokens into ETHD will prevent TVL shrinkage. Since TVL represents the locked value of funds within the protocol, an increase in TVL will lead to an increase in liquidity and availability, allowing the protocol itself to gain more substantial returns.

Additionally, through ETHD, users can achieve yield stacking, and the Spark protocol can attract more funds to lock in, encouraging users to utilize DAI. For example, users can stake ETHD on Sparklend to borrow DAI without losing ETH2.0 staking rewards, and can utilize circular borrowing to stake the borrowed ETH or DAI again or use them for other DeFi purposes, achieving yield stacking and improving capital utilization.

As of April 12, MakerDAO's ETHD has not yet officially launched.

2. Algorithmic stablecoin Frax launches frxETH to enhance ETH staking yields.

Frax.Finance is one of the earliest players in the LSD space, having launched the Ethereum liquid staking product frxETH on October 21, 2022, allowing users to lock ETH on its platform to earn Ethereum 2.0 (ETH2.0) block network staking rewards.

Currently, users on the Frax platform can lock ETH to receive frxETH. This process is irreversible and requires exchange on a DEX to convert back to ETH. Users must stake frxETH again to obtain sfrxETH to earn staking rewards. Additionally, users can provide liquidity for the frxETH/ETH pool on the Curve platform to profit.

The main difference between frxETH and staking platforms like Lido and RocketPool is that the staking yield of sfrxETH is higher than those platforms.

In a relatively equal Ethereum 2.0 block reward environment, how does Frax achieve higher yields?

Frax mainly adjusts the yield balance between "frxETH/ETH" and "sfrxETH" by influencing the emission of liquidity pool rewards on the Curve platform. The former is the trading fee income obtained by users using frxETH to form LP, while the latter is the ETH2.0 staking yield obtained by staking frxETH to receive sfrxETH.

For example, Frax can vote to increase the rewards for the frxETH/ETH liquidity pool on the Curve platform, incentivizing users to provide liquidity with frxETH. As the proportion of frxETH used to form LP increases, the amount of frxETH unstaked will decrease, thereby increasing the staking yield of sfrxETH.

For specific adjustment mechanisms, refer to the link: “How the Established Algorithmic Stablecoin Frax Finance Regained Its 'Status' with the LSD Trend”

3. Yearn launches a basket of LSD assets "yETH" to enhance yields.

On February 22, the yield aggregation platform Yearn officially announced the launch of yETH, covering a basket of LSD assets. According to the introduction, yETH includes various LSTs, diversifying investment risks while enhancing investment yields.

According to community users' speculation, Yearn's yETH is built on liquid staking platform LSD's ETH staking receipt assets like Lido's stETH and Frax's frxETH.

Users can deposit LSTs like stETH, frxETH, etc., into yETH, and Yearn can utilize algorithmic strategies to maximize the yields of these staking receipt assets while also benefiting from the governance resources of veCRV held by Yearn itself. For instance, creating a yETH/ETH LP liquidity pool on the Curve platform, Yearn can vote to guide the CRV emission rewards for that LP pool to maximize returns.

yETH product speculation image

Additionally, community users have explained that Yearn's yETH and Frax's frxETH do not directly compete, as the underlying supporting assets of yETH are not ETH but rather stETH and frxETH and other LSD staking assets, providing higher yields for holders of stETH and frxETH.

It is important to note that the above product structure is merely community speculation. As of April 12, the yETH product announced by Yearn has not yet launched and has not disclosed much information.

Second, Curve and Balancer focus on enhancing LST token liquidity.

Whether LST asset prices can anchor to ETH is an important indicator of whether an LST asset is of high quality, as this not only reflects market confidence but also indicates the stability and popularity of the LSD asset itself.

For instance, Lido's stETH experienced price decoupling during last year's industry events like the Luna collapse, causing many users to worry about potential cascading liquidations; however, it quickly regained its peg.

After the Shanghai Upgrade, LST will support users in directly withdrawing ETH on-chain, significantly improving price fluctuations and stabilizing prices.

Before the Shanghai Upgrade, DEXs were the necessary channel for LST assets to exit. After the upgrade, due to the limited daily withdrawal of ETH on the Ethereum chain, DEXs will still be the most important exit channel for LST tokens, as exchanging LST for ETH and other assets on DEXs is quick and convenient. Additionally, LST tokens can be viewed as stablecoin trading pairs, with low market-making risks and considerable returns.

Currently, users mainly exchange LST assets on the Curve and Balancer platforms. To maintain the stability of the anchored ETH price for LST tokens and provide a better user exchange experience, sufficient liquidity must be present in the liquidity pools on these DEX platforms.

LSD projects often attract more LP funds by providing higher yield incentives for their liquidity pools on DEXs, offering greater liquidity and a better exchange experience to capture more market share. Therefore, DEX platforms like Curve and Balancer naturally become important battlegrounds for LSD projects competing for liquidity. The increase in LST tokens will drive up the TVL, trading volume, and revenue of DEXs.

1. Curve and Convex - The first battleground for LST asset liquidity competition.

Before the Shanghai Upgrade, the Curve platform had become the preferred trading platform for exchanging LST tokens. Additionally, it supports users in providing liquidity for the LST/ETH liquidity pool to earn trading fee shares.

After the Shanghai Upgrade, although users can directly withdraw staked ETH using LST, due to the limited number of daily withdrawals and the complexity of the withdrawal process, Curve will still be an important trading exchange platform for LST assets.

The liquidity depth of the LST/ETH liquidity pool determines whether there is a price difference or slippage when exchanging LST for ETH. The previous instances of stETH decoupling from ETH were due to insufficient liquidity depth in the stETH/ETH liquidity pool.

This also means that if project parties want to maintain a stable exchange rate between stETH and ETH, their corresponding LST/ETH liquidity pool needs to have sufficient depth. At this point, LST issuers need to take some incentive measures to attract users to provide liquidity for that pool to support the trading and exchange needs of their issued assets. On the Curve platform, project parties often guide the CRV emission of the corresponding liquidity pool through the voting weight of their held veCRV, ensuring that the yield of their liquidity pool is higher than that of other competing pools, which is known as the LST War.

Convex, as the yield governance platform for Curve, controls over half of the Curve voting rights (veCRV), effectively determining the distribution of CRV rewards, making it a significant battleground for liquidity competition.

According to the Curve.fi official website, on April 12, the daily trading volume of the stETH/ETH liquidity pool on the Curve platform was $64.31 million, with a TVL of $1.67 billion, far surpassing its flagship stablecoin 3Pool (USDC/DAI/USDT) liquidity pool (TVL of $490 million), and the ETH/frxETH liquidity pool has a TVL of about $140 million. Such a large TVL provides sufficient liquidity depth for stETH, ensuring its redemption capability without worrying about the price decoupling of stETH assets.

Among them, the stETH/ETH locked on the Convex platform accounts for $895 million, while ETH/frxETH has $136 million.

ETH/stETH has become the largest liquidity pool on the Curve platform by TVL.

Currently, on the Curve platform, the main liquidity pools competing for liquidity are Frax's frxETH/ETH and Lido's stETH/ETH.

Frax holds about 20.5% of the Convex governance token CVX, and it influences the weight of CRV reward emissions for Curve's liquidity pools through CVX voting, adjusting the yield of its Curve LP liquidity pools, which can not only increase the depth of the corresponding liquidity pools but also adjust the staking yield of the assets.

Based on Yearn's launch of the yETH product, this project will also be involved in the LST liquidity war: by creating a yETH/ETH liquidity pool on the Curve platform and utilizing its held veCRV to vote on the emission of that liquidity pool.

It is reported that Yearn holds twice as many veCRV as Frax, indicating that the future yield of yETH/ETH will also be higher than that of frxETH.

2. Balancer and Aura Finance: The second battleground for LST asset liquidity competition.

According to data from the Balancer official website, on April 12, the top three liquidity pools on the platform were wstETH/WETH (TVL of $320 million), BAL/WETH (TVL of $250 million), and rETH/WETH (TVL of $80.17 million); the first and third pools are both LSD assets, with wstETH from Lido and rETH from Rocket Pool. Additionally, there are pools for Frax's sfrxETH, Coinbase's cbETH, and other LSD tokens on the platform.

This indicates that Balancer has become another major trading ground for LSD tokens besides Curve. Among them, the rETH/WETH liquidity pool from Rocket Pool is the most liquid among all DEXs.

Liquidity pools on Balancer

Moreover, compared to Curve, Balancer has a unique Vault liquidity pool mechanism that can reduce GAS fees involved in trading across multiple liquidity pools, providing a better user experience.

The Balancer V2 version separates trading logic (AMM) from the Vault liquidity pools, with trading logic (AMM) existing in a separate smart contract; the Vault primarily manages the tokens in each Balancer pool, calculating the amounts for swaps, additions, and exits.

In this model, the trading logic AMM smart contract acts more like a plugin, transforming Balancer's architecture into a "liquidity pool + pluggable trading" structure. Under this architecture, the AMM trading mechanism and logic can be customized, and the liquidity pool only needs to execute according to the final results of the AMM's trading, saving users from multi-step GAS fees in token transactions.

Balancer V2 architecture

In previous DEX platforms, asset exchange paths often required trading across multiple liquidity pools to achieve the final exchange result, a process known as multi-hop trading, which consumes a lot of GAS fees.

For example, exchanging BTC for stETH on Uniswap requires first converting BTC to WETH in the BTC/WETH asset pool, and then converting WETH to wstETH in the WETH/wstETH liquidity pool to complete the final exchange. This process often incurs substantial GAS fees.

BTC exchange path for stETH

However, in Balancer V2, all tokens in the liquidity pools on the platform exist within the Vault contract, allowing direct execution of the transaction to exchange BTC for stETH, saving the logical GAS fees incurred from jumping across multiple asset pools, also known as BatchSwap (batch trading).

This also means that all LSD assets deposited in Balancer's liquidity pools can seamlessly utilize its Vault liquidity center for trading, such as directly exchanging stETH for BTC or DAI, USDC, etc. In contrast, on the Curve platform, exchanging stETH for DAI requires involving three liquidity pools, first converting stETH to ETH in the stETH/ETH pool, then converting ETH to USDT in the ETH/BTC/USDT pool, and finally converting USDT to DAI in the 3crv pool.

In March 2022, Balancer launched the veToken model veBAL, allowing users to lock LP assets in a 4:1 ratio of BAL/WETH (BPT) to obtain veBAL.

For LSD projects building pools on Balancer, maintaining long-term vitality requires keeping sufficient liquidity in the liquidity pools. The best way to attract liquidity is to enhance the BAL reward distribution weight of the pools, and the only way to do this is through voting, either bribing veBAL holders or purchasing BAL/WETH to lock for voting. Currently, LST asset issuers influence the BAL emission of their liquidity pools by controlling veBAL voting, increasing LP yield rates.

For example, Rocket Pool's rETH corresponds to the rETH/WETH pool on Balancer. The higher the BAL reward distribution weight of this pool, the more people will be attracted to stake ETH in Rocket Pool to obtain rETH, and then provide liquidity on Balancer for mining, increasing Rocket Pool's market share in the LSD sector. Simultaneously, the higher the liquidity of the pool, the lower the risk of rETH decoupling, leading to a better trading experience.

Aura Finance is the veBAL yield governance platform on Balancer, established by former Sushiswap CEO 0xMaki. Aura Finance's relationship with Balancer is similar to that of Convex with Curve, with Aura's core functions resembling those of Convex. According to Dune data, Aura holds 26.2% of veBAL, making it an important battleground for liquidity competition.

The advantage of Balancer in the LST liquidity war lies in its higher bribery capital efficiency compared to Convex, with data showing that Aura's capital efficiency is 47% higher than that of Convex.

However, according to Aura's official website, the TVL of the rETH/WETH liquidity pool is only $7.456 million, which is significantly lower than the TVL of related LST token pools on the Convex platform.

It is reported that Aura Finance has established partnerships with almost all mainstream LSD protocols, including Lido, Rocketpool, Frax, Swell, Stakewise, Stader, Ankr, and StaFi.