Lido, Staked ETH and The Merge — VegaX Research Report

Throughout the digital asset landscape, one of the main focal points for developers and investors alike has been the launch of ethereum 2.0. The new and improved version of the Ethereum blockchain will use a Proof-of-Stake consensus mechanism to verify transactions via staking rather than the current Proof-of-Work model.

Proof-of-Work vs. Proof-of-Stake

Proof-of-Work systems require vast computing power as the integrity and security of the blockchain, which is upheld by miners engaging in a validation process. Miners essentially verify transactions using computer hardware. Miners of Ethereum are motivated by the chance to earn an amount of newly minted Ethereum. In doing so, they collectively validate transactions on the blockchain and prevent double-spending. Proof-of-Work systems consume a tremendous amount of electricity. ETH currently has an annual power consumption roughly equal to Finland and produces a carbon footprint equal to Switzerland.

The shift to a Proof-of-Stake system is expected to reduce Ethereum’s carbon footprint by 99.5%, addressing one of the major criticisms of Proof-of-Work systems. Proof-of-Stake systems rely on stakers of the native asset to verify transactions. Staking requires users to lock up a certain amount of cryptocurrency to participate in the transaction verification process. In a Proof-of-Stake model, an algorithm selects which validator gets to add the next block to a blockchain-based on how much cryptocurrency and the duration in which the validator has staked. Validators need to create new blocks when chosen and validate other blocks when not. Once a participant has validated the latest block of a transaction, other contributors can attest (confirm the block is valid). When enough attestations are made, greater than 50%, the network adds a new block. Currently, investors must stake at least 32 ETH to become an Ethereum validator; there are over 300,000 validators as of May 2022. However, users must be incentivized to lock up their assets — the current staking yield on Ethereum’s Beacon Chain runs around 4.3% to 5.4% annually.

ETH 2.0 Timeline

‘London’ hard fork (August 5th, 2021):

Following the Beacon Chain genesis, the “London” hard fork was largely instrumental in dictating the way miners interact and profit with Ethereum through various improvements such as EIP-1559. EIP-1559 was focused on increasing the mining speed of its native currency ether (ETH) and incentivizing it. This hard fork’s significance is derived from the substantial changes to Ethereum’s monetary policy and the introduction of the burning of base fees in transactions. Along with a reduction in fees, another drastic change in the financial incentives for miners is the “difficulty bomb” that will force the Proof-of-Work consensus to stop producing blocks and therefore make it unprofitable to mine. The EIP-3554 included in the London hard fork delayed the time bomb to December 2021 and now it is delayed until September.

Altair upgrade (October 27th, 2021):

As the first scheduled upgrade for the Beacon Chain, the Altair upgrade imposed no changes to Ethereum front-end users but required node operators to upgrade their clients. Nodes that didn’t undergo any upgrades would risk not being able to participate in the network post-Merge and might pay penalty fees.

Ethereum merged on Kiln testnet (March 16th, 2022):

Ethereum reached a significant milestone in mid-March with the Klin testnet merge. This involved a Proof-of-Work execution layer merging with a Proof-of-Stake Beacon Chain. While the merging was largely successful, core developer Tim Beiko found that one client was not producing blocks as expected.

Mainnet shadow forks (starting April 12th, 2022):

In essence, a shadow fork is a test run of the Merge. Without actually impacting the network, they simulate what the shift from Proof-of-Work to Proof-of-Stake would look like by testing it on a small number of network nodes. After running shadow forks on several of its testnets, Ethereum developers began testing on Ethereum’s mainnet. Mainnet shadow forks, which simulate the Merge on Ethereum’s high-traffic primary network, test how the Merge would work under realistic conditions.

As an example, according to Ethereum Foundation developer Parithosh Jayanthi, the Kiln merge testnet was designed “to allow the community to practice running their nodes, deploying contracts, testing infrastructure, etc” the mainnet shadow fork goes a step further to stress-test the network. Credited to Van Der Wijden, it was noted as a historical event and key in determining the timing of the final merging.

Once the shadow fork went live, the developer team noticed some issues with Ethereum-based software systems provider Nethermind and Hyperledger Besu, a Java-based open-source Ethereum client.

Overall, five successful mainnet shadow forks through April and May 2022 (with more planned) have made Ethereum developers optimistic the real Merge might be around the corner.

ETH 2.0: Massive Improvements on The Horizon

The aim of Ethereum 2.0 is to fix high transaction costs, increase energy efficiency, lower the barrier for entry amongst validators and decrease the risk of network centralization. Although the rollout of ETH 2.0 has been delayed, the Ropsten testnet is officially the first testnet to be successfully merged and as of June 8th, reached 99.2% successful participation in the validation process.

Lido: Staking-as-a-Service

Lido is a non-custodial, cross-chain liquid staking protocol. Lido abstracts away the challenges and risks around maintaining staking infrastructure by allowing users to delegate their assets, in any sum, to professional node operators. In return, stakers receive a tokenized derivative that represents their claim on the underlying stake pool and its yield. These liquid staking derivatives, known as Lido-staked assets (stAssets), can then be traded or used as collateral on a number of popular DeFi protocols.

For Ethereum, Solana, Kusama, Polygon, and Polkadot token holders, Lido is simultaneously opening up the opportunity to stake while reducing the opportunity cost of staking by offering 1:1-backed derivatives of their staked assets. Lido democratizes access and creates a more robust DeFi ecosystem while leading to more secure decentralized Proof-of-Stake networks as Lido progresses along with its roadmap.

Why Is stETH Discounted?

stETH starting to drop in price relative to ETH is the latest event in an ever-growing line of bear market dramas that have arisen recently. stETH is the largest derivative asset held in the Lido protocol with the vast majority of protocol users choosing to stake their ETH in return for the derivative. Over the last few weeks, stETH has begun to trade at a discount to its underlying asset, ETH.

For most of its history, stETH has traded at par with ETH — the divergence in price began during the Luna/UST fiasco and has increased recently. The discount for stETH is around 6.4% at the time of this article. How the discount fluctuates going forward — and what that means for Ethereum holders — will likely garner increasing attention in the coming days.

Is This Really A Peg?

A common misunderstanding about stETH is that the price is pegged to ETH. This is incorrect. There is no “need”, for lack of a better word, for stETH to maintain a tight correlation to the ETH price. It doesn’t matter if it fluctuates 90% below the ETH price or 50% above it. Confidence in stETH cannot be lost because of price action; stETH is fully backed by ETH on the Beacon Chain. The factors that influence the price in the bigger picture are:

  • Liquidity discount because the stETH can’t be redeemed until after the merge
  • Appetite for earning yields (currently at 4%)
  • Risk premium because Lido has smart contracts and governance layered upon Ethereum staking

In practice, prices are determined by the marginal seller or buyer, and there’s only 1.2 billion worth of stETH and ETH in the main liquidity venue on Curve. Selling stETH for ETH in about the $200m range without buyers on the other side would essentially break the Curve AMM function and lead to a significantly lower stETH price. For long-term ETH holders, the current situation presents an interesting dilemma and opportunity.

The current market sentiment is negative and it appears that the chance of cascading liquidations is non-trivial. That would potentially push the price of stETH quite low (theoretically, to the 0.65 range). Therefore, it makes sense to wait because the arbitrage opportunity is simple — with the merge and visibility into withdrawals increasing, the stETH price will be fine in the long run, as long as nothing disastrous occurs.

Conclusion

The Ethereum IC boasts robust computational power and arguably the largest network effects across the digital asset class. The shift from Proof-of-Work to Proof-of-Stake represents a major milestone in the Ethereum roadmap and will help to reduce negative externalities such as intense energy consumption and instead create a more well-integrated digital economy across numerous chains. While stETH is still trading at a discount to Lido’s NAV, This can be viewed as a potent arbitrage opportunity where savvy investors can look to profit in the long run. The Ethereum Foundation has proven its ability to innovate at scale, but over the coming months, they face their biggest challenge to date; laying the groundwork for the future of Ethereum.

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