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Ethereum’s Shanghai upgrade has been the catalyst for the emergence of new financial demand for liquid staking derivatives, an emerging class of assets also called LSDs. Following a brief period of uncertainty about withdrawing capital, ether (ETH) staking participation has surged by 95% over the past year to approximately $41.6 billion from just over $22 billion, according to Dune Analytics.
This article is part of "Staking Week." Jordi Alexander is the chief investment officer at Selini Capital, and the chief alchemist at Mantle.
However, amid the meteoric rise of decentralized finance's (DeFi) latest investment vehicle, there’s a growing concern regarding the consolidation of power within the nascent sub-sector as large staked ETH pools accumulate across a small number of players. The emerging market of liquid staking derivatives finance, or LSDFi, is dominated by a select few.
With decentralization core to the blockchain ethos, Ethereum’s most vocal advocates have been united in spearheading distributed validator technology to quell centralization fears. As we inch closer to the next era of the ubiquitous smart contract blockchain ecosystem, what lies ahead for the future of staking? And could concerted collaboration in fact push the industry towards a more decentralized future?
First move advantage in a decentralized age
Understanding the reasons behind increasing centralization within the LSD market necessitates a deep-dive into the broader landscape. The premise of capital efficiency and long-term yields is an irresistible allure for retail and institutional investors alike.
The explosive growth of LSDFi, with its three-pronged offer of yield maximization, capital liquidity and network security validation has been garnering attention from players in conventional finance. At the same time, for crypto-native traders who approach Ethereum with a long-term horizon, active staking participation serves as a logical next step.
See also: Staking Brings Decentralization Back to DeFi | Opinion
This interest fueled the creation of a specialized LSD service offerings, donimated by a few early entrants. Critics of the nascent LSD market have argued this disproportionate control by a few potentially stifles equitable access and market advancement.
Post-Shanghai, the Ethereum upgrade that allowed validators to withdraw their staked ether, many stakers have withdrawn bulk of their ETH rewards and moved to popular LSD providers like Lido and Rocket Pool. These players were best positioned to capture these flows due to their potential for immediate liquidity through on-chain pools, expansive utility of liquid staking tokens as DeFi collateral and added accessibility to new staking innovations such as EigenLayer.
Issues around regulatory risk faced by centralized exchanges further encouraged the move towards liquid staking providers, who have yet to face such intense scrutiny. The first-mover advantage of these LSD primitives who established the initial infrastructure and liquidity pools resulted in a pendulum swing of market share distribution to be heavily weighted towards such players.
It’s important to note this was not a malicious orchestration. Dominance by players including the likes of Lido and Rocketpool is in code, and not control — rather, it’s a natural outcome that speaks volumes to daring innovation in uncharted terrain.
Efforts to establish effective governance over decentralized autonomous organizations (DAOs), which manage a number of crypto protocols including Lido, deserve further recognition for attempts to develop robust frameworks to advance decentralized and self-custodial ethics, enabling credible neutrality and permissionless innovation on Ethereum.
By allowing users to implement safe compounding yield strategies, alongside market-making opportunities to provide further earning potential, decentralized LSD providers, including Rocket Pool, Frax Finance and Lido, have brought significant merit to the Ethereum ecosystem by securing coveted institutional and retail buy-in.
Such trailblazers have strengthened the overall repute of DeFi and Web3 by credibly lowering entry barriers like high upfront capital, lock-in periods, complexities in technical know-how — bridging the gap to substantively, and sustainably, establish a new financial system.
Preserving permissionless: A subtle balance
Despite the momentum, crypto and DeFi are miles away from achieving the goal of mass adoption. At the same time, threats to crypto's core tenets of decentralization and self-custody grow more urgent as it incrementally reaches critical mass. Finding a way forward that preserves decentralization, noting the realities of today's market, is essential.
The latest push in distributed validator technology provides such a path towards a more decentralized and resilient Ethereum ecosystem. But keeping hold of crypto's core tenets in a fast-evolving industry requires deliberate action — not letting competition completely determine where the market will lead, and fostering cooperation.
By pooling the resources of decentralized protocols, layer-2 (L2) scaling solutions and DAOs, staking presents immense potential to expand the Web3 pie for all by proliferating unique LSDFi innovations in the market. This is another level of interoperability, not just at the technical level but making sure a contingent of the industry remains committed to decentralization.
On the building front, it is simply more cost efficient to deploy and maintain advanced DeFi protocols and other computing-intensive apps on L2s, which are seeing a jump in stakers and ousers of other LSDFi activities. Ethereum's emerging scalability solutions (and items in the pipeline like danksharding) are a pressure release for the World Computer.
By letting L2s take care of infrastructural tooling needs, developer support and liquidity provision, app teams are able to consolidate resources to focus on app-specific strategies.
I’m of firm belief that liquid capital will remain in LSDFi and, as a result, infrastructural ecosystems should be built for the user as well as the protocols. Growth and longevity across L2s will therefore need to cater to diverse DeFi user bases, while actively streamlining cross-collaborations to capitalize on synergies across platforms.
Take the tokenization of real-world assets (RWA): This sub-sector is gaining traction for use-cases that strike the balance between DeFi and centralized finance. Bringing RWA into the LSD realm is imminent as technically, anything that bears yield and is stackable could become an LSD.
Taking this a step further, there is potential for a decentralized stablecoin partially backed by both LSD and RWA primitives to supercharge an effective yield strategy and reduce dependencies on today's dominant providers. (The Mantle ecosystem is planning to launch an LSD product.)
See also: How Tokenized Governance Can Make DeFi More Resilient
Soon, we’ll also see LSD integrations into other DeFi sub-sectors such as perps and option markets. As mentioned, LSDs can be made from any yield-generating asset meaning this market can evolve in unpredictable directions.
This version of Web3 that preserves decentralization will depend on getting users to actively participate in token-governed technologies. This will require making staking more streamlined for users by increasing composability across the ecosystem, upending information asymmetry and taking a hands-on approach to what users want.
More needs to be done in cultivating a nuanced user understanding of ETH portfolio exposure that is not solely motivated by yield, but one that also recognizes the importance of the asset class’ long-term growth before appreciating the benefits of staking returns.
With all that is said, DeFi is still very much in its infancy. New components of DeFi will come into play with more regulatory clarity and technological advancements. As the LSD market continues to evolve, let’s seize this opportunity to course-correct, adhering to Ethereum’s foundational principles of decentralization, while propelling accessibility and innovation in a security-first way.