What is LSDFi?

How LSDFi works

LSDFi stands for Liquid Staking Derivatives Finance — an ecosystem formed around liquid staking derivatives (LSDs) on the Ethereum network after the Shapella update. There are attempts to create a similar ecosystem on other networks, but at the moment, LSDFi is only fully functional on Ethereum.

As is easy to guess, liquid staking derivatives (LSDs) are the cornerstone of the entire ecosystem. They are tokenized representations of staked ETH, which holders can use in DeFi products while generating revenue from staked ethers.

The emergence of LSDs was a response to three major problems associated with ether staking after Ethereum's transition to the Proof-of-Stake consensus protocol.

1. Ethereum's high threshold for entry into Ethereum staking.
2. It is a technically difficult process for many users to enter Ethereum staking.
3. Lack of liquidity. Once the staked ETH is locked, it is impossible to use it, and retrieving coins from the stack is time-consuming and involves financial loss.

LSD protocols allow users to enter Ethereum stacking in a "pay-as-you-go" fashion: they block their ETH in a protocol that takes care of all the technical aspects of the stacking and distributes the rewards. In return, users receive tokens representing their staked coins, such as stETH (the token ticker depends on the specific protocol). Users can already use these tokens in other DeFi products without stopping receiving rewards for Ethereum staking.

The opportunity to use their funds twice has gained impressive popularity in the DeFi community.

LSDFi ecosystem

LSDFi refers to both the LSD protocols themselves and all DeFi products that allow users to leverage LSD. The only exception is "old" DeFi protocols that added LSD support later — some experts believe that it is not quite right to classify them as "true" LSDFi.

The largest LSD protocols include:

• Lido is the first such protocol on the market.
• Coinbase — the most popular LSD protocol among institutional investors.
• RocketPool is the most decentralized of the popular protocols.
• Frax — LSD-protocol with the highest yield (5.23%).

The number of protocols and products allowing the use of LSD-tokens is already measured in dozens. The most popular are the following:

Decentralized exchanges (DEX)

Many decentralized exchanges (DEXs) have created liquidity pools where LSD and ETH are combined. Such pools allow users to instantly exit positions and exchange LSD for ether without waiting for the withdrawal queue or wasting time. As such, while DEXs are the least "spectacular" part of the LSDFi infrastructure, they are vital for the ecosystem to function.

The current leaders in this market segment are the Curve and Uniswap platforms.

Lending platforms

LSDs are steadily overtaking "old" coins and tokens (including the "original" ETH) as the main asset on decentralized lending platforms. On Aave (the market leader), for example, LSD already accounts for more than a third of turnover.

Stablecoins

Several platforms, including market leaders such as MakerDAO, accept LSD as collateral for issuing stablecoins.

However, collateral alone is not the only issue. Libra, for example, has issued eUSD, a stablecoin that earns an 8% annualized return simply for being in the wallet. This is achieved because eUSD is given when a deposit is made in ETH, this ether is staked and converted to stETH, the rewards in stETH are sold, and interest is paid to eUSD holders.

Re-staking

The simplest type of protocols from a conceptual point of view, although their number in the market is still relatively small. The most notable one is EigenLayer.

Users simply stake ETH, get LSDs, and stake them already, generating additional revenue.

Index LSDs

Some platforms, such as Index Coop and Yearn Finance, issue synthetic tokens representing a whole basket of different ether LSDs. This allows for some risk diversification and, in some cases, enhanced returns compared to "regular" LSDs.

Profitable strategies

Protocols popularized by DeFi that invest user-provided tokens in a variety of liquidity pools and other high-yield products have also begun to accept LSDs.

LSDFi outlook

LSDFi has seen genuinely explosive growth in 2023 — from January to October, blocked funds in LSD grew 5.870% to over $900 million. At the same time, LSDFi protocols account for about 45% of the total ETH staked of 23 million coins.

And the growth potential is far from exhausted. Ethereum stands out from other PoS cryptocurrencies by its abnormally low share of stacked coins — less than a quarter of the total volume in circulation. Coins such as Cardano, Solana, Cosmos and Avalanche have this figure exceeding 60 per cent. And there is no tendency to slow down the number of stacked ethers growth. So, the LSDFi segment has room to grow.

However, we must not forget about the risks associated with LSD. And we are not even talking about the ongoing general contraction of the DeFi market (by 8% since the beginning of the year). The LSD price can fluctuate significantly, deviating from the underlying asset's price. On top of that, the LSDFi segment is still in its infancy, so the likelihood of vulnerabilities in protocols and smart contracts is relatively high. Finally, in case Ethereum penalizes validators, not only will they suffer, but also the users who gave them their coins in exchange for LSD.