The Birth of LSDfi

https://medium.com/intotheblock/the-birth-of-lsdfi-b06e084d185a

A successful Shapella fork has paved the way for a new market of DeFi products

The successful Shapella fork has brought forth a mental shift in how users now interact with ETH and its Liquidity Staking Tokens (LSTs). The risk of not knowing when you could unstake your ETH is gone and now users can move freely (with some limits) between staked ETH that earns yields to secure the blockchain and unstaked ETH. This change in accessibility has substantially reduced the risk of staking ETH, turning staking yields into the de facto risk-free rate of holding ETH. This has subsequently reduced the risk of holding LSTs. While some of the protocols have yet to implement a redemption process, the success of the fork has reduced many users’ concerns and the deep liquidity pools for many LSTs means swapping back to ETH at a good rate is easily feasible.

The New Marketshare Battle

As users will now be able to switch more easily between the different Liquid Staking Derivative (LSD) protocols, a new competition between the protocols will begin to attract and retain stakers. This competition will be driven by three main components:

Liquidity: This will continue to play a large role in competition between LSTs, especially in the short-term for those that have yet to enable withdrawals. Furthermore, as transactions and volume on Layer-2 (L2) chains begin to outpace mainnet, there will be more competition to become the primary LST on the L2s. Having a large enough LST supply to provide sufficient liquidity for protocols on the L2 chains to prioritize adoption will require a strong incentive push to get users to migrate off mainnet.

Source: ITB, Etherscan, Arbiscan, Optimistic Etherscan, Polygonscan

Incentives: Providing incentives for users to adopt an LST has always been a priority for LST protocols. Pre-Shapella incentives were focused on pools in AMM protocols to increase liquidity and get ETH holders to stake in their LST protocol. Now that redeeming LSTs for underlying ETH is possible, users have the ability to switch between LST protocols to find the best staking APR. This will mean that on top of providing incentives to external DeFi protocols to promote users supplying their LSTs to the ecosystem, the LST protocols will also need to stay competitive on the staking APRs they provide. This will come in the form of integrating MEV-boosted rewards and also potentially reductions on staking commissions that they charge.

New Use Cases: While related to the previous two components, the creation of new use cases for LSTs is where much of the competition amongst protocols will be in the post Shapella ecosystem. In the long-run, holding LSTs will likely be seen as equivalent to holding ETH. This means that LST protocols will need to differentiate between themselves by their useability. The one difference with holding an LST is the yield it earns from securing the network. Being able to unlock this steady yield with new DeFi products is what will be the new catalyst for user adoption of a specific LST.

Yield Bearing LSTs + New DeFi products: Welcome to the world of LSDfi

The Rise of LSDfi

LSDfi refers to the new world of potential products that harness the yields earned on LSTs. This potential has been one factor in why we continue to see growth in market share for many of the LSTs. The chart below highlights this growth, with Lido and RocketPool being some of the largest gainers in the last week with many US based CEXes being the biggest losers.

Source: ITB, Dune Analytics (As of April 26, 2023)

These new products and protocols being developed on top of LST protocols will have different goals and mechanics from many of the familiar DeFi primitives. For this reason, it will be important to dig into the design of each protocol to understand how yields are generated and what are the added technical and economic risks.

New and Revamped DeFi Products

Stable and consistent yields generated from LSTs make them appealing assets to build new DeFi products on top of. In addition to new products, now that staked ETH can be withdrawn, some existing DeFi products have seen new life breathed back into them. Below are some of the categories that could see success in LSDfi.

Loans

Self-repaying loans and borrowing future interest are some of the types of loans that could see large success using LSTs. While these already exist, protocols with these products could see increases in TVL in the near future.

An older protocol that has seen a resurgence, partly due to LSDfi, is Pendle Finance. This protocol allows you to buy assets at a discount now if you agree to receive that asset at a later date. This design works well for LSTs by effectively using some of the staking yields now to acquire the asset later.

Leveraged Yield

also known as leveraged staking. New and existing protocols will most likely look at new ways to unlock more capacity in this category.

Yield DeFi

Decoupling the yields earned from LSTs to develop a marketplace that is focused on different yield tokens. Yield swaps to hedge on which LSTs will have the best staking rates and derivatives, such as options, to hedge against drops in yields will be some of the products we will see in LSDfi.

UnshETH is a new protocol aiming to create a LSDfi marketplace. On top of building a yield marketplace, they have an added mission to improve validator decentralization among the different LST protocols. In this regard, they plan to create validator dominance options as a way to hedge against certain validators gaining too much marketshare.

Liquidity Aggregator

Harnessing the veTokenomics that were popularized by Curve, liquidity aggregating protocols are emerging that will have DAOs to vote on providing liquidity for protocols to bootstrap new pools or provide more depth to attract swaps from aggregators. Think something similar to Tokemak but only for LSTs.

Agility Protocol is an example of this new liquidity aggregator design. Framing themselves as a liquidity layer for LSDfi, they aim to use their pooled LSTs and ETH to “lend” out to other protocols that need extra liquidity in their market places.

The protocols listed here are examples of how LSDfi is being implemented. IntoTheBlock does not endorse any of the protocols specifically and users should always research each protocol in depth to find the products that suit their risk profile.

Not all that is shiny is gold

With all DeFi trends, there is a rush to the market to try and capture initial liquidity and attention of users in the ecosystem. While some of these products and protocols will last, the majority will most likely have short lifespan. It is important in these situations to dive into the protocols to better understand the products and their potential longevity.

Understand where the yields come from

Several protocols that have recently launched in LSDfi are aiming to attract liquidity through high APRs. In these cases the important questions to ask are:

If offered APRs are higher than that of LSTs

Where is it coming from?
What risk does it add?
Is the user forfeiting ETH APR for a higher APR in another token?

How do Protocols Hold on to Liquidity

Protocols will often try to dissuade mercenary liquidity that comes to farm its pools and then leaves when the high yields dry up. Therefore, many protocols will put some sort of disincentive in place to deter users from withdrawing their liquidity so freely. These disincentives are often in the form of liquidity lock ups or redemption fees.

Revisited Tokenomics Designs

While new protocols may not be a fork, it is common to reuse certain tokenomic designs from previously launched protocols. When this is the case, review the other protocol where the design was taken from. If the protocol was not successful, it is worth understanding what went wrong and if these same problems could arise in the new protocol.

Roadmap Risks

While the new LSDfi protocol might check all the right boxes above, a roadmap full of exciting new upgrades and features can also present risks. Each new code change should be audited, but even then, exploits can sneak through. This is additionally important for protocols that have liquidity lock ups.

Conclusion

LSDfi is here. New products and protocols are popping up weekly since the successful Shapella fork. There will surely be some successful and innovative products among what will launch in the coming months. These successful protocols will be able to attract the attention of the LST protocols as they try to expand the use cases for their token to further increase their own market share. However, as with most trends in DeFi, there will be many unsuccessful launches and so it is important to do research into these new products.

The Birth of LSDfi was originally published in IntoTheBlock on Medium, where people are continuing the conversation by highlighting and responding to this story.

The Case for a Decentralized 3Pool

https://medium.com/intotheblock/the-case-for-a-decentralized-3pool-33a70ecc3e8d

With recent volatility amongst stablecoins and the upcoming launch of Aave’s GHO and Curve’s crvUSD, the time is right to make a change to one of DeFi’s most well-known stablecoin pools

The last year has been a volatile period for stablecoins. Two major existential events have forced crypto users to rethink the normally non-volatile stablecoin markets. The first large shock was the total collapse of UST. The collapse of the algorithmic stablecoin brought into question the feasibility of the entire algorithmic design. The second shock is the recent depegging event of USDC. What had been seen as one of the most resistant stablecoins in the ecosystem, was momentarily at the mercy of the traditional finance world, when two banks that it operated with collapsed. This left users unable to redeem their USDC for USD during the weekend of March 10–12 and subsequently induced a run in the markets as people traded their USDC for other stablecoins. The chart below highlights the peak panic price of about $0.94 on Saturday, while it was still unclear if USDC was fully backed and users were not able to redeem.

These two events highlight two points on the outlook of stablecoins in the crypto ecosystem, collateral backed stablecoins are currently the best way to hold value in non-volatile assets and there needs to be more stablecoin options that are decentralized.

The upcoming Aave GHO and Curve crvUSD stablecoins both satisfy the two points above. In addition, they are being launched by two of the most successful and longest enduring protocols in crypto. Both being slightly different versions of a collateralized debt position (CDP) stablecoin issued by two of the four largest protocols by TVL, positions these stablecoins to have initial rapid growth and adoption.

To continue the effort in the crypto ecosystem to mitigate centralization risks while providing stable assets that can hold value, the idea of a new CDP 3Pool (GHO,crvUSD,DAI) should be considered as an option that can help achieve those efforts.

To better understand the implications of a new CDP 3Pool, we will dive into some of the underlying aspects of the upcoming GHO and crvUSD stablecoins. Then we will compare differences between the original and newly proposed 3Pools.

Make the Crypto World GHO ‘Round

While a deep-dive into GHO mechanics can be found from IntoTheBlock here, this article will focus on three components of GHO that are relevant for its resiliency in a pool:

Pegging mechanisms

GHO will primarily rely on market forces to maintain its peg. Since GHO will be redeemable at $1, if it is trading above or below the peg on the open market, users are incentivized to bring it back to peg. Above $1, users can mint GHO and then sell it on the open market, pocketing the premium and paying back the loan when it has re-pegged. Below $1, users that have open mint positions are incentivized to buy GHO from the market at a discount to pay back their loan.

Bad debt prevention

The main preventative measure against bad debt for GHO will be both the choices of collateral used to mint GHO and the flashmint function that will be enabled. Currently most of the collateral on Aave v3 markets are well-known assets with high market caps. This means that manipulation of these assets will be difficult and should reduce the risk of bad debt. These collaterals paired with the flashmint function that will work similar to a flashloan and will mint GHO repay a loan and liquidate the collateral in one block. This should reduce complexity and potentially reduce the cost of GHO liquidations.

Utility

While all potential utilities are unclear with GHO not yet launched, strong use cases are important to drive demand. GHO already has many utilities that should make it a popular choice. Using the testnet for GHO as an indicator, minting GHO should be relatively cheap compared to borrowing other stablecoins which will incentivize users to pay off loans of other stables to mint GHO instead.. The testnet currently states interest rates for minting GHO between 1.62–2.02%. With low rates, new opportunities will arise, such as rate arbitrage between stablecoin markets on Aave and cheaper long/short strategies for other assets. Another utility that should arrive around the same time as GHO is Aave’s portals. This will allow users to transfer GHO between chains without a third-party bridge, eliminating many bridge risks.

crvUSD on the Horizon

Curve’s crvUSD appears that it will launch after GHO and many of the specific details on general interest rates to mint and collateral to be used are still unknown. However, from the whitepaper that was released last year, the three components like what was reviewed above for GHO are available:

Pegging mechanisms

crvUSD, similar to GHO, will mainly rely on the markets to arbitrage the prices back to peg. If a depeg occurs for a prolonged period, the crvUSD design will have an Automatic Stabilizer mechanism that will mint or burn crvUSD to bring it back to peg.

Bad debt prevention

Curve’s novel LLAMMA (Lending-Liquidating AMM Algorithm) model is designed to gradually sell off collateral as its price drops. This gradual liquidation design means that there should always be sufficient collateral to cover and pay off the loan. However, if for some reason liquidations are not happening via LLAMMA, external liquidators will be incentivized to liquidate the positions.

Utility

A clear utility for minting crvUSD is the gradual liquidation design that is implemented in the LLAMMA model. This will provide more flexibility in using the crvUSD positions as hedging strategies because you will only get gradually liquidated instead of having a 30%+ loss of collateral immediately. Though it is not confirmed yet, another potential utility is being able to unlock capital in LP positions by using them to mint crvUSD. This feature would have a large impact on liquidity in the market.

Traditional 3Pool vs. New CDP 3Pool

The original

The original 3Pool consisting of USDT,USDC, and DAI is one of the largest and most well known pools on Curve. At its peak, it held over $6B in assets and with the use of Curve’s Stableswap AMM, it is able to make large swaps between the three stablecoins with minimal slippage and price impact to the user. However, TVL has been in a slow decline. The bear market has definitely had its impact on total liquidity in the pool, but low incentives compared to pools found in other protocols has also taken its toll. This is where a CDP 3Pool could have an advantage.

CDP 3Pool

After the UST and USDC events of this year, it is safe to assume that there is a growing appetite for collateral backed decentralized stablecoins. Just on this alone, a CDP 3Pool makes sense and will most likely get immediate traction. However, another advantage of this pool is the possibility for a coordinated rewards scheme from each of the stablecoin’s protocols. Since each protocol has a governance system, token, and treasury set up, a coordinated voting effort to incentivize the pool could produce attractive yields for the pool creating a flywheel effect encouraging more minting. Aave governance has already started a conversation about GHO liquidity incentives, indicating that there will be a push by Aave to build GHO traction and deepen liquidity pools. Furthermore, if the 3Pool were to be on Curve, veCRV voters would have an incentive to vote for rewards to be directed to this pool as they will receive rewards from the fees generated by crvUSD.

Final Thoughts

A criticism to the creation of this 3Pool is that it could further fragment liquidity by splitting pool TVL between the original 3Pool and the new CDP 3Pool. While this could be the case, these two stablecoins will be launched regardless. This could be an opportunity to change liquidity in the ecosystem in a way that brings more decentralization with comparable security.

The CDP 3Pool would have a lot of potential. Synchronized efforts in incentives and governance between Aave, Curve, and Maker could push this new pool to become one of the largest stablecoin pools in the space. It is not easy to determine how much TVL the pool could attract in the beginning, but as an indicator, there is 3.3M stkAAVE in the Aave safety module. This means that $330M GHO could be minted at a 1.62% interest rate. Even if a third of this went to the CDP 3Pool and was matched with equal amounts of crvUSD and DAI, the pool would already be nearly 75% the size of the current TVL in the original 3Pool.

The Case for a Decentralized 3Pool was originally published in IntoTheBlock on Medium, where people are continuing the conversation by highlighting and responding to this story.

Euler Exploit: IntoTheBlock’s Risk Radar Perspective

https://medium.com/intotheblock/euler-exploit-intotheblocks-risk-radar-perspective-8dccf125db5d

Reviewing how the Euler exploit looked from IntoTheBlock’s DeFi analytics and a reflection on risk in the DeFi ecosystem.

On March 13, 2023, right before 9AM UTC, an attack began on the Euler protocol that took advantage of an exploit in their code to steal approximately $197M worth of stETH, wstETH, WBTC, USDC, DAI, and WETH. Euler has published a thread detailing the incident, showing that even with multiple audits and reviews of the code, there is always a non-trivial chance that a vulnerability can be found.

While this exploit was a technical attack on the protocol, the attack can be seen through IntoTheBlock’s (ITB) economic risk indicators in the Risk Radar Dashboard for the Euler Protocol. Below we will dive into some of the indicators that show the attack in process and reflect on some different ways the DeFi ecosystem as a whole can work to mitigate risks and losses.

Brief Summary of the Exploit

As the attack has been explained in detail already many times such as that by Omniscia and Igor Igamberdiev, we will briefly go over the key points of how the attack took place.

There were multiple attacks from the same hacker that took place over the course of about 20 minutes (8:50 AM to 9:08 AM). Each attack targeted a specific asset market on Euler and the hacker used unique contract addresses for each market. This is seen through IntotheBlock’s liquidation history indicator where each liquidation in the highlighted boxes has a separate borrower and liquidator address.

Each attack followed the same general process:

Acquire an amount of the targeted asset through a flash-loan from another protocol (Aave and Balancer in this case)
Deposit about 2/3rds of the acquired amount into Euler to mint ETokens (token representing a lending position in the market)
Leverage the position about 10x to mint more ETokens and newly minted DTokens (representing a debt position in the market)
Use the remaining ~1/3 of the flash-loan amount to repay a portion of the leveraged position to reduce the DToken position
Leverage again to mint even more ETokens and Dtokens
Finally, donate a portion of the ETokens to the reserve (burning these ETokens)

This sequence puts the hacker’s position below a health factor of 1, which opens the position for liquidation. Due to a portion of the ETokens being burned through the donate process, there is an imbalance in the total amount of ETokens and DTokens in the position. The liquidator contract processes the liquidation based on the manipulated difference between the ETokens and DTokens repaying the hacker for the liquidation at a rate higher than it should have been.

As seen in the chart above, each attack was an atomic transaction where everything occurred in the same block. This means that countermeasures on any of the individual attacks would have been difficult, with one of the only potential solutions being a MEV bot front-running the hackers liquidations process. Mitigation could have potentially been possible after the first attack since several blocks elapsed before the following attacks began. This could have been possible by some sort of “circuit-breaker” style function that pauses markets after abnormal activity occurs in the protocol, such as a liquidation that is near to the size of the entire tvl of the protocol the block before.

The Exploit Through Charts

Initial red-flags that a potential exploit is occurring can be seen through the rapidly increasing TVL and recursive lending supply share in the Euler protocol. Over the course of an hour, we can see a 22x increase in supply volume in the protocol.

The rapid increase in supply occurs simultaneously with the spike in Health Factors below or near the liquidation point as seen below.

In both of these charts we can see that enough time had passed that some individuals had begun to take notice that an attack was happening. However, with many of the markets already exhausted of borrowing capacity, users who had supplied to these exploited pools were not able to remove their liquidity. This caused a cascading effect where the users of exploited pools began to borrow other collaterals to try and recover some of the stuck assets. As the USDT pool was already at max capacity with users performing a long USDC strategy due to the depegging event that began the previous week, the only pool with a large capacity still available to borrow assets from was the cbETH pool.

The exodus to this pool can be easily seen through the recursive borrowing chart above. There had been initially little borrowing on the cbETH pool, with ~99% of the borrowers doing recursive lending to farm EUL token rewards. However, after the hack, we see a sharp drop in the ratio of recursive borrowing and a large inflow of non-recursive borrowers seeking to pull some amount of value out of the protocol.

Risk in DeFi

Economic and technical risks are still widely prevalent in DeFi. This is unfortunately highlighted by the Euler protocol, which stood out as a protocol for risk management with multiple audits, bounties, and analytics to track the protocol. The best that the ecosystem can do is to continue learning and supporting each other through improvements in practices, standards, and innovations to mitigate known and unknown risks and to have a secondary plan when the worst still happens.

Risk Analytics

There is still a lot to be done in the space of developing risk analytics for individual protocols and the ecosystem as a whole. IntoTheBlock has been developing risk metrics for several years now for our clients to help with their risk management and strategies. However, we believe that it is important for the larger DeFi community to have access to high-quality risk indicators that we have been using internally for years. This is why we have begun to partner with multiple protocols to develop risk dashboards in our Risk Radar Platform that are publicly available for anyone to use. With more and more protocols building risk indicator dashboards, there is a larger potential for multi-protocol risk analysis to be done which can help prevent certain economic attacks on specifically lending and collateralized debt position (CDP) style protocols. Increased risk analytics for each protocol that are publicly available will benefit the protocol itself, but also have a positive spillover effect on the entire ecosystem as it makes it easier to track risks and money movement across protocols and chains.

Insurance as a Standard

Another space that needs more development are DeFi insurance markets. This has long been a topic of discussion within IntoTheBlock and is summarized here by our CEO. Insurance markets are vastly underdeveloped in DeFi compared to other financial products such as lending and exchanges but are a critical piece of infrastructure in a financial system. Fortunately, there are protocols that are solely focused on insurance products and other protocols that incorporate internal insurance designs into their protocol, but a general push for greater innovation and native products is needed. For now, there are some possibilities that could improve loss recoveries from hacks and exploits that could work in the current system.

Streaming revenue sharing to insurance fund at protocol level

A protocol could incentivize an insurance fund internally or with an outside insurance fund by creating a revenue sharing mechanism. Individuals who stake assets in the fund would receive a portion of the fees generated by the protocol. If an exploit occurs, the funds would be used to compensate the users of the protocol.

Redirected token rewards to safety module at boosted rate

This is an adaptation of Aave’s safety module, but the idea would be similar. A safety module is created to compensate users for exploits or potentially bad debt. However with this system, the idea would be that users of the protocol are receiving incentive rewards for using the protocol, but there is an option to divert your rewards to the safety module. If a user chooses to divert their rewards to the safety module, they receive a boosted amount of rewards. If the protocol is exposed to a loss, these individuals are eligible for higher compensation.

Conclusion

At IntoTheBlock, we are saddened by the exploits that occur far too often in DeFi. The Euler exploit was especially saddening as we have worked closely with the Euler team to build their Risk Radar dashboard. While we hope the best for the Euler team and community on their road to recovery, the best step forward for the rest of the DeFi ecosystem is to learn from the exploit and support each other. At IntoTheBlock, we believe that our risk indicators can be a good step in the right direction and we are open to partnering with any interested protocols to develop risk dashboards to be available for the entire DeFi community.

Euler Exploit: IntoTheBlock’s Risk Radar Perspective was originally published in IntoTheBlock on Medium, where people are continuing the conversation by highlighting and responding to this story.

Ethereum Withdrawals: Liquid Staking Derivatives Edition

https://medium.com/intotheblock/ethereum-withdrawals-liquid-staking-derivatives-edition-ff8e02d19946

Overview of the unstaking process for individuals stakers in the largest liquid staking derivative protocols after the Shanghai fork.

As the Shanghai/Capella fork approaches, there is an increasing focus on how users will be able to withdraw their staked ETH. A couple weeks ago, IntoTheBlock’s Juan Pellicer wrote about the withdrawal process for validators, explaining the types of withdrawals and how long they will take to process.

This post builds on top of that and examines how each of the largest liquid staking derivative (LSD) protocols will process withdrawals from their platforms. Specifically, we will dive into how the withdrawal process will look for individual stakers that are not running a validator. Below we dive into the current information available from Lido, Rocket Pool, StakeWise, and Frax on what their redemption process will be and how the differences could affect holders of each the different LSD tokens.

LSDs Gaining Momentum

Since Ethereum’s merge to Proof-of-Stake last September, user confidence has been growing in LSD tokens. This has been exemplified by the growth seen in users holding LSD tokens outside of the most well known token, Lido’s stETH. The chart below shows the day over day growth of addresses holding one of the 4 decentralized (excluding cbETH) LSDs with over 100M worth of supply. While they have all been increasing in holders of the course of the past year, we can see the biggest growth in new addresses for Rocket Pool’s rETH and Frax’s sfrxETH tokens. The most notable growth in addresses clearly being for sfrxETH which launched only after the merge, but has seen significant growth due to its high staking APY.

Though there has been substantial user growth in the smaller LSD protocols, the lion’s share of the total staked ETH in LSDs belongs to Lido. The table below breaks down the largest ETH LSDs. With nearly 33% of all staked ETH under its purview, Lido dominates the LSD market. However, this means that there will be more scrutiny on how Lido designs its LSD redemption system to attempt to mitigate long withdrawal queues for their holders. If the queues get to long and DeFi users get anxious to convert their Lido LSD tokens, a run on swapping stETH or wstETH back to ETH in the market could have far reaching consequences in DeFi from drops in ETH prices and impermanent losses to LP holders to liquidations in money markets where Lido’s LSD tokens are used as collateral.

While long queues to redeem ETH from Lido could have a larger impact on DeFi, long redemption times for any of the other LSD tokens could impact holders of those tokens. With this in mind, we will summarize below the current redemption strategies that each of the LSD protocols are proposing to aid users in navigating the upcoming fork.

Lido stETH

Lido has extensive documentation and forum discussions around their withdrawal process. Lido estimates they could have 200,000 ETH available in the week after the fork as a buffer for initial withdrawal requests. This will help mitigate any runs on swapping out stETH to ETH in the market before the withdrawal request volume begins to stabilize. As withdrawal volumes stabilize, the protocol will rely on a two-mode system (Turbo mode and Bunker mode) they have developed to prevent any manipulations to the staking/unstaking process and to minimize any negative impacts to holders.

Turbo Mode

The default mode that Lido will use aims to process withdrawals for stakers as fast as possible. This means that under normal conditions, non-validator stakers wanting to withdraw their ETH will need to wait an estimated 2–7 days to be able to claim. In the first week after the Shanghai fork, wait time might be higher while long-term stakers look to withdraw some of their rewards that have been accruing, but the buffer pool in place should keep the wait time around the regular estimated wait.

Bunker Mode

Under catastrophic scenarios, Lido’s withdrawal process is switched to bunker mode. This mode is enacted if mass slashing events occur across a large portion of Lido’s Validators. The current threshold Lido has set is 600+ validators to be slashed in the same window of time. If this occurs, bunker mode is activated and the protocol waits for all losses from slashes to be calculated so that they can socialize the costs across all stETH/wstETH holders in an even manner. When bunker mode is activated, the amount of time before withdrawal is initialized will be longer than turbo mode. Estimates for withdrawal time will be between 6–18 days, but under a doomsday scenario it could take as long as it takes for a slashed validator to exit (~36 days).

Rocket Pool rETH

Rocket Pool’s core design of partnering individual stakers ETH with validators that only need to deposit a portion (8 or 16 ETH) of the 32 ETH needed to set up a validator. With this design, if validators are slashed, they will normally take the full slash of the cost which is absorbed by the insurance provided upfront by the validator.

To redeem rETH to ETH, there will be a pool where holders can perform the unstaking process. If funds are available in the pool redemptions will be immediate. A recent proposal has passed that will increase the size of this pool giving more capacity for users to unstake. In a worst case scenario, if available ETH runs to be redeemed, demand to swap will move to open markets and create a discount on rETH. This will create an arbitrage opportunity that can incentivize validators to exit their positions, adding more ETH into the pool.

StakeWise sETH2

Full documentation has not been provided yet by the StakeWise team, however initial proposals appear to be that sETH2 holders will be able to make claims against the deposit pool (max 32 ETH) that StakeWise uses for collecting enough ETH to create a new validator. Additionally, as sETH2 holders begin to request redemptions, the protocol will begin the process of having their validators exit to provide sufficient ETH for those who are requesting to redeem. If ETH is available in the deposit pool, redemptions sub 32 ETH could be near immediate. However, if the pool is empty, a validator would need to initiate the exit process which could take around 7–8 days (and up to 36 days if the validator is slashed).

This design could be susceptible to staking/unstaking gaming if there isn’t a robust way, similar to Lido, to socialize slashing costs. I expect that a detailed documentation will be provided in the coming weeks explaining the process.

Frax frxETH

Similar to StakeWise, there isn’t currently any documentation on how Frax will manage withdrawals of frxETH back to ETH. Conversations with team members have indicated that there will be a buffer pool to handle the withdrawals, but it is unclear if there will be a waiting period. Given Frax’s larger treasury and the design on how staking rewards are allocated between frxETH and sfrxETH, it can be assumed that a reallocation will be designed to support frxETH holders redeeming back to ETH. Announcements from the Frax team on how this will be designed should come out in the near future.

To Stake or not to Stake Post Shanghai?

The Shanghai fork prompts the question of what should be the expectations on how much ETH we should expect to be unstaked? This question is hard to answer since it will be significantly dependent on how smooth the fork goes and also the global macro outlook. However, with the Shanghai fork design, rewards accumulated to validators will be automatically distributed through a sweep mechanism that will occur on average once a week. This means we can assume that most validators will initiate a partial withdrawal (withdrawing accumulated rewards) within the first week after the fork. Looking at the distribution of how much ETH validators are holding in the chart below, we can make an estimation that about 834k ETH could begin the partial withdrawal process in the first week. If no validators had been recently slashed, this process could take potentially as little as ~5 days (total validators/(16 withdrawals per block * ~7200 blocks per day). This would amount to less than 5% of all staked ETH being withdrawn.

The second question is, if all this ETH is withdrawn where will it go? This question will be specific to each individual staker/validator. While some will realize profits on their rewards, others might reinvest into staking by creating new validators or minipools on Rocket Pool.

Another possibility is that this newly unstaked ETH will find its way into other DeFi protocols. A quick calculation of the weighted APY across larger (greater than $5M) ETH-based pools without IL shown on DefiLlama gives us an average APY of 5.25%. This is notably larger than the current average APY for staking in LSDs (4.4%). If this gap in yields drives some of the ETH into DeFi, it will be a substantial boost for LSD protocols since many of the high yield pools are paired with LSD tokens.

Summary

The design and mechanisms of how each of the LSDs will support unstaking vary substantially. Lido is taking a route where all unstakers will need to wait for some period of time, while Rocket Pool redemptions will be immediate if the ETH is available. On top of this, the potential for about 5% of all ETH to be withdrawn in the first days post-fork could cause a lot of volatility with significant opportunities for arbitrage between the different LSD tokens. The general consensus among LSD protocols seems to be that enabling withdrawals will prompt more ETH to be staked. However, the market likes to be contrarian. All of this means that during the immediate window before and after the fork, there could be large price fluctuations in ETH and potential temporary depegs of some of the LSDs. Pools partnered with LSD tokens could be exposed to substantial IL if a liquidity provider removed their position during this time. As a DeFi user, it is important to review the mechanics of each of these protocols and decide in advance of the fork how to position yourself.

Ethereum Withdrawals: Liquid Staking Derivatives Edition was originally published in IntoTheBlock on Medium, where people are continuing the conversation by highlighting and responding to this story.