Lido Finance-Decentralized Guardian of ETH2.0

30 min readAug 20, 2021

By Li Yuxuan, Mint Ventures

Updated on: 2021–08–20

1. Key Points

• Lido is a staking pool selected by Ethereum community to fight against CEX, shouldering the mission of ETH2.0 decentralization. If Lido becomes the largest staking pool, the governance value of LDO actually implies a part of the governance value of ETH;

• stETH has a moat and a strong network effect due to its liquidity. Lido is likely to become the DeFi protocol with the largest TVL before ETH2.0 goes online;

• Through the comparison of vertical and horizontal valuations, we believe that: now LDO is extremely undervalued for short-term investors; the valuation of LDO is moderate for long-term investors.

2. Basic Situation of the Project

2.1. Project business scope

Lido Finance’s major business is the staking pool service of POS (Proof of Stake) public chain. Currently, it supports two chains of ETH2.0 and Terra, and it may expand to other POS public chains such as Solana in the future.

At present, the Total Value Locked (TVL) of Lido Finance exceeds US $4.8 billion, of which $2.85 billion is ETH and nearly $2.0 billion is LUNA.

2.2. Past Financing History

Lido Finance has completed two rounds of financing in total:

In December 2020, Lido Finance completed a financing of US $2 million. The investors include companies such as Semantic Ventures, ParaFi Capital, Terra, KR1, Stakefish, and Staking Facilities, as well as individuals such as Rune Christensen of MakerDAO, Stani Kulechov of Aave, and Kain Warwick of Synthetix.

In April 2021, Lido DAO passed a proposal for financing the LDO tokens reserved by the Ministry of Finance. A total of 100 million LDOs were sold in this round and 21,600 ETHs were raised, which is equivalent to 0.000216 ETH/LDO. This investment was officially reached on May 5, 2021. According to the ETH price on that day, it was about 0.75U/LDO, which means that US $75 million were raised. These tokens will be released linearly in 12 months after the one-year lock-up period, but its governance right was given to these investors from the date of investment. The investment lineup for this round is luxurious. Among them, Paradigm has obtained 70 million LDOs, and the remaining 26 million LDOs have been obtained by Three Arrows Capital, DeFiance Capital, Jump Trading, Alameda Research, iFinex, Dragonfly Capital, Delphi Digital, Robot Ventures (the fund of Compound’s founder), Coinbase Ventures, Digital Currency Group, The LAO and other institutions. In addition, 4 million LDOs were allocated to a series of individuals (partially anonymous), including 0xmaki of Sushiswap and Jinglan Wang of Optimism.

It can be seen that the investors of Lido Finance include almost all of the active investment institutions in Ethereum ecosystem and a considerable number of DeFi blue-chip founders.

2.3. Team

The founding team mainly comes from P2P Validator. P2P Validator is a professional non-custodial staking platform that supports users to stake tokens with more than 20 POS mechanisms, including ETH, DOT, SOL, ATOM, etc.

The founding members of Lido include:

Konstantin Lomashuk, the founder of P2P Validator, is a very early BTC investor who founded Satoshi Fund in 2015 focusing on blockchain investment.

Vasiliy Shapovalov, CTO of P2P Validator.

Kasper Rasmussen, CMO of P2P Validator. Before that, he was the Marketing Director of Bitfinex.

In addition, Georgios Konstantopoulos, Hasu and Arjun Balaji from Paradigm conducted in-depth research on Lido Finance and contributed to Paradigm’s investment, and they also influenced and even guided the development route of Lido Finance on the key decentralization issue of Lido Finance. In combination with the voting rights represented by the large number of LDOs held by Paradigm and the huge impact on Lido, these three members of Paradigm can also be counted as team members of Lido Finance to some extent.

2.4. Historical development

On November 26, 2020, Lido Finance launched the testnet.

On December 18, 2020, Lido Finance officially launched the staking of ETH and launched Lido DAO on Aragon.

On January 5, 2021, the native cryptocurrency LDO was released.

On January 27, 2021, LDO-ETH liquidity pool has been added to the SushiSwap Onsen menu, in which users can stake LDO-ETH SLP tokens to obtain Sushi rewards.

On March 17, 2021, it began to provide staking services on Terra.

On June 2, 2021, Delphi Digital proposed to include Aave’s staking into Lido’s service. The proposal and voting have been passed.

On July 15, 2021, it updated the withdrawal certificate of smart contract, after which all newly deposited ETH on Lido became non-custodial.

On July 19, 2021, it launched the Lido recommendation plan, which will issue 15 LDOs as rewards to ETH recommended by each user.

In addition, Lido Finance’s stETH has been deeply integrated with various DeFi protocols in less than one year since it was launched. We will introduce it in detail in Section 3.2.

3. Business Analysis

3.1. Industry analysis

Regardless of the reason and whether the reason is correct, we can see that the regulatory authorities do not like the PoW (Proof of Work) mechanism. A recent severe crackdown on Bitcoin mining in China shows this stance. Energy consumption is contrary to the theme narrative of Wall Street in the past 10 years — ESG (Environmental, Social, and Governance), and Elon Musk, who is ‘dominating’ the digital currency market, has also criticized Bitcoin’s energy consumption problem.

As for the PoS (Proof of Stake) mechanism, it seems that the attitude of the regulatory authorities and Wall Street is much more positive:

On July 6, 2021, the bank Sygnum, which has received regulatory approval from the Swiss Financial Market Supervisory Authority (FINMA) to enter the cryptocurrency market, officially began to provide staking services for ETH2.0. It has already provided staking services for Tezos before.
Goldman Sachs pointed out in a recent report that “the advantage of PoS is that it can greatly improve the energy efficiency of the system, rewarding miners based on the number of ETH they choose to hold rather than their processing power, which will end the competition to reward miners”.
JPMorgan Chase published an industry study on staking on July 1, 2021. They believed that with the upgrade of ETH2.0, the staking industry worth US $40 billion might be launched and “as the volatility of cryptocurrencies decreases, the ability to obtain positive real returns will become an important factor in helping the market become more mainstream”. “Compared with other investments in other asset classes such as the U.S. dollar, U.S. Treasury bonds, or money market funds, the yields obtained through mortgages can reduce the opportunity cost of owning cryptocurrencies”.

In addition to a large amount of energy consumption, PoW mining also needs to prepare mining machines to obtain yields. Facing with the problem of iterative upgrades of mining machines, PoW mining is a capital-intensive and energy-intensive industry, with a high threshold for ordinary users. For PoS mining, although the mechanism of each public chain is different, its threshold is usually much lower than that of PoW.

ETH2.0 staking

On December 1, 2020, Ethereum started the formal transition from PoW to PoS by launching the Beacon Chain. This means that the consensus of Ethereum will change from miner protection to validator protection. In the design of Ethereum, each validator node needs to stake a deposit of 32 ETH to increase the opportunity of creating a new block in the network (and get rewards), and vote to reach a consensus on the status of the Beacon Chain. The validator’s good behavior will be rewarded with additional ETH, while offline or malicious behavior will be punished. At the time of writing this report, there are already more than 212,000 validators on the Beacon Chain, which is equivalent to about 7.03 million ETHs staked (accounting for 5.81% of the total ETH).

Source:https://launchpad.ETHereum.org/en/

In theory, all users can stake their ETHs to become a validator to obtain a 5% to 20% yield. But there are still several major obstacles to generate this yield:

i. High operation cost: Staking has considerable hardware, bandwidth cost and knowledge reserve requirements. Once there are offline or operation error, validator may be fined rewards and even principal.

ii. High capital requirements: Due to the requirements of the Beacon Chain, users can only stake multiples of 32 ETH. This not only creates a high threshold, but also reduced the fund utilization efficiency (a user with 60 ETHs can only run one verification node, and the fund utilization rate just exceeds 50%).

iii. Liquidity loss: Once ETH2.0 is deposited, all staking cannot be cancelled until the transfer function of the Beacon Chain is enabled (at least by the end of 2021), which will make users lose the liquidity of this part of ETH.

(In fact, all POS public chains have this problem, just not as extreme as the Beacon Chain currently. For the stability of the system, most POS public chains generally still need to pay some time cost to withdraw from staking: the unlocking of Polkadot takes 21 days, and 7 days for Binance Chain. When the transfer function of the Beacon Chain is enabled, ETH unlocking takes at least 27 hours — up to 1 month, depending on the degree of congestion withdrawing from the staking).

Obviously, as an aggregator platform for stakers, a staking pool is very useful in this scenario, because the platform can effectively solve the above 1 and 2 obstacles:

For the obstacle 1, the marginal operating cost can decrease. In addition, the professional knowledge of the platform can avoid operational risks.
For the obstacle 2, the platform can match all users who have the interest-bearing needs by staking, so as to improve the overall capital efficiency.

But for users, the most important thing is the obstacle 3. When the Beacon Chain goes online, the lock-up period of at least 1 year (still half a year now) will greatly affect the confidence and enthusiasm of ordinary people to participate on ETH2.0. For this problem, theoretically all staking pools can reserve a portion of ETH reserves in a way similar to banks to meet the withdrawal needs of staking users, so as to achieve a balance between the staking needs and liquidity needs of users. However, due to the possibility of the deposit running risk, the current mainstream platforms have not adopted this kind of scheme. The solution for players including CEX and Lido Finance to solve the obstacle 3 is mainly to establish and incentivize the liquidity between the ETH2.0 staking certificates and ETH.

There are two main types of staking service providers in the market. The first type is service providers that only solve the obstacle 1, such as stucked.us and stakefish. The services they provide are similar to mining machine custodians of PoW, and the fees are generally charged monthly according to the number of nodes. The threshold of such solutions is not high, nor can they produce network utility. The second type is service providers trying to solve obstacles 2 and 3, such as various CEX and Lido. Because it provides an experience far beyond the user’s own operation, this type of solution will have higher value. This type of service providers is also the subject of our discussion below.

It is worth noting that if you want to solve obstacles 2 and 3, it will inevitably not be able to provide completely non-custodial services, and the operation rights of ETH must be transferred to other people or contracts. However, since the contract code can be open sourced and audited, we will regard “authorizing the operation rights of ETH to the contract” as a non-custodial service, and “authorizing the operation rights of ETH to one or several individuals” as a custodial service.

3.2. Project Mechanism

The core mechanism of Lido is as follows:

For stakers, they can stake any amount of ETH to Lido’s contract account, and Lido will distribute the corresponding amount of stETH (an ERC-20 token) to users. The balance of stETH will be updated at 24:00 UTC time every day to ensure that stETH is consistent with the total amount of ETH on the Beacon Chain, so as to achieve real-time acquisition of staking yields every day. Stakers can get 90% of the ETH staking yields on the Beacon Chain.

Whenever 32 ETHs is gathered on the Ethereum smart contract, the DAO will select a new verification node from a list of verification nodes. Then it will call the deposit contract to allocate 32 ETH to the verification node. There are currently 9 verification nodes, including P2P Validator, Stakefish, Blockscope, etc. After selected by Lido DAO after verification, they are responsible for obtaining yields according to the staking contract where stakers deposit one or multiples of 32 ETHs on ETH2.0. Verification nodes need to bear hardware and bandwidth costs, and they can receive 5% of the total revenue now.

The last 5% of the yield is controlled by Lido DAO. At present, it is fully allocated to the insurance fund. The insurance fund is mainly used to supplement the user’s yield and even the principal when the ETH2.0 verification is punished.

Since the balance of stETH changes every day, which is not conducive to the combination with certain DeFi protocols, Lido also launched the wrapped version of steh as wstETH. The balance of wstETH after being wrapped will not change, but the yield during the wrapping period still continues to accumulate and will be recalculated when the stETH is unwrapped.

The core mechanism of the staking liquidity solution protocol is basically similar to Lido, and Lido’s success is mainly due to many DeFi use cases they provide for stETH:

3.2.1 stETH on DeFi

Since the launch, Lido has attached great importance to the integration with other DeFi protocols. They set up the Lido Ecosystem Grants Organisation (LEGO) to promote the progress of this work.

We summarize the current use case expansion of stETH and the progress of integration with DeFi blue chips as follows:

DEX:

Curve: Not long after Lido Finance went online, Curve launched the stETH/ETH trading pair. Lido DAO uses a large number of LDOs (about 5 million) to incentivize the stETH/ETH pool to ensure the liquidity of stETH. At present, the effect of this incentive is significant: Curve’s stETH/ETH pool is the most liquid trading platform for stETH, and there are currently 1 million ETH and stETH in this pool, with deep liquidity. Especially in May, under the huge fluctuation of ETH’s own price, stETH has remained anchored slightly lower than the price of ETH (this is reasonable because users can use 1 ETH in Lido at any time to exchange 1 stETH).

Source: https://duneanalytics.com/LidoAnalitycal/Lido-Finance-Extended

Sushiswap provided a Onsen plan for LDO-ETH.
1inch: shortly after Lido went online, stETH was integrated by 1inch.
DeversiFi: LDO officially launched DeversiFi on the L2 exchange in March.
Bancor: On July 13th, wstETH launched wstETH-BNT mining pool of Bancor, and users can earn stETH yield under the protection of Bancor’s impermanent loss mechanism.
Uniswap: Since the Uniswap pool is completely unlicensed, there has been stETH liquidity on Uniswap V2 for a long time. Considering the fit of Curve to the stETH/ETH scenario, the team did not provide incentives for Uniswap’s liquidity, so there is little liquidity on Uniswap v2 now. After Uniswap V3 went online, Lido’s LEGO team also initiated a proposal to test on Uniswap V3.

Lending:

In March, Lido integrated with ARCx, allowing stETH to be used as collateral to mint STABLEx tokens, which is the native stablecoin of the ARCx platform.
Inverse Finance supported stETH as collateral on June 21.
Aave — unlaunched: Anjan of ParaFi Capital put forward a proposal at the Aave Governance Forum, which proposed to use stETH as collateral. Now the community is discussing it.
Maker — unlaunched: The community is currently discussing it.
Compound — unlaunched: ParaFi Capital has already put forward a proposal at the Compound Governance Forum, proposing to use stETH as collateral.

Other:

Insurance: Lido cooperated with the insurance protocol Unslashed to insure more than 200,000 stETH; it also cooperated with Nexus.
Yield protocol: Yearn, Harvest and Convex have all launched the yield pool of crvSTETH (the deposit certificate of stETH on Curve).
Entrance integration: Lido is integrated into Gnosis Safe, which is a trusted multi-signature wallet. At present, there are more than 2 million ETHs stored on Gnosis Safe. In addition, aggregation platforms such as Zapper, Zerion, and wallets such as Argent Wallet, Trust Wallet, and Imtoken also integrate with Lido.

The full application of stETH on DeFi enables users to maintain the stability of ETH2.0 (and obtain yields), while the ETH (actually stETH) staked by users can still be used in various DeFi applications. This makes Lido truly provide a “liquidity staking solution”: Users can participate in staking with little loss of liquidity. Due to stETH’s liquidity moat and related network effects, the derivatives staked by stETH on ETH will very likely be “winner takes all”. Therefore, stETH may replace ETH in many use cases, or even completely replace ETH. At present, stETH only needs to be integrated by the three main lending products (Maker, Aave and Compound), by which it will be not very different from ETH. We predict that this process will happen at the latest when the transfer function of the Beacon Chain is turned on (the ETH can be retrieved with stETH), and whether it can happen in advance mainly depends on the market’s confidence on ETH2.0, the degree of participation, and Lido’s continuous efforts.

The ETH Staking derivatives represented by stETH will have a significant impact on the entire Ethereum ecosystem, including ETH stakers, ordinary ETH holders, and even Ethereum itself.

Staker: The main benefits for stakers is that these derivatives can be remortgaged, which allows them to obtain staking yields while also depositing into the loan protocol or DEX as LP for other yields. This greatly reduces the opportunity cost of staking.

Non-staked ETH holders: If stETH can borrow ETH as collateral, it can unlock the demand for borrowed ETH for leveraged staking. This will push up the interest rate on the supply of ETH and ultimately benefit all ETH holders with higher interest rates.

Ethereum: On the impact of derivatives such as stETH on Ethereum, Paradigm’s Georgios and Hasu’s had a wonderful argument (https://research.paradigm.xyz/staking). Our excerpt is as follows:

“There exists a popular argument that staking derivatives lower the security of PoS because they separate block production from staking and slashing. This is also known as a principal-agent problem, and can lead to scenarios where the block producers may not be incentivized to follow the protocol since they have nothing at stake.

However, this argument has to be weighted against the benefits: If staking derivatives lower the cost of staking, they could lead to far more (or even all) ETH being staked. Note that this is a perfect example of a virtuous cycle: the more liquid stETH becomes, the lower the opportunity cost of staking, which leads to more ETH being staked, which in turn further deepens the liquidity of stETH, and so on.

Without staking derivatives, we might expect 15–30% of ETH to be staked. However, with staking derivatives, this number could be as high as 80–100%, because there is no additional cost to staking compared to non-staking.

To show why this leads to higher economic security, consider the following attack scenarios:

· If 20% of all ETH is staked, and an attacker wanted to acquire 66% of all stake (a critical threshold to corrupt the chain), they would have to buy 40% of all ETH in the open market.

· If 60% of ETH were staked, but the stETH is liquid, then the attacker would have to buy 66% of all stETH, which also comes down to 40% of all ETH. Note that this has additional steps, where the attacker would first have to redeem the stETH to remove the honest validators and then re-stake their ETH.

· Above 60% staked, the share of all ETH the attacker would have to buy is now higher than 40% and only increases from there.

· If 100% of ETH are staked, then the attacker would need 66% of all stETH to get to the same threshold.

We can conclude that if staking derivatives can increase the number of ETH staked above 60%, they would strictly increase Ethereum’s economic security instead of decreasing it.”

In addition, we can find that a considerable amount of integration is facilitated by Lido investors. Both ParaFi and Delphi are actively promoting the cooperation between Lido and various DeFi projects, and Paradigm is guiding the development of Lido. This is a very important feature in the development process of Lido, and it is also a very important advantage: Lido has received the full support of Ethereum core developers, communities and funds representing Ethereum orthodox.

3.2.2 Decentralization problem

In fact, the service provided by Lido is not completely decentralized (trustless), and users still need to trust Lido in the following aspects:

i. From the launch of Lido to July 15, 2021, the deposits of all users are not non-custodial. The withdrawal certificate of ETH2.0 is not controlled by the user himself, but by 11 multi-signature users selected by Lido.

ii. Withdrawals require verification nodes to cancel the mortgage manually: According to the current design of withdrawal certificate, if the staking user wants to cancel the staking, Lido’s verification node must cancel the mortgage manually at present. There is no way to force the verification node to cancel the mortgage according to the user’s needs.

iii. Becoming a verification node is not unlicensed now. The verification node is currently open to all users to apply, but it can officially become a verification node only after it is reviewed and passed by Lido DAO.

(In order to understand the above two problems 1 and 2, you need to have an understanding of the architecture of ETH2.0 and the current stage. Due to space limitations, this article will not cover them. Interested friends can go to https://blog.Lido. fi/the-road-to-trustless-ETHereum-staking/)

In fact, since the withdrawal (transfer) function of the Beacon Chain has not yet been activated, no one (including 11 people with multiple signatures) can withdraw funds from the deposit contract. Therefore, the first two problems may not seem to be a problem today, but they will indeed become a problem once the Beacon Chain enables withdrawals.

On July 27th, Lido published an article “The Road to Trustless Ethereum Staking” signed by 3 people from Paradigm and 2 founders of Lido. This article introduces and discusses solutions to these three problems (for technical details, please check the original text https://blog.Lido.fi/the-road-to-trustless-ETHereum-staking/):

Regarding the problem 1 that deposit is non-custodial, due to the limitation of the ETH2.0 system at the beginning of Lido’s launch, it did not support the use of smart contracts as withdrawal certificates, so this problem was not solved by Lido at that time. Their solution is to choose 11 people who are closely related to the interests of ETH and have a good reputation (and users who have nothing to do with Lido’s interest，as they did not participate in the seed round) to control the multi-signature of all Lido withdrawal certificates. On July 15, Lido updated its withdrawal certificate of smart contracts. After that, all newly deposited ETH on Lido is non-custodial (the withdrawal certificate is a smart contract).

Problem 2 is actually a problem encountered by all staking pools in the current staking scheme of ETH2.0. Recently, Ethereum put forward a new proposal (this proposal was proposed by Georgios Konstantopoulos of Paradigm). After this proposal is passed, stETH holders will be allowed to remotely trigger the cancellation of staking from the Beacon Chain. After this proposal is passed, the problem can be completely resolved.

Problem 3 is the most difficult problem to solve. Since the ETH staked by any verification node on ETH2.0 generates the homogenized ERC-20 token stETH, the risks of mistakes or malpractices of all verification modes are borne by all stETH holders. Triggered from this perspective, it is necessary to audit the verification nodes, which is also the core work of Lido Dao. Only honest and experienced verification nodes can have better operational capabilities, thereby protecting users’ yields and even their principals.

This is actually a quality control problem. On the basis of quality control, Lido also needs to make the solution more decentralized and trustless. The solutions proposed by Lido include:

All verification nodes approved by the system are open to users to choose;
It is required that the verification node must stake with users in accordance with a certain minimum ratio. In this way, if a verification error occurs, the funds of the verification node will be deducted first, so as to realize trustless;
Insurance;
Technical solution SSV (Secret Shared Validators)
Performance tracking and scoring mechanism of verification nodes;

The specific scheme has not yet been fully determined. It is likely to be a combination of the above-mentioned solutions, but the depth and original intention on decentralization of the team’s approach to this issue is impressive.

Lido’s trustless issue is very important for Lido and even the entire Ethereum community. Paradigm is leading Lido towards full decentralization. Therefore, to some extent, it is not Lido who chose Paradigm, but Paradigm who chose Lido. We will discuss this issue in detail in the next section.

3.2.3 Terra Staking

The staking service provided by Lido on Terra was officially launched in March of this year. Terra is a public chain of DPoS. The staking process for users to participate in Terra is:

Users stake LUNA and obtain the staking certificate as bluna, which can also participate in various ecosystems in Terra. After receiving the users’ Luna, Lido will proxy Luna to the verification node selected by Lido DAO, and the verification node will help the user to obtain verification rewards.

Unlike ETH2.0, Bluna can be extracted into Luna, with the need of a lock-up period of 21 days to 24 days.

It is worth mentioning that staking on Terra will not bring any revenue to the Lido protocol now, and all revenue will be captured by the node operator selected by Lido.

3.2.4 Solana and Aave — unlaunched

Solana is also the public chain of PoS. Lido DAO has passed a proposal to provide Solana with liquidity staking services, which is expected to be launched in the near future.

What is noticeable is that Lido provides staking services to Aave:

On June 2, 2021, Luke Saunders. CTO of Delphi Digital proposed to include Aave’s staking into Lido’s service. The proposal (https://research.Lido.fi/t/Lido-for-aave-proposal-by-delphi-digital/671) and voting have been passed, the code has also been written, tested, and audited, and it is currently waiting for the repair of audit problems.

Disadvantages of Aave Staking’s current solution

At present, there are two main ways for users to staking AAVE tokens: 1) through the staking contract provided by Aave, and 2) through a third-party staking service, such as xAAVE contract of xToken.

When using the AAVE contract for staking, the user can get 1 stkAAVE token for every AAVE token staked, and the staking reward is calculated separately. In this way, if users aim to obtain compound interest yields, they need to frequently claim the reward and reinvest, which will incur very high gas costs.

When using xToken for staking, users can obtain a certain amount of xAAVE tokens for each AAVE token deposited. With the accumulation of staking rewards, the exchange rate between AAVE and xAAVE will change, and the xToken contract does not allow xAAVE holders to vote in Aave governance. Instead, the xToken team votes on behalf of users. As a result, governance rights are concentrated in a small number of xToken team members.

Lido’s solution

The proposal for Aave’s liquidity staking solution is as follows:

Users stake AAVE on Lido, then Lido distributes stAAVE to users. Meanwhile, Lido performs the staking operation of the contract on behalf of users as a whole to reduce gas costs;
The balance of stAAVE token in each user’s wallet automatically updates each block to reflect the accumulated staking reward (similar to stETH), that is, the automatic compound interest of staking rewards;
stAAVE holders can vote in Aave governance just as stkAAVE holders (subject to Aave governance approval);
Simultaneously the liquidity of AAVE and stAAVE is incentivized in the Curve pool.

There are many details worth considering in this proposal. For example, after the gas is reduced (after all the progress of L2 is very fast), users can directly go to AAVE and stake the contract, by which the foundation of the whole scheme will not exist. Another example is whether the liquidity pool of AAVE-stAAVE is necessary, because users should be able to cancel the staking of stAAVE and regain AAVE, etc. There are also some discussions on this in the community.

However, this solution is an abstraction of the problem solved by Lido. Lido’s service is further abstracted from the “PoS staking liquidity solution” to “all staking liquidity solution”, so that it can be extended to all scenarios where “need to stake to obtain yields while staking assets for liquidity needs”. This makes the combination of Lido and DeFi projects more scenarios possible.

4. Competitors

Let’s first look at the deposit distribution of ETH2: (the deposit distribution mark involves manual judgment, so data sources will be different. Let’s look at it together with the data disclosed by Etherscan and Lido).

Source: https://bi.ETHerscan.io/public/dashboards/KH9jbP687szqlAnHiNEfNictrwNhvdOEQl0PwB6m?org_slug=default

Source: https://blog.Lido.fi/the-road-to-trustless-ETHereum-staking/

We can find that CEX is currently the largest player of ETH2.0 staking, accounting for about 30% of the market share. Exchanges such as Kraken, Binance, Coinbase, BitcoinSwisse, Huobi, etc. all have a larger share. In addition to CEX, Lido Finance has the largest share. In addition, professional staking pool service providers such as Staked and Stakefish also have a high share (stakefish is also one of the nine nodes of Lido Finance).

Next, let’s look at the comparison between Lido and other DeFi protocols and CEX respectively.

4.1 Lido vs other DeFi staking pools

In the DeFi field, Lido Finance’s competitors include Ankr, StakeHound, Fis, Rocket Pool, Liquidstake, Kira, etc. Their solutions are basically similar. They all provide ETH derivatives to stake ETH that users deposit on the platform to meet users’ capital needs after staking by incentivizing the liquidity between ETH derivatives (similar to stETH) and ETH. Through the integration of ETH derivatives and other DeFi protocols, they also meet users’ interest-generating needs for ETH derivatives and reduce the opportunity cost for users to participate in staking.

Regardless of whether it is from the perspective of TVL, the market value of its staking certificates, or the anchoring between ETH derivatives and the market value of ETH, Lido’s advantages are very significant. Its market share has exceeded 70% and is still rising gradually. Its competitive advantage is solid.

TVL plot of ETH2.0 staking projects (*https://duneanalytics.com/vsh/Lido-finance-extended*)

TVL rankings of ETH2.0 staking projects (*https://DeFillama.com/protocols/staking*)

If the original degree of Lido’s decentralization may be the weakness attacked by competitors, this final weakness has been made up with the follow-up decentralization measures announced by the team on July 27.

We believe that Lido, supported by almost all DeFi blue chips and funds representing the orthodox Ethereum, is likely to “win all” in ETH staked derivatives due to the liquidity moat and related network effect after the weakness of decentralization is supplemented. This will further increase Lido’s share on ETH2.0.

4.2 Lido vs CEX

For Lido, the main battlefield is against CEX.

Compared with Lido, the main advantage of CEX is that it has a large number of custodial ETHs, which will have the following advantages:

1. When users deposit ETH into CEX, they have already expressed trust. Therefore, participating in the staking of ETH2.0 does not require users to pay any additional trust costs.

2. The operation of CEX is also relatively simple. They already have a large amount of ETH reserves, which can meet the liquidity needs of users, or they can completely open the trading pairs between ETH and ETH derivatives to users, just like kraken and Binance.

3. For the sake of business integrity, CEX may not even charge fees in this process.

In addition, we have to admit that if we regard CEX as a whole, then CEX can reach more user groups than DeFi.

The advantages of Lido include: 1) strong stability and liquidity of stETH; 2) powerful use cases brought about by the composability of DeFi, and 3) the full support from Ethereum core developers, communities and funds representing Ethereum orthodox.

1) stETH’s strong stability and liquidity

The following figure shows the price trend, transaction depth, and transaction volume of Kraken’s ETH derivative ETH2 and Binance’s ETH staking derivative BETH.

It is obvious that in terms of price stability and liquidity of ETH derivatives, there is a large gap between Kraken and Binance from Lido. Of course, this is related to Lido’s incentives to the stETH/ETH pool, but for users, Lido brings the deepest liquidity and better price anchoring of ETH staking derivatives.

2) Powerful use cases brought about by the composability of DeF’ is Lido’s strongest advantage over CEX.

In CEX, after the staking of ETH2.0, the certificate obtained can only be used for trading into ETH, and the transaction needs to endure a slippage of 3–4% points, otherwise it needs to wait. As we introduced earlier, stETH can be re-used in various DeFi protocols. StETH is also an interest-bearing asset. Users can use stETH for Curve, 1inch, Yearn and other protocols to obtain double yields while obtaining ETH staking yield.

3) The full support of Ethereum core developers, communities and funds representing the Ethereum Orthodox

For Ethereum, it must need a decentralized, trustless, and preferably minimally governed staking pool to become the largest staking pool, which can be used to balance the impact of CEX on Ethereum. After all, any real Ethereum supporters are unwilling to see the situation that “the biggest staker of the Ethereum network is CEX that owns a competing public chain”. This is also why Paradigm has been guiding Lido to be as decentralized as possible. Because only if Lido is decentralized as possible, can it meet Ethereum’s expectations for its largest staking pool, and become a decentralized guardian of ETH that can compete with CEX after ETH is converted to PoS.

5. Token Economy

The main use cases of LDO are for governance.

In addition, Lido DAO will receive 10% of users’ total staking rewards. The current distribution ratio is: 5% for verification nodes and 5% for insurance funds. Therefore, it does not directly generate income cash flow for LDO tokens, so we do not think Lido has generated profits.

5.1 Token distribution

The max supply of LDO tokens is 1 billion. As of August 3, 2021, the distribution of LDO tokens is as follows:

Investors received a total of 321.8 million tokens (32.18%)
Investors in the seed round obtained 220 million tokens, which will be unlocked linearly in 12 months starting from December 2021.
Investors in the round of Paradigm obtained 100 million tokens, which will be unlocked linearly in 12 months starting from May 2022.
The initial Lido developers obtained 200 million tokens (20%), which will be unlocked linearly in 12 months starting from December 2021.
The founders and future team members obtained 150 million tokens (15%), which will be unlocked linearly in 12 months starting from December 2021.
Validation nodes and multi-signature members obtained 65 million tokens (6.5%), which will be unlocked linearly in 12 months starting from December 2021.
There are 28.4 million tokens (2.84%) in circulation. Most of these LDOs are released to stimulate the liquidity of stETH/ETH (about 5 millions are released every month). In addition, the cooperation with 1inch, Arcx, Unslashed, DeveriFi and Bancor and the airdrop also consumed some LDOs.
The remaining 235 million tokens (23.5%) are still controlled by DAO treasury.

In general, the token share of the team and investors is high, accounting for more than 62% of the total circulation, and there will be a large number of releases starting from December 2021.

6. Risk

a. The risk of ETH2.0

ETH2.0 is still a developing product, which may have errors and vulnerabilities, resulting in the impairment of stETH. In addition, the transfer function of the Beacon Chain has not been opened, and stETH cannot maintain a 1:1 rigid payment with the staked ETH. This means that Lido cannot redeem all ETHs in case of a deposit run.

b. Staking penalty risk for improper node operation

If the verification node of ETH2.0 fails to verify, a maximum of all staked funds can be deducted. Although Lido has selected multiple professional verification nodes to spread risks and use insurance funds to compensate for losses, there may still be situations where losses cannot be covered.

c. Security risks of smart contract

Lido’s code is open source, which has been audited by Sigma Prime, Quantstamp, and MixBytes (https://github.com/Lidofinance/audits) and is covered by an extensive error bounty program to minimize this risk. But there are still security risks of smart contracts.

d. Management risk of DAO key

All ETH deposited before July 15th is controlled by 11 multi-signature users. Although these 11 users are closely related to the development of ETH and have good reputation, they may still be moral hazards, private key loss risks, hacker kidnapping and other force majeure risks.

7. Valuation

7.1. Five core questions

What business cycle is the project in? Maturity stage or the early and middle stage of development?

The project is in the middle stage of operation, with leading position in ETH2.0 staking. It is expanding to other public chains.

Does the project have a solid competitive advantage? Where does it come from?

As analyzed in the section of 3.3, the project has a relatively solid competitive advantage, which comes from the scale effect of stETH and the support of ETH community.

Is the medium and long-term investment logic of the project clear? Is it in line with the industry trend?

The medium and long-term investment logic of the project is clear, aligned with the general trend of the industry.

What are the main variables in the operation of the project? Are these variables easy to quantify and measure?

The main variables are the use case expansion and price stabilization mechanism of stETH, and the progress of ETH2.0. This factor can be observed by paying attention to the daily release of the project and community governance proposals, etc., and other business data can be viewed directly on the chain.

What is the management and governance of the project? What is the level of DAO?

DAO was created on Aragon at the beginning of the project, and the community forum is active. Paradigm and other top institutions were introduced through the governance of DAO. Now the level of DAO is high.

7.2. Valuation Assessment

7.2.1 Vertical valuation assessment

10% of the staking yield will go to LidoDAO, but at present LidoDAO has allocated all this part to insurance funds and verification nodes. Therefore this 10% yield will not directly generate value for LDO token, thus we do not think that LDO generate profits. We use P/S ratio for vertical valuation assessment.

https://www.tokenterminal.com/terminal/projects/Lido-finance (The “P” in the figure refers to the full-diluted market cap.)

We can see that with the gradual increase in the number of ETH staked on Lido, the protocol yield gradually increases, so the full circulation P/S of LDO continues to decrease, remaining within the range of 20–40. The protocol revenue has also continued to grow, rising to the magnitude of US $300,000 per day.

Considering that the current circulation of LDO accounts for only less than 3%, its circulation P/S is only about 1, which is extremely underevalued compared to the past.

7.2.2 Horizontal valuation assessment

There is a big gap between other staking pool projects and Lido, and there is no project that is close to Lido in terms of business form. So when we compare Lido, we compare Lido and top TVL protocols separately using several indicators such as “full diluted market cap/annualized protocol revenue” and “circulating market cap/annualized protocol revenue”, “full diluted market cap/TVL” and “circulating market cap/TVL”.

Note: The market cap data is taken from coingecko, revenue data is from tokenterminal, and the TVL data is from Defillama. The units are all millions of U.S. dollars. The data time is August 20th at 16:00 UTC+8.

From the data, all indicators of LDO calculated by circulating market cap are extremely underevalued, and the indicators using the total market cap make the valuation appear relatively reasonable.

In terms of TVL indicators, due to the small circulation of Lido and Balancer, their “circulating market cap/TVL” indicator is obviously underesvalued. However, after considering the circulation ratio, the current valuation of LDO is higher than that of the head protocols except UNI.

In terms of more exaggerated revenue indicators, the circulation P/S of LDO is only less than 2, which has an order of magnitude gap with the head DeFi protocols. So it is extremely underevalued by the naked eye in the whole DeFi protocols. Even considering the full-diluted market cap, LDO is still not overvalued.

Of course, this is mainly caused by the current low circulation rate of LDOs.

Each investor may have his or her own answer to the question of “whether the valuation of DeFi protocol should use circulating market cap or the fully-diluted market cap”. We believe:

From Lido’s business data, LDO is currently extremely undervalued for short-term investors; for long-term investors, it has a moderate valuation.

7.2.3 About governance value

Qualitatively speaking, LDO represents Lido’s governance rights. Lido is the staking pool selected by the Ethereum community to fight against CEX, shouldering the mission of ETH decentralization. If Lido becomes the largest staking pool of ETH2.0 as they wish, the governance value of LDO actually implies a part of the governance value for ETH. The competition for computing power on the PoW public chain is reflected in the battle for staking power on the PoS public chain. Lido Finance will have the largest staking power, and all governance of Lido needs to be done through LDO.

It is worth noting that this value cannot be quantified, and it may not necessarily be recognized by the market. However, holding LDO may participate in the governance of ETH, which may be the value that cannot be reflected in the LDO business data.

7.2.4 Future outlook

We expect that in the future, with the progress of ETH2.0 and Lido’s current advantage in the track, Lido’s TVL will continue to grow. With the increase of the total staking amount of ETH2.0, the yields generated by the overall staked ETH of the protocol will marginally decrease. However, we believe that the growth rate of Lido TVL will far exceed the reduction rate of staking yield, so we believe that Lido’s revenue will continue to grow. Moreover, with the increasingly blurred distinction between stETH and ETH and the characteristics that can bring higher revenue, Lido is likely to become the DeFi protocol with the largest TVL before ETH2.0 goes online.

Summary

Lido is a staking pool selected by the Ethereum community to fight against CEX, shouldering the mission of ETH2.0 decentralization. If Lido becomes the largest staking pool, the governance value of LDO actually implies a part of the governance value for ETH;
stETH has a moat and a strong network effect due to high liquidity. Lido is very likely to become the DeFi protocol with the largest TVL before ETH2.0 goes online;
By comparing horizontal and vertical valuations, we believe that now LDO is extremely undervalued for short-term investors; for long-term investors, its valuation is moderate.