Lido Finance: The Risks of Liquid Staking Derivatives
The good and bad of LSD protocols
In this post, we will talk about:
Lido Finance and stETH
Risks of LSD Protocols
Unlike traditional finance where institutions and banks verify transactions, crypto requires individuals to validate networks. This is done through staking, a.k.a locking up your stake (portion) of the token supply. Stakers are then able to receive a percentage of the transaction fees as a reward for securing the blockchain.
One of the challenges with staking on Ethereum is the initial requirements. While you don’t have to buy mining rigs (like with Proof-of-Work Bitcoin), you do need to hold at least 32 ETH to start earning rewards. At the current ETH price of ~$2,000, the cost of becoming a staker is $64,000 - not exactly accessible for the everyday investor.
Lido Finance allows users to pool their ETH together to get around this constraint. Individual investors can stake any amount of ETH they want and earn an APR of 4% (lower than the current staking reward of 4.2%). The difference in APR (0.2%) is how Lido earns its revenue.
Since staking involves locking up the tokens, users lose the liquidity of being able to use these tokens on other applications. However, staking through Lido gives you a derivative asset called stETH, which can then be used across many ecosystem apps, such as Curve, AAVE, and Sushiswap. Users are able to benefit from the APR of these protocols while continuing to earn staking rewards on their Ethereum.
The mere existence of Lido Finance is bullish, both for ETH price and for Ethereum’s network security. By eliminating the lack of liquidity related to staking, Lido reduces opportunity costs and creates incentives for locking up tokens. More ETH locked up means lower circulating supply, and higher prices - making everyone happy in the process.
The Risks with LSD
Clearly, Liquid Staking Derivatives have been a positive force for Ethereum adoption. But, pooling a bunch of tokens together under one umbrella has inherent risks (that often get forgotten in the light of higher prices).
Centralization is the biggest concern when it comes to LSD protocols. As of today, about 32% of the staked ETH supply (~4 million ETH) is held by Lido itself. If the entity ends up owning more than 50% of the overall ETH supply, Lido could impose censorship on the Ethereum network, or at the very least, earn outsized profits through MEV extraction.
The problem becomes worse when considering the fact that the success of Lido Finance is now encouraging many competitors to spin out similar products. Other protocols such as Rocket Pool are following the same trajectory as Lido, and could very well end up owning large portions of the ETH supply. Some are worried that this might end with cartelization, where a few large players are able to control and determine the future of Ethereum.
The other risk lies within the peg mechanism of stETH to ETH. Without the 1:1 peg, holders are no longer incentivized to stake their Ethereum through Lido, which could mean a Terra-like bank run on the system. As we enter the depths of the 2022 crypto bear market, the peg has already come under pressure, signaling some distress in the mechanics.
Many Ethereum builders and researchers are already ringing the bell on the possibility of cartelization amongst LSD protocols. In my view, the community will force Lido Finance (and others) to impose self-regulating governance on node operators to minimize centralization.
In upcoming posts, I will highlight some steps Lido could take to best serve the long-term goal of Ethereum’s ecosystem.
To learn more about the protocol, check out Lido’s website here.