Protocol Deep Dive: Lido Finance

Key Insights

• Lido is the leading provider positioned well to benefit from Ethereum’s upcoming Merge.
• The protocol charges a fee on the underlying staking yield - we value Lido's business as a traditional closed-end fund.

Staking ETH currently poses significant barriers, such as the 32-ETH minimum required to operate a node, which prevents many network users from running their own validator and there is no built-in method for delegating one's stake to avoid these minimum capital requirements. Furthermore, staking on the Beacon chain today is a one-way transaction which results in a high opportunity cost of capital given the abundance of yield-generating alternatives that exist in DeFi.

Due to these challenges, centralized exchanges have been best-positioned to offer staking services due to their efficiency of scale. Companies like Binance, Kraken, and Coinbase can easily pool their users' assets, stake it on their behalf, and issue a liquid market for this staked asset, unlocking liquidity and allowing users to swap back from staked ETH to ETH.

These services are valuable for their users, but ultimately carry a high degree of risk for two reasons: first, the counterparty risk associated with centralized exchanges. Second, there are concerns that exchanges will ultimately grow their business to a point at which they can influence the functioning of blockchains themselves (i.e. their bond is too big). This has created a significant white space for decentralized alternatives. Lido, which operates in a fully-decentralized manner, offers one of the easiest ways to stake ETH and other PoS assets today. Simply put, Lido democratizes staking.

Lido enables liquid staking through its platform on Ethereum and other smart contract ecosystems. Users can deposit their staking asset into the Lido smart contract and receive an IOU derivative known as a Lido-staked asset (stAsset). The liquid staking derivative can be exchanged 1:1 with the protocol for the underlying staked asset subject to the network's withdrawal period, or it can be sold in the open market, where it usually trades at the same price as the base asset. With Beacon Chain withdrawals halted, Lido today is highly similar to a closed-end fund with a vibrant secondary trading market for the fund's shares (stETH).

Through this, users can earn staking yields without the significant investment of running a node or sacrificing liquidity to protocol-enforced lock-ups. By creating a liquid staking derivative, stETH, users can bypass these restraints by delegating their ETH to a smart contract to receive an interest-bearing asset that is interoperable with a growing set of use cases.

As Lido has created new partnerships and integrations, more users have chosen stETH as their staking derivative of choice. Lido solves the competitive incentives between staking and seeking yield in DeFi. By issuing an Ethereum-native liquid token, Lido allows you to use staked ETH as collateral within DeFi in the same way you can use ETH currently.

Lido’s Economic Blueprint

LDO is the governance token for Lido DAO. It controls key parameters for Lido, including fee structure, validator selection, incentives, insurance, and the Lido treasury.

The protocol charges a 10% fee on staking income generated for holders of stETH. With no overhead, this revenue is currently split between the treasury’s de facto insurance fund and LDO’s pool of validator nodes. Since its launch at the end of December 2020 the company has amassed $4B in total deposits, generating $14M in annualized revenue.

‍stETH Utility Drives Lido’s Dominant Position

Today, LDO is by far the largest staker of ETH, with over 24% of the total staked ETH supply in the DAO. With the release of ETH 2.0, we’ve seen an acceleration of staked ETH as holders look to earn yield on their assets.

LDO has also begun to capture impressive shares of the staking markets on LUNA, Solana ($61.9B TAM), Aave ($1.1B TAM), Polygon ($2.5B TAM), and Polkadot ($24.7B TAM).

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Lido’s Powerful Partnerships

As of March 1, the total number of ETH staked is 1.98 million. Let’s take pledging ETH as an example and analyze how to earn more on Lido.

• Users staking any amount of ETH get 1:1 in stETH, and can earn 4.5% APY. By comparison on AAVE, depositing ETH generates 0.2% APR.
• Users can turn otherwise interest-bearing stETH asset certificates into liquidity and earn more by participating in other DeFi protocols such as Curve, AAVE, and Convex Finance.
• Users can earn approximately 3% APY by investing stETH in Curve.

The stETH/ETH pool on Curve Finance is a liquidity pool containing stETH and ETH. Users can interact with these pools to purchase stETH or ETH with low slippage. Any transactions that take place within this pool are paid out to liquidity providers via trading fees in CRV.

Users who provide their liquidity to this pool will receive LP tokens in return. They can then stake their LP tokens into the Curve gauge to receive trading fees in CRV alongside the newly proposed incentivised rewards; LDO and CRV.

In summary, users can stake any amount of ETH on the Lido platform for use in other DeFi platforms to earn 12% to 14% APR, which is a significant amount of revenue for users. Curve and Convex Finance are the top 5 protocols on the network, which are not only risk-controlled, but also have no liquidation risk and are completely single-coin staking models.

Momentum is Building

stETH’s new partner integrations and expanding pool of deposits has attracted more users and node operators to the platform. We attribute this not only to the expanding use cases of stETH but, more importantly, the fact that Lido offers the liquid staking derivative with the most liquidity and integrations today. As this trend accelerates, so will Lido’s value proposition to users.

Performance and Financial Analysis

JP Morgan estimates that the staking industry will grow to $40B in revenue by 2025, representing a 45% annual growth rate from current levels. We build a margin of safety into our valuation by assuming a conservative 30% growth rate.

We value LDO by DCF, forecasting the amount of staked on each chain and assuming constant market share.  Our model supports $60M in annual revenues by 2025 under these assumptions. Our models always assume the price of deposited assets does not change over the time period.

Closing Thoughts

Lido is the leading liquid staking service provider positioned to benefit from the Merge and the switch to greater on-chain activity. The treasury has clear cash flows that accrue value to the token holders, allowing a valuation model to be built.Cash flows accrued from holding LDO are similar to holding a basket of the underlying staked assets.

We actively contribute to our favorite networks and communities, so in addition to our investment in Lido, we have staked a portion of MJL Capital’s ETH holdings on the Beacon chain. Staking with Lido removes many of the logistical complexities that institutional investors have faced.

We look forward to supporting the Lido community on its long journey ahead. There will be competitive incentives even after the PoS transition between securing the Ethereum network by staking and alternatively seeking higher returns from participating in DeFi. We will contribute, as both a staker and governance participant, to help ensure a fair, transparent, and credible staking ecosystem.

We would prefer a world where a diverse set of centralized staking services, decentralized staking pools, and individual validators all play a role in securing Ethereum. We are excited to be working with Lido as we collectively build towards this future.