An Intro to Ethereum’s Proof of Stake Network

As of September 2022, Ethereum is now a proof of stake network, which reduced its energy usage and carbon footprint by 99.99%. Under this design, node operators (humans) will run validator client software on dedicated hardware devices. In turn, validators (software) are responsible for correctly proposing or attesting to new blocks that get added to the chain. To run a successful validator, node operators must deploy and maintain both a consensus client and an execution client.

To align incentives across the network of node operators, each validator is required to deposit at least 32 ether in a “validator deposit contract” that can be slashed in the event of misbehavior. This deposit acts as a node operator’s pledge that they will not take their validators offline or behave maliciously, thereby threatening the overall security of the network. Hence, the term “proof of stake”.

Right now, validators are rewarded in newly issued ether for performing consensus-related duties. While this rate of return is contingent on the number of validators that are actively working to maintain the network, the current staking yield sits around 4%. This would imply that a node operator, maintaining one validator that has deposited 32 ether as collateral would earn an additional 1.28 ether after one year.

The Problems with Running Your Own Node

Liquid staking tokens (LSTs) like Lido’s stETH were designed to address the following problems with the traditional staking process:

Accessibility: not everyone has access to 32 ether, limiting the amount of token holders that could successfully run their own node. However, according to members of the Ethereum community, the requirement of 32 ether represents a carefully considered balance between network security and accessibility. By lowering the staking requirement, it would therefore cost less (with less value at stake) to misbehave and threaten the network’s security.

Liquidity: during the initial phase of Ethereum’s merge to proof of stake, node operators were unable to withdraw ether from the validator deposit contract. However, withdrawals opened in April 2023, allowing node operators to access liquidity.

Opportunity Cost: while maintaining validators can earn node operators around 4% annually, there are currently risk-minimized opportunities to put ether to work across DeFi that earn well above 10%. As such, node operators must consider the opportunity cost of depositing ether in the validator deposit contract.

Lido and Liquid Staking Tokens

Lido’s stETH and other “liquid staking” tokens were designed to mitigate the problems mentioned above. Instead of having to operate their own node, token holders can earn the staking yield by simply exchanging their ether for a liquid staking token like stETH.

In the background, the Lido protocol batches user’s deposits (ether) and assigns them to a network of trusted node operators, who then use the ether to run their own validators. In return, any staking yield earned (net of slashing) is distributed between the Lido depositors and node operators, who capture a small management fee.

By design, LSTs like stETH are tokenized “receipts” of ether that have been sent to the validator deposit contract. The value of any LST is pegged to the underlying value of protocol deposits. In other words, if 1,000 ether has been deposited into the Lido smart contracts, then there will be 1,000 units of stETH in circulation.

So how exactly do liquid staking tokens mitigate the problems mentioned above?

Accessibility: users can deposit any amount of ether into Lido’s protocol in exchange for yield-bearing stETH. Unlike traditional staking, users do not need to deposit a minimum of 32 ether.

Liquidity: when withdrawals were blocked during the initial phases of Ethereum’s merge, tokens like stETH were easily transferrable peer-to-peer and therefore eliminated the liquidity issues once faced by node operators. If a stETH token holder wanted to generate liquidity, they could simply visit their favorite DEX and swap stETH (or wstETH) for a stablecoin like USDC.

Opportunity Cost: Across DeFi, LSTs can be used for lending, liquidity provision, and other activities, thereby “freeing” the staked ether that was otherwise unusable. As a result, holders of LSTs can benefit from the Ethereum staking yield while also boosting their yield by putting their tokens to work onchain.

Example: by lending stETH on Aave, a token holder could earn a boosted 15% yield which comprises the 3% staking yield and a 12% lending yield.

How Can You Acquire stETH?

To stake your ETH with Lido, you simply need to visit their DApp and swap ETH for stETH at a 1:1 ratio. This will increase the circulating supply of stETH in proportion to your deposit.

Alternatively, you could swap ETH for stETH (or wstETH) on a DEX like Uniswap at the same exchange rate. Although, this would not increase the circulating supply of stETH, and would simply transfer ownership of existing stETH from one user to another.

Accruing Yield on stETH

If the average staking yield over a given year is 4%, then how is this yield returned to holders of stETH? Well, in Lido’s case, they use a “rebasing” mechanism to inflate the total token supply in proportion to any staking rewards. Here is an example.

Assume that 100 users each lock 1 ETH in the Lido protocol in exchange for stETH. This means that the total circulating supply of stETH is 100 units, backed by 100 ETH. Now, after these deposits are made, the Lido protocol would deposit the 100 ether into the validator deposit contract, and then allow node operators to use these deposits to validate transactions.

Over the course of the next year, the node operators would earn a 4% staking yield from their activities in the form of ETH. They would get to keep 1% for themselves, and remainder would be distributed back to the Lido treasury. In other words, node operators would get to keep 1 ether, and the Lido DAO would keep the remaining 3 ether.

At this point, there would be 100 units of stETH in circulation, backed by 103 units of ETH. To ensure that the stETH:ETH ratio remains constant, the Lido protocol would initiate a token rebase - each depositor’s balance of stETH would therefore increase proportionally to their ownership of deposits prior to earning the staking rewards. As part of this rebasing mechanism, each user would simply see their balance of stETH grow by 3% automatically.

In this case, a user who deposited 1 ETH in exchange for 1 stETH would see their balance grow to 1.03 stETH after a full year. However, this rebasing mechanism doesn’t take place yearly, but daily. This means that stETH holders should see their token balance change marginally from day to day in proportion to the staking yield earned by Lido’s deposits.

For this reason, the ETH:stETH trading pair should trade at par across most exchanges. If the trading pair were to swing in favor of one asset over the other, then arbitrageurs would quickly trade away this imbalance.

Using stETH Across DeFi

Not all DeFi protocols are created equal. Protocols like Yearn and Curve can support rebasable tokens. However, others like Uniswap and Aave do not. This means that if you were to deposit your stETH into a liquidity pool on Uniswap, you would no longer capture the staking yield via a rebase. So how can we put our stETH to work across these DeFi apps without sacrificing the staking yield?

This is where the concept of “wrapping” comes into play. By wrapping one token for another, a user is essentially performing a token swap, receiving tokenB in exchange for tokenA. In the case of stETH, Lido has developed wstETH, a “wrapped” equivalent of their LST. While stETH benefits from a daily rebase, wstETH is not a rebasable token and can therefore be used more broadly across DeFi.

But how exactly is staking yield accrued to token holders if wstETH doesn’t rebase? Let’s refer back to our example from earlier.

Now, suppose that of the 100 stETH that was created in exchange for 100 ether, 50 stETH is instantly “wrapped” in exchange for wsETH. Lido’s balance sheet would therefore look something like this:

Assets: 100 ether

Liabilities: 50 stETH & 50 wstETH

Over the course of a year, a 3% staking yield would be earned on the assets that were initially deposited into Lido’s protocol. Thus, the value of Lido’s assets would rise to 103 ether. In parallel, the value of Lido’s stETH liabilities would rise to 51.5 ether, and 1.5 stETH would therefore be created and distributed to existing stETH token holders via the rebase mechanism. Now what about the remaining 1.5 ether that must also be accounted for?

Well, the value of the 50 wstETH would rise to 51.5 ether, but no rebasing would take place. In other words, the Lido protocol would not mint any additional wstETH to account for the staking yield that was earned. Instead, the value of each wstETH in circulation would simply rise relative to the value of ether. Initially, 1wstETH was worth 1 ether. Whereas now, 1 wstETH is worth 1.03 ether.

Then, if every holder of wsETH decided to redeem their wrapped tokens in exchange for stETH, the Lido protocol would return 1.03 stETH for each wstETH that is redeemed. On the other hand, if holders of wstETH decide not to unwrap their tokens, the gap between wstETH and ether would rise as more staking yield is earned.

Right now, Lido will redeem each unit of wstETH for 1.16 units of stETH. This would imply that across the pool of wstETH, there is 16% of “pent up” staking yield. While the wsETH: stETH exchange rate may vary by a few basis points across different DEXs, the exchange rate quoted directly on Lido’s front-end interface represents the “true” exchange rate. Across other DeFi venues, arbitrageurs would technically be able to buy/sell any differences until prices converge to that quoted by Lido.

What Makes Lido’s LSTs Valuable?

In the case of LSTs, liquidity is the name of the game. The more stETH in circulation, then the greater liquidity it has across exchanges. For example, if only 100 stETH tokens are in circulation, then a user would have trouble offloading 20 tokens at all once – this would cause significant price impact.

In this way, we can think of liquidity as a reinforcing moat for many DeFi projects and protocols. The more liquidity an LST has, the more users will be drawn to it… increasing liquidity even further…and the flywheel continues.

At the same time, composability can also be seen as a moat for tokens and their underlying protocols. For example, the more lending protocols that integrate stETH as “accepted” collateral, the more they reinforce its strength.