👉 News. By switching to Proof-of-Stake, Ethereum no longer works with miners (like Bitcoin) but with validators.
👉 Background. To become a validator, you need to tie up 32 ethers (over 40,000 euros) on Ethereum.
👉 Why it matters. Lido is a pretty ingenious protocol that allows anyone to become a validator without necessarily having 32 ethers.
For the past week, there has been a sense of relief in much of the crypto ecosystem. Ethereum's Merge, which we explained to you in detail over the past two weeks, went very well. The blockchain is still working and consumes much less power than before - a 99.5% drop - thanks to Proof-of-Stake. Perfect, you may say!
Except that this update has also changed the way Ethereum works, which no longer runs in exactly the same way. It is no longer miners (Proof-of-Work) who run the protocol, but validators.
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However, to be a validator, to participate in the network and to earn cryptos (ethers in this case), it is necessary to "store" (immobilize) 32 ethers. Even if the prices have fallen sharply, this represents more than 40,000 euros! And imagine if the prices go back to their level of 2021 (more than 150.000 euros)... Not very democratic and decentralized all that. Fortunately, solutions exist.
There are two main ones:
- Immobilize your ethers via an exchange platform like Kraken or Binance. This solution is the easiest for beginners because there is no technical complexity and no minimum threshold is required (no more 32 ethers!). You can currently expect about 4% annual return via these platforms. On the other hand, it is a very centralized option. You are forced to trust Kraken or Binance who hold your crypto-currencies and can take a significant commission on *staking* rewards.
- Go through a decentralized liquid staking provider(liquid staking). It's a bit like using an exchange platform, but without the exchange platforms: the ethers you place remain associated with your wallet (non-custodial). Lido, Rocket Pool and Stakewise are the main protocols in this field.
We're going to focus on Lido in particular, as it is the largest and most innovative player in the industry. To date, about $6 billion worth of ethers have been placed in Lido, which represents 30% of the Ethereum validation market.
How does Lido work?
Although Lido is commonly referred to as a validator, it should be described as an "intermediary" of validators. All funds that Lido receives are actually distributed to 29 companies that specialize in validating transactions on Proof-of-Stake protocols. They are selected by Lido's governance (the holders of its LDO token).
The advantage of this system is that there is no minimum deposit for users. "Lido democratizes access to staking for crypto holders who don't have the amount of money needed to have an entire node," stresses Stanislas Barthélémi, a blockchain and crypto-asset consultant at KPMG.
When the user deposits his ETH in the Lido smart contract, he instantly receives its equivalent in stETH. "This is the first DAO to offer such a service, which is a significant advantage over competitors," he says.
Simply put, it's like your bank giving you a document that certifies that you have funds in an escrow account to use as collateral.
Why use Lido?
The stEH offers a major advantage because it allows the representation of ETH to be used while they have been immobilized. "This makes it possible to have a liquid version of one's investment, which can be reused as collateral in decentralized finance protocols," continues Stanislas Barthélémi.
Example of a farming loop developed by Hugo Panczak, co-founder of the White Loop Capital fund:
A person who holds stETH can collateralize them on the Aave protocol to borrow as many ETH as possible. Once this is done, he can exchange his freshly borrowed ETH for stETH on the Curve protocol (to take advantage of the slight difference with ETH). With these new stETH, one can again exchange ETH for other stETH on Curve, before putting them as collateral on Aave in order to increase one's health factor and reduce liquidation risk.
This system can theoretically yield about 8% per year at the current rate, compared to the 4.90% yield proposed by Lido.
The other advantage of stETH is its high liquidity. It can easily be exchanged for other tokens.
While owning a stETH is guaranteed to be convertible into an ETH in the future (probably in early 2023), its price can sometimes fluctuate relative to the underlying asset. At the height of the spring crash, the price of stETH fell to 0.88 ETH... Conversely, it also means that there are some nice arbitrage trades to be had 😎.
How much can you earn with Lido staking?
Lido offers one of the best staking yields, but can never be higher than that of an individual validator. And for good reason: Lido charges a 10% commission to pay validators and to feed the cash flow of its DAO.
Currently, Lido's rate of return is around 5% per year, but experts estimate that it could rise to 8%. As the number of Lido users increases, the value extracted from staking will increase.
This is far superior to exchange platforms such as Coinbase or Kraken which offer 1 to 2% less.
Is it risky?
Thanks to the transparency of the blockchain, it can be constantly checked whether the ETH deposited in the validators correspond to the number of stETH issued by Lido. Contrary to what one might fear with a classic player, there is no risk on the level of the reserve.
On the other hand, as the funds are deposited via smart contracts, there is always the possibility that the latter could be attacked. It cannot be repeated often enough, zero risk does not exist. What is certain is that the Lido code is audited every year by specialists: Quantstamp (December 2020), SigmaPrime (December 2020), MixBytes (April 2021), StateMind (September 2022).
How is the governance of Lido organized?
This is surely one of the weak points of Lido: for the moment, the LDO token holders (who ensure the governance of Lido) are highly concentrated in the hands of the team developing the project and the venture capitalists (Andreessen Horowitz, Paradigm, Alameda, etc.).
"Like many DAOs, decentralized governance via a token is a red herring. More than 64% of Lido's tokens are held by investors, team members or selected validators," points out Stanislas Barthélémi.
Does Lido present a centralization risk for Ethereum?
Not for the moment. Because Lido is not a centralized player, but is "a proxy for 29 different companies", reassures Stanislas Barthélémi. "However, this could change if tomorrow Lido no longer has a sufficiently large competitor and maintains such concentrated governance," he moderates. "In the same way that there are several stablecoins, there should be other protocols offering a tokenized version of staking," he continues.
In detail, the distribution of funds among Lido validators seems rather balanced. None of them can control more than 1% of Ethereum's staking. Another important point is the geographical distribution of validators. "We will have to continue to improve the geographical distribution of these companies in order to avoid an over-concentration in the United States," Stanislas Barthélémi emphasizes. And quite quickly! The American stock market regulator (SEC) has just explained that Ethereum could fall under its jurisdiction because many validators are in... the United States.
