The Evolution of LSDfi
Everyone knew the Merge would have positive implications for DeFi, but not even a year has gone by and it’s exceeded the wildest of bull cases. One of the places we can see this most clearly is in LSDfi - the growing world of DeFi built on liquid staked derivatives. The narrative has been around for a while at this point, so it’s worth examining where it came from and - more importantly - where it’s going.
In this article, I’m going to separate the evolution of LSDfi into 3 stages, then look at a few projects on the cutting edge of what can be done with LSDs. Safe to say there is plenty on the horizon, and what we’ve seen is only the beginning.
Stage One: Liquid Staking Protocols
Heading into 2023, one of the hot sectors in crypto was LSD providers like Lido and Rocket Pool. As you probably know, these protocols let users lock their ETH on the smart contract, which then stakes them to help secure the network. In return, the user is issued an LSD like stETH or rETH - liquid tokens that represent the ETH they have staked. The result is a liquid token that can be traded, lent, or borrowed, that still accrues the staking yield of ETH itself.
Earlier this year, many thought that these protocols would benefit due to a rise in demand for staking, especially after withdrawals were enabled. I think it’s safe to say this trend has played out in an extremely bullish way. Just look at the increase in validator count:
Likewise, the number of staked ETH continues to climb rapidly:
By keeping staked tokens liquid, LSD providers played a major role in encouraging users to feel comfortable staking their Ether. With that said, the protocols who issued this first wave of LSDs were not the only ones to benefit from them. If you consider these staking protocols the first-order beneficiaries of LSDfi, we can easily go several layers deeper.
Once LSDs were out of the bag, it logically became necessary to find a way to keep them pegged to their underlying asset. The last thing we need is a repeat of last summer when stETH, the biggest ETH LSD, depegged due to forced selling by 3AC, among others. As a result, protocols like Curve and Balancer have seen big inflows into ETH LSD related pools, magnifying their TVLs.
Right now, Curve’s stETH/ETH pool is the most prominent LSD pool in DeFi with about $740m in TVL. They also have over $164m in their frxETH/ETH pool, which is their 5th largest pool on mainnet.
Balancer – 3 of their top 4 pools on mainnet are related to LSDs, and they have over $136m in TVL, which accounts for over 13% of their total TVL.
Zooming out, we can see that LSDs have in fact become the largest source of TVL in all of DeFi:
When you put this in context, it’s even more impressive: right now, there are about 10 million ETH deposited in liquid staking protocols. That number is up over 5x since the beginning of 2022!
Pretty much everything else in DeFi and the broader crypto universe has collapsed during that same time period, so if LSDfi has experienced this kind of growth, obviously it must be providing some genuine innovation.
With that in mind, let’s move onto stage 2.
Stage Two: LSDs as Collateral
The second stage of LSDfi has been a spate of projects with a similar basic concept: users lock LSDs in a CDP, then mint and borrow stablecoins against them.
You’re probably tired of seeing stuff about new LSD-backed stablecoins at this point, but don’t let the overwhelming number of protocols using this model take away from its importance. Personally, I’d argue that the reason so many protocols are doing this is because it’s such an amazing use case.
Not only does it further extend the utilization of LSDs, but it also contributes a much-needed level of decentralization to the existing stablecoin market. On top of that, LSDs by definition earn the yield that their underlying asset makes by performing certain tasks (i.e. providing security to a PoS blockchain). The staking APR is typically higher than most money markets pay for deposits (barring high incentives), so you’re already at an advantage there. In essence, using a yield-bearing token as collateral turns every CDP position into a self-repaying loan.
So far, three of the biggest beneficiaries of Stage 2 have been Lybra, Curve, and Raft.
Lybra has been all over CT now for months, and for good reason. Its eUSD stablecoin, which is backed by ETH and stETH, has reached a market cap of $177 million. Only DAI, FRAX, and LUSD have higher market caps when it comes to decentralized stablecoins.
And in less than 3 months, Lybra has accumulated $345 million in TVL, making it the 3rd largest CDP protocol on Ethereum behind Maker and Liquity – good company to be in!
Curve’s CRVUSD stablecoin is backed by wstETH, WBTC, sfrxETH, and ETH.
In total, over $120m of these assets have been deposited as collateral, but over 80% of that is from the two LSDs on the list (wstETH and sfrxETH).
As a result, nearly $80 million of crvUSD is now in circulation, which is up over 7x since June 7th.
Raft and its LSD-backed stablecoin R have flown under the radar compared to the first two protocols, but they’re still making impressive progress thus far. In a matter of weeks, Raft’s TVL went from 55-60 million, and it currently sits at nearly $54 million:
So far, over 99% of R’s backing has come from stETH collateral. However, they also accept Rocket Pool’s rETH as collateral, and more forms of collateral will likely be available in the future.
Right now, Lido’s stETH comprises the overwhelming majority of the collateral for these Stage 2 protocols. There are two ways that I believe this will change: One way is that smaller LSDs will take additional share of the collateral market.
This will come in the form of CDP protocols offering different collateral options, as well as DeFi users becoming more willing to buy smaller LSDs and use them as collateral. We’ve seen a few such projects recently gain traction in this area (in addition to crvUSD), such as Gravita which accepts rETH in addition to stETH. So far, Gravita is an exception to the rule, in that they’ve had a large amount of their stablecoin (GRAI) minted against rETH compared to stETH.
The other route has been the most common path for LSD providers. Lido’s stETH has dominated thus far with nearly 75% of the market:
I think that as LSDfi evolves, more options for LSDs will gain market share. In fact, it wouldn’t surprise me to see stETH dominance drop below 50% by the end of 2024. After all, only 17% of the supply of ETH has been staked so far, and less than half of that is through LSD providers. So the game is far from over here.
Stage Three: Collateral Diversification
So if Stage One was LSDs, and Stage Two was LSD-backed lending and borrowing, what does Stage Three have in store?
Since the underlying trend this whole time has been LSDs of the 2nd largest asset in crypto, ETH, the natural progression would be further expansion via other composable assets. This could be done by using things like LP tokens, stablecoins, money market deposits (such as Aave’s aUSDC), and more. Just think: what if you could do all of the things that Stage Two protocols like Lybra are doing with ETH, only using your other tokens and positions?
One great example of an up-and-coming DeFi project looking to implement this strategy is Seneca. While their product isn’t public yet, they’re building a protocol that will be able to unlock credit for all sorts of different DeFi users.
While you can earn a decent yield through LP tokens, LSDs, deposit receipts, etc, there are always ways to seek out higher and higher capital efficiency. Seneca will enable these tokens to be put up as collateral against loans in their native stablecoin: senUSD. That way, liquidity is freed up while the collateral holders can still earn yield on their assets.
Another project that’s paving the way forward in this regard is EraLend, the first-mover in zkSync money markets.
EraLend has several features that make it stand out. First, they’re carrying out the Stage 3 process already by accepting SyncSwap’s USDC/WETH LP tokens as collateral. This is likely to be the first of many alternative assets used as collateral on EraLend – the catalyst for expansion is their upcoming P2P lending product. Not much is known about this product yet, but I believe it’s likely that anyone will be able to post any variety of tokens as collateral (LP tokens, LSDs, debt receipts, NFTs, etc).
EraLend has caught fire in recent weeks, as their TVL has exploded from 22.9m since June 1st:
As the zkSync narrative heats up, this is definitely a project to watch – in fact, it’s already #3 on zkSync in terms of TVL.
Finally, another interesting feature of EraLend is the fact that any token can be used to pay gas fees, which hints towards a future of account abstraction for the young protocol.
Even if you do trust that Tether and Circle have the assets they claim to have, it would be optimal to see a native DeFi stablecoin with trackable on-chain collateral (without heavy exposure to legacy stables) eventually replace them at the top. At this point, the most obvious way to do this is by creating a model like Seneca’s.
Looking ahead, a fractional reserve system in DeFi is a necessity, as it enables more to be done with less. In fact, I’d argue that DeFi can easily be optimized for this sort of system. For one thing, code is law in DeFi, meaning the parameters such as collateral limits are set in stone and can’t be adjusted in special circumstances. Additionally, unlike TradFi, DeFi is inherently composable, which makes integrating new forms of assets and use cases for said assets much easier. DeFi is also inherently transparent, which makes use cases like LSD- and LP-backed stablecoins that much more attractive vs legacy stables like USDT and USDC.
Published on Jul 20 2023