Digital assets: Liquid staking derivatives

The US Federal Reserve once again revealed the amount of influence it has on financial markets, specifically on digital assets. The interest-rate hike reflected expectations accurately and immediately translated into a positive price action for the entire asset class, fuelling a crypto-wide market-cap increase of almost 5%. Ether (ETH) rallied 6%, but it has not been the biggest winner lately as providers of liquid ETH staking derivatives surged, such as Lido.

While it is all about staking at the moment, the upcoming upgrade of the Ethereum blockchain will bring another test for the network. Even though cryptos have likely left the worst behind, we still believe there are many improvements to be seen on the regulatory side and much room to grow in terms of market development.

Macroeconomic headwinds have eased and a less punishing US Federal Reserve is bringing back some of the risk appetite for digital asset investors, but the most anticipated event in the space will be the upcoming Shanghai hard fork on the Ethereum blockchainWhy is this important?

The upgrade will bring back liquidity to those who have been staking the asset since December 2020, making a sizeable tranche of the total supply now liquid. Stakers are those that are directly or indirectly validating the proof-of-stake chain, by committing 32 ETH to a smart contract to activate validator software. Around 17 million ETH have been staked, which represents around 14% of the total supply. 

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With the upgrade, over 1 million ETH in accumulated rewards can be withdrawn at once, and 23,400 ETH will also be able to be withdrawn on a daily basis. Even though a large portion of the stakers have voluntarily committed their assets at higher price points, last year’s liquidity crisis will potentially lead some to withdraw the assets and write down the losses. 

Staking can take several forms, but the largest one is by far pooled staking, as it brings down barriers by offering the possibility to stake smaller amounts and avoid being an active validator. More importantly, it can be done in a liquid fashion by purchasing synthetics or going to centralised exchanges. Lido, which is a liquid staking provider and the largest holder of staked Ether, rallied strongly more recently. 

They produce a derivative token representing a claim on the staked asset; these tokens go by the tickers of STETH (rebasable) or WSTETH (non-rebasable). Both are highly liquid, with plenty of depth in the largest liquidity pools, and are currently one of the safest collateral types to be used in lending protocols. 

The rally is driven by the opening of new doors for Ethereum holders that were at first reluctant to stake because of the liquidity constraints. Even though the Ethereum upgrade will likely solve the largest issue with staking, and even though we believe the asset class has left the worst behind, we reiterate our assessment that more regulation and better governance will be required to restore confidence in cryptos.

Eventually, this should lead to a more developed market and a level playing field between decentralised finance (DeFi) and traditional finance (TradFi).