The Business of Liquid Staking
And an analysis of Lido Finance
Hello readers,
Welcome back for another edition of The DeFi Report. Liquid staking is emerging as a powerful new business model within DeFi. Meanwhile, the Ethereum Shanghai Fork updates — allowing for staked ETH withdrawals — are set to go live in March of this year. It’s time for a deep dive. In this report we cover:
The business model of liquid staking
An analysis of Lido Finance
Disclaimer: Views expressed are the author's personal views and should not be taken as investment advice. The author is not an investment advisor.
The DeFi Report is an exploration of the emerging web3 tech stack and an ongoing analysis of where value could accrue. We provide easy-to-follow mental models, frameworks, and data-driven analyses of DeFi and web3 business models.
Let’s go.
The Business Model
Liquid staking is a fairly straightforward business. These protocols allow anyone in the world to become a validator of a proof-of-stake network with a few clicks of a mouse. For example, if you want to make your ETH useful and earn a yield, you can connect your wallet to a website like Lido Finance and deposit into their smart contracts. Current yields are 5% APR (paid in ETH). Unlike many yields in crypto, this one is legitimate. Your yield will consist of user transaction fees, MEV, tips, and protocol inflation.
The benefits to the user are two-fold:
Have your cake and eat it too.
If you’re bullish on ETH, you probably want to hold onto it long-term. With Lido, you can do that while making your ETH a productive asset. But there’s more. When you deposit your ETH into Lido, you’ll get a certificate of deposit via a derivative token that represents your staked ETH. In some ways, we could analogize this to folks bringing their gold to a goldsmith and receiving a redeemable paper certificate back in the day. The paper certificate could then be used as collateral.
In the case of Lido, the certificate of deposit you receive is called stETH. stETH is accepted as collateral within most DeFi blue chips: Aave, Curve, Maker, Uniswap, etc. So, for those with excessive risk appetites, you can drop your ETH into Lido and capture a 5% yield. You can then take your stETH, and provide liquidity elsewhere in DeFi to earn additional yields. There is obviously risk here. If you got caught offside in a DeFi trade, your stETH could be liquidated. Now someone else has a claim on your ETH locked in Lido.
Ease of Staking.
You need to be pretty technical to set up a validator node on your own. You’ll also need to come up with 32 ETH to run your own node. With Lido, you just connect your wallet to a website and can stake as little as .1 ETH.
Lido takes a 10% cut of your yield for providing this service. That 10% is split between the DAO treasury and the network of node operators that sit underneath Lido.
Here are the 365-day total fees ($330m) and the 10% ($33m) captured by the protocol & node operators.
*Fees show Ethereum only, which is the vast majority of the network’s revenue today.
That’s really it. Lido combines a nifty website/front end with some well-designed smart contracts on the back end and a network of nodes underneath. They have 22 employees (per LinkedIn) and generated $33m last year for the DAO and node operators. Not bad.
Let’s dig in further…
Network Effect/Product Market Fit
A whopping 30% of the staked ETH is sitting within Lido smart contracts right now. This makes up about 95% of their revenues. Lido is providing the same service on Polygon, Solana, Polkadot, and Kusama. The protocol is now live on Optimism and Arbitrum as well — and is expanding to Near, Avalanche, and Cosmos — which are wide open for the taking as we speak.
Lido owns the market right now. And it looks like this could be a *winner take most* market. We’ll touch on competition and centralization concerns later in the report.
Addressable Market
This depends on where you see the market for proof-of-stake networks going. If you’ve been following along, you know that we believe there will a small handful (4-5) of major L1 smart contract networks at the end of the day. Meanwhile, about 1% of the population is using these things right now.
Lido’s revenues are pretty straightforward as far as modeling. We can forecast things like the growth of L1s, % of ETH staked, Lido’s market share, and the price of the native token on each chain to come up with a general direction of where things could go. For example, if we assumed that the % of ETH staked goes from 14% today up to 30% (most chains are 60% +), and Lido simply maintained its market share, this would double its revenues. And we haven’t even talked about the price of ETH. Let’s say ETH goes to $10k in the next bull run. We just broke the model. Lido’s revenues would jump to roughly $478m/year (again, half is paid to node operators) without any growth from the protocol. Never mind what happens if they expand their market share on Ethereum or capture 30% of the market on the other chains.
For this reason, we think a bet on Lido (or a competitor) represents a pseudo-leveraged bet on the future success of proof-of-stake public blockchains.
Tokenomics
Circulating Supply: 836 million
Total Supply: 1 billion
Future dilution: 16.4%.
Future Unlocks: The remaining tokens locked are investor/insider allocations. Most are on a linear vesting schedule and will complete their vesting around April of this year. Another 8.5 million tokens will unlock in August of this year.
The network does not burn or buy back tokens on any set schedule. The treasury could certainly do that through a governance proposal but nothing is in place at this time.
Token incentives: the network issues tokens to incentivize users and bootstrap liquidity (for the derivative/CD token) when they deploy to new networks. They also have issued tokens in the past to ensure the stETH/ETH exchange rate stays pegged. In total, they have issued $105m of token incentives since inception while generating $493m in total fees over the same time period.
Token utility: Used only for DAO governance voting today. Similar to most DeFi tokens that do not earn a yield/% of fees directly at this time.
Treasury
The on-chain treasury smart contract currently holds $354m. Plenty of runway for a small team. Note that the treasury value swings up/down based on the value of the LDO token.
Narratives
Liquid staking is a narrative that is picking up steam currently, and for good reason. EIP 4895 (Shanghai Fork) is projected to take place in March. The wave of updates from Ethereum devs will allow stakers to withdraw their ETH deposits. There are a few schools of thought regarding the implications of this. One group thinks it will introduce sell pressure on ETH with long-term validators running for the exits. The other school of thought sees it as a pivotal moment for sidelined stakers, creating a net inflow of ETH into staking contracts. ETH stake rate is currently about 14%. It’s over 60% on most chains.
We think we’ll see some initial selling activity from the long-term validators. As soon as that passes, we expect to see a steady increase in the ETH stake rate. The beneficiaries? Protocols such as Lido and their competition.
Investors
Lido raised a $2m seed round in 2020 which included a list of power names within DeFi. Folks like Rune Christensen (MakerDAO founder), Stani Kulechev (Aave founder), Kain Warwick (Synthetix founder).
Big VCs came on board in later rounds. Firms such as Paradigm, a16z, Coinbase Ventures, Dragonfly Capital, Digital Currency Group, Jump Capital, etc.
In total, the team has raised $167m across several funding rounds — the latest was 9/13/22.
Core Team
Konstantin Lomoshuk is the brains behind Lido. He was extremely early in the Ethereum community and participated in the initial ICO. He launched a staking company in 2017 and has been working on solving the liquid staking problem ever since.
The core engineers have deep, deep knowledge of Ethereum and are the pioneers of liquid staking solutions. Their close ties to the rest of the ecosystem and the OG entrepreneurs within DeFi give them a considerable edge over their competitors.
Competition
Coinbase has entered the liquid staking game and has 1.06m ETH staked right now (20% of Lido’s total). Coinbase is also the largest US exchange, and the most trusted centralized exchange in crypto. As such, anyone who is holding their crypto assets on Coinbase can earn yield by staking them through Coinbase infrastructure, without leaving their account. This is significantly less friction when compared to using Lido, and appeals more to less advanced crypto users. The trade-off? Coinbase takes a 25% cut of the yield they pay you — compared to 10% for Lido.
We expect all centralized exchanges to offer staking services. Kraken has entered the game and charges 15%. Binance started offering ETH staking in December and charges just 5% — the lowest take rate we’ve seen. Binance has lost millions of users of late and is likely using the low-cost staking program to lure them back. The key question to consider: what do future crypto users look like and will self-custody solutions become so easy that users can bypass centralized exchanges? Time will tell. If this is not the case, and future crypto users are looking for ease of use, they may pay high fees on centralized exchanges. More advanced users will seek solutions such as Lido and save 5-15%.
Rocket Pool is Lido’s largest decentralized competitor today. They have 379k ETH staked and take a slightly different approach. Rocket Pool allows anyone to be a node, and earn fees from passive stakers. In the case of Lido, they have a permissioned set of validators/node operators sitting underneath the protocol. Users pay 15% on Rocket Pool today and can stake as little as .1 ETH, the same minimum as Lido.
If you believe the future of staking is more decentralized, Rocket Pool would be a way to express that bet today.
Security Audits
Lido’s smart contracts are incredibly vital to the protocol and Ethereum ecosystem at large. A hack would be absolutely catastrophic. We are not experts here, so we have to rely on the auditors. Lido has undergone several audits and has passed all of them. You can learn more about that here, here, and here.
Lido has a robust bounty program as well, which encourages hackers to identify weak points. The protocol rewards these white-hat hackers with bounties of up to $2m.
Risks
Centralization risk. This has become a hot topic within the Ethereum community, and it should be. Lido became really big in a short period of time. It would not be healthy if Lido captured more than half of the ETH stake rate due to centralization and censorship concerns. As such, we think it will be difficult for Lido to grow its market share much larger than the current 30% — not only because of competition entering, but because the Ethereum community could introduce blockers. It’s a tricky problem. Should the Ethereum Community be stifling free market activity? Probably not. But the alternative is a massive centralization risk to the entire network.
Smart contract risk is another concern. The bounty program has created strong incentives for white-hat hackers to battle-test the contracts, which we always look for in well-run protocols.
Finally, competitors are entering the market and will continue to do so. Will a rising tide lift all boats? Will users flock toward centralized exchange alternatives? Time will tell.
Fair Value Assessment
Current market cap: $1.76 billion.
Fully diluted market cap: $2.1 billion.
We’ll note that Lido is currently near an all-time high in terms of its fully diluted market cap. Meanwhile, the price is $2.13. Lido peaked above $6 back in August of ‘21. This highlights why we should always assess a project based on fully diluted value. When lido was $6, its market cap was about $250 million. The price was able to get that high because of the low circulating float at the time.
Lido took in $333m over the last 365 days. 10% is kept by the DAO, which then pays out half to the permissioned set of node operators they work with. So, they kept $16.5m. From this perspective, the $2.1 billion valuation is way too high.
That said, is it fair to judge the protocol on the revenue they kept? What about all the revenue they created for others? Should that be factored into the valuation? From this perspective, we’d have to look at the full $333m. Now the valuation seems more reasonable. And what about the fact that users could earn those fees and also earn additional yields in DeFi with stETH?
It’s difficult to find a comp for a business model like this. This is a problem we often run into when assessing value for many web3 and DeFi business models. Value is often distributed outward, rather than inward with traditional business models.
We think it’s possible that Lido and other liquid staking protocols are ultimately helping to establish a base yield for each smart contract network. What’s that worth?
Lido controls 30% of the ETH staked in validator contracts securing the network as we speak. Meanwhile, Ethereum has a market value of $194 billion. 84x Lido’s.
Another way to analyze this would be to compare the fully diluted market cap to ETH staked for competitors. If we focus on RocketPool, we get 1,899x ($720m/379k ETH). Stakewise comes in at 1,807x. At 419x, Lido seems cheap on a relative basis using this metric.
Finally, we could compare Lido to some of the DeFi blue chips across a number of metrics: market cap/TVL, users, market cap/developers, value/user, revenues, etc.
The reality is that all blockchain assets trade expensive. We’re not looking to give you a buy/sell recommendation here, but rather a framework to think about relative valuation.
Liquid staking is a promising sector within DeFi that we’ll continue to monitor, especially as the Shanghai Fork updates go live in March.
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Individuals have unique circumstances, goals, and risk tolerances, so you should consult a certified investment professional and/or do your own diligence before making investment decisions. The author is not an investment professional and may hold positions in the assets covered. Certified professionals can provide individualized investment advice tailored to your unique situation. This research report is for general educational purposes only, is not individualized, and as such should not be construed as investment advice. The content contained in the report is derived from both publicly available information as well as proprietary data sources. All information presented and sources are believed to be reliable as of the date first published. Any opinions expressed in the report are based on the information cited herein as of the date of the publication. Although The DeFi Report and the author believe the information presented is substantially accurate in all material respects and does not omit to state material facts necessary to make the statements herein not misleading, all information and materials in the report are provided on an “as is” and “as available” basis, without warranty or condition of any kind either expressed or implied.