How will Ethereum Shanghai upgrade affect the future of staking?

By Juan Gadea

Translation: John, ECN

Proofreading: Stephanie, ECN

The much-anticipated Shanghai upgrade is just around the corner, launching on the Goerli testnet on March 14 and expected to go live on the mainnet in the second week of April. The Shanghai upgrade is a major milestone for the Ethereum ecosystem, allowing people to withdraw funds from staking contracts for the first time.

This upgrade gives the staking industry its first opportunity to completely overhaul itself. Until today, market participants have struggled to efficiently switch between staking products due to delayed rewards. Withdrawals provide the freedom to switch between products, allowing users to pause validation, try new services, or find enough confidence to run a node themselves. The reduced friction of withdrawals will drive the next transformation of the Ethereum staking market.

The general consensus is that withdrawals will greatly reduce the risks associated with staking Ethereum, making it a more viable option for more institutions and investors. Until now, the inability to withdraw has hampered access to the global inventory of one of the world’s most valuable assets (valued at approximately $29 billion). Soon, staking rewards will be constantly accessible and liquid through a variety of actions, including donations and funding public goods. Enabling withdrawals is also an important step in the evolution of Ethereum’s micro-economy, and for stay-at-home validators, withdrawals bring much-needed cash flow to fund their operations (and potentially more).

With this background, below we will introduce a series of key indicators to watch when heading towards the Shanghai upgrade, why they are relevant, and how they may change before and after the Shanghai upgrade. Unlocking the circulating value flow of Ethereum has the potential to be a major catalyst for network growth and global adoption. As Dune said, data must flow... In this case, it's time to make ETH flow.

Participation Rate

Since the beacon chain went online in 2020, more than 17.5 million ETH has been staked on it, growing steadily at a rate of 13.4% per month (there are now approximately 546,000 validators providing security for the beacon chain). The current amount of ETH in circulation is approximately 120.5 million, and the network participation rate remains at 14.5%. However, since the merger, the monthly deposit growth rate has dropped to an average of 4%, indicating that enthusiasm for running validator nodes has declined.

Source: Etherscan, Dune Analytics @obol_labs

After the Shanghai upgrade, the reduction in risk may lead to a significant increase in participation rate, and the value may double. Ethereum researcher Justin Drake clearly pointed out this direction as early as 2019. He said that about 33.5 million ETH is reasonable for the security of the network (to reach this security threshold, the current staked ETH deposits need to be doubled).

However, despite the withdrawal feature being enabled, it is reasonable to be concerned about the apparent decline in staking participation, given that current annualized staking rewards for validators are lower than some more stable options (such as US Treasuries).

Finding a balance

Even more interesting is that the Shanghai upgrade will bring Ethereum’s reward rate closer to true market equilibrium. For the first time, the reward rate can actually rise faster, creating the two-sided market we need for staking to mature, which will not only incentivize more people to stake, but also provide an exit mechanism for those who want to switch to new things, which may increase validator rewards (for example, lowering the number of validators will effectively increase staker returns).

While it is expected that participation may double or grow more as withdrawals come in, it is unlikely to reach equilibrium levels similar to other PoS chains, where participation rates are often above 60% of the circulating supply or more. Such high participation rates result in lower staking rewards, which may make it unattractive for validators to participate (if 60% of circulating supply is staked - that is, about 72 million ETH - then the average Ethereum validator's net annual return is about 0.86%). Therefore, it is unlikely that pure economic incentives can maintain such high participation rates.

In addition, the widespread use of ETH as a medium of exchange will further limit participation. ETH as a currency means that many token holders are reluctant to stake their coins because they may prefer to use them elsewhere, such as trading or investing. So even if the economic incentives of staking are more attractive, the overall participation rate may still be limited because token holders do not want to lock up their coins for a long time.

We can calculate the participation rate like this:

Participation rate = Staked ETH / Total ETH supply

Source: Dune Analytics @obol_labs

The main reason to focus on this metric is that Ethereum validator rewards are inversely proportional to the number of active validators. In other words, as participation decreases, network validator rewards increase, and this dynamic relationship has a ripple effect throughout the network. The most basic validator behavior (that is, the process of validators entering and exiting) can cause huge fluctuations in this metric. We view this as an important macro indicator that has a trickle-down effect on the rest of the behavior.

We also view participation rate as a multiple of safety, called “safety capitalization”:

Security capitalization = total ETH market value / staked ETH market value

This metric represents the economic security of a network compared to its total market capitalization. When this multiple is too high, investment outweighs network security, and vice versa.

At the current ETH market capitalization, the security capitalization reaches about 6.89 times, which is a 94.5% drop from the historical high in December 2020, when the multiple reached 125.5.

Historically, Security Capitalization has been steadily declining each month, with speculation clearly decreasing as the cryptocurrency market matures and Ethereum network security approaches reasonable thresholds (see here). It will be exciting to see this metric mature as chain security stabilizes after the Shanghai upgrade.

Source: EtherScan, Dune Analytics @obol_labs

Ethereum staking, where is the future?

Source: Dune Analytics @obol_labs, @hildobby

We closely track where staked deposits go after they enter or exit the network, based on total participation. After the Shanghai upgrade, the shape of the staking network will have an opportunity to change to accommodate different market realities than when we launched the beacon chain.

As shown in the above figure, liquid staking protocols currently have the largest market share, maintaining about 43% of the staked ETH¹, followed closely by centralized exchanges. Liquid staking protocols represent a market of approximately $11.5 billion, which has continued to grow over the past few years, with an average monthly growth rate of 28.2%.

As the chart below shows, a significant portion of ETH’s total stake is held by just four entities — Lido, Coinbase, Kraken, and Binance — accounting for a staggering 56% of total ETH staked. In contrast, an equivalent amount of ATOM staked on Cosmos is distributed among 18 validator entities.

Source: Dune Analytics @obol_labs, @hildobby

The question of centralized vs decentralized staking is widely discussed in the Ethereum community. When it comes to the issue of centralized staking, there are still some technical barriers that make it difficult for the average person to run a validator node. While centralized entities make staking easier for non-technical users, further efforts are needed to decentralize staking operations for the health of the network.

The fear of slashing and offline penalties still makes people who stake tokens uneasy, although the number of validators slashed is still relatively small (only 229 validators out of more than 546,000 validators have been slashed). Secondly, the capital requirements required to run a validator (32 ETH / ~$50,000) force many people to rely on staking providers, which naturally leads to a pooling effect, further exacerbating the existing staking centralization risks.

There is a big push to decentralize staking, with one focus being led by DVT (Distributed Validator Technology). Some of the benefits of DVT include:

Increased participation : By lowering the barrier to running a validator node, DVT encourages more people to participate in staking, resulting in a more diverse and representative network. DVT enables small validators to provide comparable uptime and efficiency to large validators. The ETH required to run a node is also reduced, as multiple nodes can be combined to meet the 32 ETH (about $50,000) requirement to participate in validation.

Decentralization : DVT decentralizes the verification process by implementing a structure called multi-operator verification, where the validator responsibilities are distributed among a group of entities or individuals.

Security : Multi-operator verification makes the risk of single point failure almost zero, greatly improving the overall security of the network.

Improved Return on Investment (ROI): By increasing uptime and reducing slashing risk, DVT allows stakers to optimize their staking APR.

Flexibility : DVT allows validator nodes to run under different configurations, clients, locations, and organizations, which brings greater flexibility to staking and optimizes Ethereum’s client diversity.

In-depth guides and popular science on staking also help lower the technical barrier. Plug-and-play staking hardware is also gaining traction, led by Dappnode and Avado. These efforts could make it easier for a wider range of users to participate in staking and increase the number of network nodes, thereby improving decentralization.

Liquid staking is also moving towards a more decentralized specification. Rocket Pool, Stakewise V3, and Lido V2 are all examples of liquidity staking models that use a modular approach, where users have more control over how to set up their validator nodes, and use DVT as a core element of these specification designs.

Ultimately, the issue of centralized vs decentralized staking is likely to remain a topic of ongoing debate. While technical barriers and the popularity of staking as a service make centralization a bitter reality for Ethereum, the introduction of DVT, new legal formats, and more usability/decentralization efforts could lead to a more democratic and secure network in the long run. Users and stakers should carefully consider the tradeoffs involved in each staking method and strive to find a balanced and sustainable staking approach.

Liquidity Staking

Source: Dune Analytics @obol_labs, @LidoFinance

Another area worth watching is monitoring the inflow of ETH into the liquidity staking pools, both from an individual and collective perspective. As mentioned above, liquidity staking currently accounts for the largest share of the staking market, and the streamlined business model of liquidity staking pools reduces the high opportunity cost for stakers when delegating their tokens, making staking very efficient, so it can grow further.

The purpose of liquidity staking is to solve the liquidity limitation problem of traditional staking methods. It is mainly to solve the liquidity limitation of Ethereum, that is, users cannot withdraw funds after the beacon chain is launched. We believe that liquidity staking is an important part of a mature market because it allows the popularization of staking services in the most direct way.

Although Lido currently occupies a dominant position in the market, it still faces severe competition from other liquid staking protocols, such as Rocket Pool, StakeWise, and Frax, which are slowly forming a challenge to Lido's market dominance. In addition, the entry of Coinbase (one of the top centralized exchanges and also an industry giant) has made the competition more intense. Due to its strong brand and reputation, Coinbase is in a good position to bring in a large number of new stakers, and people can already feel the impact of its 15.4% market share of liquid staking.

Although Lido currently occupies a dominant position in the market, it still faces severe competition from other liquid staking protocols, such as Rocket Pool, StakeWise, and Frax, which are slowly forming a challenge to Lido's market dominance. In addition, the entry of Coinbase (one of the top centralized exchanges and also an industry giant) has made the competition more intense. Due to its strong brand and reputation, Coinbase is in a good position to bring in a large number of new stakers, and people can already feel the impact of its 15.4% market share of liquid staking.

The table below shows the top liquidity staking providers on Ethereum, with Lido leading the pack with a 74.7% share, followed by Coinbase with 15.4%, and Rocket Pool in third with 5.8%. As we get closer to withdrawals, new stars of the market will also hit the market. Players like Alluvial with their institutional liquidity staking solution, Stader Labs, and Swell are likely to deploy their products before the Shanghai upgrade. In the development trend of the liquidity staking market, EtherFi should not be underestimated.

Source: Dune Analytics @obol_labs , @eliasimos

The main trend currently observed in the liquidity staking market is that most liquidity staking tokens have been trading at a discount to their underlying value. This phenomenon is caused by different reasons, such as market volatility, liquidity constraints, and shortages caused by delayed cash flows. In the past year, we have seen several major sell-offs in the liquidity staking market, including the collapse of LUNA in May, the 3AC circuit breaker in June, and the collapse of FTX in November.

Since validators no longer have cash flow issues, the question that remains is whether Liquid Staking Tokens (LST) will trade at a premium or discount. Prior to withdrawals, the price has been sustained by incentivized liquidity and faces strong headwinds due to their structurally delayed cash flows. Now that people can get their ETH back, this will be a turning point for the future trading of LST. However, the expected entry delay could be as long as weeks, forcing heavyweight players to quickly move to LST, pushing the price into the premium zone. Additionally, traditional financial theory suggests that validators should hold more than 32 ETH due to the reward stream attached to it. This can be said to be the dawn of a new era.

But a notable exception is Rocket Pool, whose rETH has been trading at a premium, mainly due to the push for more decentralization and Rocket Pool's mechanism design. The supply of rETH is correlated to the growth of node runners. Since Rocket Pool has a widely distributed set of node runners and there is a lack of demand for them to run mini pool nodes, they now have a large amount of ETH in the storage pool waiting to be paired with mini pool validators. Since there is not enough demand for mini pool validators to absorb deposits, this has prompted rETH to trade at a premium.

The chart below compares two scenarios: LST which should trade at 1:1 parity with ETH, and a reward token which appreciates relative to ETH. The premium/discount of the reward token comes from the conversion rate, which in turn creates an implied fair value rate².

The chaos caused by the collapse of Luna and 3AC had a profound impact on all LSTs, forcing them to trade at severe discounts for a considerable part of 2022. Lido's stETH has been trading at a discount for almost the entire year, especially between May and August, with an average discount of -1.42%. However, it has recovered since then and now trades close to its peg. Stakewise's sETH2 also struggled to maintain parity trading over the past year, but recently recovered and is trading close to parity. In contrast, frxETH has remained fairly stable since its launch in October, rarely deviating from its peg with some exceptions.

RocketPool was trading at a premium until Luna collapsed in May. Like most LSTs, it traded at a significant discount until October, when it began to return to parity. Currently, it is back to trading at a premium, averaging a 1.78% premium to its implied fair value rate since October 2022.

Source: Dune Analytics @obol_labs, @eliasimos

Source: Dune Analytics @obol_labs, @rp_community

ETH Inflation

At the end of the report, we would like to talk about the inflation problem of Ethereum. In September 2022, the Ethereum consensus switched from Proof of Work (PoW) to Proof of Stake (PoS). As the execution layer no longer issues tokens, ETH tends to deflation. The community calls this concept Ultrasound Money.

This has resulted in a significant drop in inflation compared to previous years. In 2022, ETH’s inflation rate remained at an average of about 4%. However, after the merger, the annualized inflation rate reached an astonishing 4%, as the circulating supply of ETH has effectively decreased by approximately 27,300 ETH since the merger, a decrease of 0.023%.

Source: EtherScan, Dune Analytics @obol_labs, @blockworksres

Transactions on Ethereum require a base fee paid in ETH to be considered valid (see EIP-1559). The fee is burned during the transaction, reducing the amount of ETH in circulation. The fee burn base went live in the London upgrade in August 2021 and has remained in place since then.

To put it more simply, when more people use Ethereum mainnet transactions, more ETH will be burned as transaction fees. This brings deflationary pressure on ETH supply, which will be particularly evident in major on-chain events (such as NFT airdrops or market sell-offs).

ETH inflation may experience a significant drop around the Shanghai upgrade for different reasons, but largely due to withdrawal opportunities, which allow approximately $29 billion of validator balances to be transferred on-chain in a permissionless manner.

When this balance effectively affects the market, a large number of on-chain transactions will occur, resulting in a large amount of fees being burned. In addition, due to the low price of ecological assets, validators may directly exchange their ETH for other blue-chip tokens. This may lead to a sharp drop in the inflation rate, similar to what was observed in the Otherside Mint (BAYC) event on May 1, 2022.

However, the validator balance will not all flood into the market immediately, and the Ethereum specification limits the number of partial withdrawals: 256 per epoch (partial withdrawal means withdrawing the balance of more than 32 ETH, i.e., the staking reward). This means that 57,600 partial withdrawals can be processed in one day. If all the current number of validators (about 546,000) want to make partial withdrawals, it will take about 9.48 days to complete, which may cause the reward transfer to last for several days. For validators who want to exit the validator set, WestieCapital from Blockworks Research has created a reference chart that depicts how long the withdrawal waiting period will last at a specific time, depending on the percentage of validators who want to exit the validator set.

Conclusion

The upcoming Ethereum Shanghai upgrade will mark a major milestone in the network's roadmap and a reset for the entire staking industry. After withdrawals are enabled, market participants will be able to freely switch to other staking products, and the reduction in friction will change the landscape of the staking market. Withdrawals will also greatly reduce the risks associated with Ethereum staking, ushering in the next wave of investors and institutions.

Reducing the risk of Ethereum in general will increase network participation as staking becomes a risk-free bond in the crypto market, allowing people to actively participate in providing security for public blockchain networks.

At Obol, we will enter the market as part of the larger Shanghai upgrade infrastructure transition to help provide security for validators preparing to increase ETH staked into the Ethereum network. Distributed Validator Technology (DVT) further de-risks Ethereum staking by reducing the risk of validator slashing to almost zero while providing highly available validators to the industry (Obol labs launched the first distributed validator (DV) cluster on the Ethereum mainnet on December 30, 2022 - see here for details).

Decentralization and modular specifications will make liquidity staking the driving force behind the next wave of staking, such as Lido V2, Stakewise V3 and Rocket Pool. By giving stakers greater control over node operations, liquidity staking will empower users to actively participate in the network while increasing decentralization. As this field develops and matures, we can expect to see greater adoption and innovation in the staking industry.

As the Ethereum community grows, we must strive to support the work that is being done to improve the security and resilience of the network. The deployment of DVT alongside withdrawals will make staking a new and fruitful ecosystem with all the necessary elements to thrive in a healthy way.

As we approach the Shanghai/Capella upgrade, we invite you to read our Dune ETH staking ecosystem dashboard for other important insights - link

Special thanks to @hildobby @eliasimos @LidoFinance @BlockworksRes @rp_community for providing open source materials for the report and dashboard

Notes:

1. The market share of beacon chain depositors is an approximate figure, because not all addresses correspond to different entities

2. Incentive token calculation formula: ETH/rETH conversion rate → Implied rETH fair value → Actual rETH value → rETH premium/discount

3. The calculation method is average validator balance x number of active validators x ETH price on March 6 ($1560)