Lido Finance: First Look

11 min readDec 24, 2021

*Initially published May 3rd, 2021; Published again 12/24/2021*

Exploring an up-and-coming decentralized L1 staking service

“Lido builds state of the art liquid staking protocols to grow the staking economies”

Overview

Lido is a Decentralized Autonomous Organization (DAO) offering users yield on their Ether and other digital assets by use of third party staking services who stake the digital assets on the user’s behalf. Launched in December 2020 Lido currently oversees the staking of 738,210 Ether representing 10.9% of all Ether staked on Ethereum 2.0. It has a commanding lead for the liquid staking solution with 79% of the liquid staking market sharp and offers the premier liquid ETH 2.0 derivative with it’s stETH (staked Ether) token.

The DAO is governed by LDO token holders who vote on governance proposals. This article’s focus is the LDO token as an investment. Currently LDO is set up as a valueless governance token with none of the protocol fees being returned to LDO holders. In the future LDO holders could vote to utilize protocol fees to drive up the price of the LDO token through buy backs or directly delivering dividends.

Currently ~5% of the yield earned by users staking ETH on Ethereum 2.0 goes into the Lido treasury. At the current price of $3,100 per Ether this represents revenue of $6.87 million — $11.4 million per year from Ethereum staking alone. With a market cap of $145 million this gives LDO an estimated market cap to revenue ratio of 12.7–21. As Ethereum 2.0 gets closer to launch I expect staking with Lido to increase thus increasing their revenue. Also Lido is working on expanding the chains they stake on having already begun staking on the Terra blockchain with plans to introduce staking on Solana and other blockchains soon.

Lido faces numerous risks. Due to constraints on the Eth 2.0 chain Lido is not ideally decentralized with a large portion of the staked ETH being controlled by a 6 of 11 multi-signature wallet. Current Eth 2.0 architecture also puts Lido at risk of being griefed by the miners they have chosen as the Eth can be held hostage. Lido also faces competition from other liquid decentralized staking solutions as well as centralized exchanges like Binance, Kraken, and Coinbase. Lastly, LDO has questionable tokenomics with a great deal of the LDO tokens owned by early supporters of the protocol putting later investors at risk.

The Need for Liquid Staking Derivatives

Proof of Stake (PoS) is a consensus mechanism whereby Validators put at risk (i.e.stake) a digital asset in order to validate transactions on the network. If a validator correctly proposes blocks to the network AND has minimal time off network then they are given the block reward as well as the network fees from the blocks they mine. If a validator proposes invalid or malicious transactions or if they are off the network for a prolonged period of time (power outage, internet down, hardware failure, etc) then their deposit gets ‘slashed’ as a penalty.

In December 2020 Ethereum began Phase 0 of its long awaited migration to PoS Ethereum 2.0 with the launch of the Beacon Chain. This chain currently has limited functionality simply serving as a live testnet to sort out any unknown bugs. While it is still somewhat experimental it uses real Ether for staking and mints real Ether to reward validators. There is currently no way to transfer any Ether earned on the Beacon Chain so there is no way to buy or sell it making it completely illiquid. This illiquidity is an obvious risk to anyone wanting to be an Eth 2.0 validator as transfer functionality is not expected to be available until October 2021 at the earliest (more likely Q1 2022).

Lastly, it takes a minimum of 32 Ether to stake on Eth 2.0 as well. At the current price of $3,100 this represents a $99,200 investment. Running an ETH 2.0 node also requires a moderate amount of technical ability. Thus we see there are 3 major problems facing the average Ethereum investor when it comes to staking: Cost, Illiquidity, and Complexity. These combine to make running a personal validator on Ethereum 2.0 out of reach for most retail investors.

Lido and the stETH token

Lido solves the three major problems of Eth 2.0 staking through the use of professional staking services and the stETH token.

Lido solves the cost and complexity problem through the use of professional staking services. The DAO partners with reputable staking services to stake users’ deposited Eth. These stakers go through a vetting process overseen by the DAO to ensure they are trustworthy and high quality. The use of professional staking services off-loads the complexity of Eth staking from users. Also, users’ capital can be pooled together into 32 Eth bundles allowing users with any amount of Ether to participate in Eth 2 staking. In return, staking services are awarded 5% of the staking yield (with another 5% going to the DAO and the remaining 90% being returned to users).

Lido solves the liquidity problem with stETH, a token distributed by Lido representing staked Ether. stETH is pegged 1:1 with Ether locked on the Beacon Chain. When users deposit Eth into the Lido staking contract they receive an equivalent amount of stETH. The stETH smart contract is a rebase contract. These contracts automatically adjust, or rebase, user account balances at regular intervals based on specific parameters, in this case how much Eth is held by Lido nodes. So as Lido nodes accrue Eth rewards on the Eth 2.0 Beacon Chain the amount of stETH in users’ wallets increases. Conversely, if a Lido node gets slashed, the amount of stETH in users’ wallets goes down with the decrease in Eth held by staking nodes.

If a node gets slashed or otherwise loses Ether the loss is socialized amongst all stETH holders. This mechanism keeps stETH tokens fully fungible with each other as there was discussion of having specific tokens be bonded to specific validators however this would mean not all stETH tokens would be valued equally. The Lido Treasury does buy insurance against ETH losses by staking nodes and currently uses Unslashed to insure 5% of all of the staked Ether. Losses greater than 5% would be backstopped by the Lido Treasury.

In the future when transfers between Ethereum 1.0 and Ethereum 2.0 are enabled a trader will be able to swiftly arbitrage any deviation in the stETH peg. If stETH falls below peg a trader would buy stETH on the market with ETH then unstake the newly bought stETH yielding more ETH than when they started. When stETH goes above the reverse trade could be performed until fees make the arb unprofitable.

Currently, however, Ether on the Beacon Chain cannot be moved in any so there is no such arbitrage trade to keep the stETH token pegged 1:1 with ETH at the present moment. The Lido DAO has so far successfully used LDO mining incentives to maintain the 1:1 peg (blue line in above chart). Since the stETH token is designed to be pegged 1:1 with ETH, Lido has heavily incentivized the stETH/ETH liquidity pool on Curve, the premier AMM for pegged assets. Currently 67% of all stETH is LP’d in the Curve stETH/ETH pool. stETH stores on other exchanges do not come anywhere close to this volume.

This high level of liquidity in the Curve pool is incentivized via LDO mining. The Lido DAO has voted every month to extend LDO mining rewards to liquidity providers in the Curve AMM pool. The mining reward is 0.5% of the total LDO supply or 4.8 million LDO tokens given to LPs. As robust stETH/ETH markets are essential to maintain the 1:1 peg the Lido DAO expects to extend LP rewards until stETH is redeemable directly for ETH.

Lastly, the yield on stETH is slightly lower than the yield for staking on Eth 2.0. This is because stETH is minted and distributed immediately upon deposit of ETH into the Lido smart contract. However, there is a limit to the number of new Eth 2.0 validators that can be added every day. This creates a queue of 32 ETH deposits waiting to start validating on the Beacon Chain. Ether in this queue is not earning yield thus bringing the yield on stETH slightly below the yield of Eth 2.0.

stETH is the most popular Eth 2.0 derivative token on the market. It is accepted as collateral for loans on Maker, Aave, Compound, Inverse, and other lending markets. Other Eth 2.0 derivative tokens have much lower adoption and, as shown in the chart below, far lower market share.

Since Eth on the Beacon Chain is currently locked, stETH can be viewed as a perpetual Ether bond with dynamic yield dependent upon the yield of Eth 2.0 staking. With this in mind investors can calculate Yield to Maturity and compare it to similar ETH investments. A great writeup of this can be found here: https://medium.com/tally-blog/treasury-building-blocks-steth-c9073beb843e

Numerous DAOs are looking at using stETH in place of ETH in their treasury as a safe source of yield.

LDO Token

The LDO token is a valueless governance token used for voting in the Lido DAO. Supply is set at 1 Billion tokens. LDO was distributed at launch as outlined below. LDO tokens have been slowly emitted as LP rewards since January representing 4% of all LDO tokens which should be subtracted from the treasury.

The current estimated circulating supply is 28.4 million. The LDO tokens delegated to investors, founders, and other early supporters are locked from 1 year starting December 2020. These tokens will then vest over the course of 1 year (~0.3% unlocked daily).

The LDO token currently has no value accrual mechanism. Those buying it outright assume in the future a value accrual mechanism will be voted in by the DAO. This generally is avoided until projects are “sufficiently decentrallized” to avoid the unregistered offering of securities. Value accrual mechanisms include dividends and LDO buyback-and-burn strategies (the latter may not violate SEC rules). It is unclear when, if ever, such a value accrual mechanism will be voted on.

Considering LDO as an investment

The most concerning issue facing LDO as an investment for me is its poor distribution among retail investors vs founders/early investors. With the estimated circulating supply at 25–28 million this only represents 2.5% of all LDO tokens. 22% of the tokens remain in the Treasury leaving >50% of the tokens in the hands of early investors and contributors. These tokens unlock over 1 year starting in December. The currently circulating market cap of Lido is around $145 million putting it at rank #310 on CoinMarketCap. However the fully diluted market cap is $4.8 billion. It is unlikely all of the tokens in the LDO treasury will be divested any time soon however it is quite likely a large number of the LDO tokens held by insiders will come to market starting in December and continuing through the year.

LDO holders are governors of the LDO Treasury. The treasury currently stands as follows:

It is not clear but the ETH in the Lido treasury appears to be payment from early investors for equity in the protocol and is not anticipated to grow. The stETH in the treasury comes from the 5% rake Lido takes from all staking profits. With 739,575 ETH staked with Lido on Eth 2.0 and current staking APR of 6.5% Lido is expected generate 48,072 ETH in profit. With 5% of this going to the Lido treasury we would expect the stETH reserves to grow by 2,403 stETH this year or $7.45 million. It does not appear a substantial amount of stETH will be spent or otherwise used from the treasury.

LDO in the treasury will continue to decline as 0.5% of the total supply continues to be used monthly to reward liquidity providers. This will end when ETH 2.0 withdrawals are enabled (6–12 months away). LDO is also used to pay for insurance to protect against an up to 5% loss of staked ETH. LDO is also used to pay for research, protocol work, and employees.

The net value of the LDO treasury is $1.18 Billion assuming an Ether price of $3,100 and LDO price of $5. LDO represents 94% of this while ETH and stETH make up 6%.

If the crypto market heats up between now and December then LDO likely represents a good investment until December. With no way to value the valueless governance token the sky’s the limit to what investors could price it at. Further it has many high-profile backers who will likely help price along as their token unlock period nears.

Price has been constructive but not parabolic, generally following the market trend. It currently is hovering around its all time high. Again, if the overall market continue to run hot then I would expect LDO to follow along with it.

Another issue with the LDO token is it does not have a story or large community behind it. Uniswap has VC backing and tie-ins to TradFi. Doge, Yearn, and Sushi have vibrant communities of supporters with big ideas and visions. LDO is more akin to MKR with relatively limited vision and thus a relatively small community. LDO is working on adding more PoS blockchains which will enhance its revenue however with no value accruing back to the LDO token it is unclear what this means. As stated above investors could go either way as the project progresses given there is no fair way to value it.

There are numerous technical risks for Lido such as lack of decentralization (small community, 6-of-11 multisig controlling funds, etc), competition from exchanges, competition from other liquid staking providers, protocol risk of Eth 2.0 failing, the potential for node operator griefing, and others. I won’t go into detail on those issues here but I like the admission of these risks by the Lido team and the progress they have made on reducing or eliminating these risks.

I wish I had more opinions on the tokenomics of LDO and its potential as an investment but this is my first such writeup and it’s already long. It is hard to say what the potential drivers of LDO price will be other than the crypto bull market in general. I do not get a sense retail investors are bristling for a liquid staking solution valueless governance token, although investors clearly want a liquid staked ETH derivative (i.e. stETH).

As disclosure, I already own LDO bought at $2.30 each.