Detailed explanation of the similarities and differences of Ethereum 2.0 liquidity staking solutions

Original title: "The Tokenomics of Staking Pools. What Are Staked ETH Tokens and How Do They Work?"

Original source: StakeWise

Original translation: 0x26

Just over a month after the launch of the Ethereum 2.0 beacon chain, the balance of Ethereum 2.0 staking addresses has exceeded 2.4 million Ethereum. At the same time, a large number of third-party staking platforms have been launched, including centralized trading platforms Binance and decentralized DeFi projects such as Rocket Pool and Lido. These different staking solutions differ in many aspects.

Despite their differences, they have one thing in common: All of the projects are proposing solutions to the inevitable frictions that arise from staking Ethereum. So, what exactly are those frictions?

First, the technical complexity of Ethereum 2.0 staking is beyond the reach of the average user. With the price of Ethereum rising rapidly ($1,040 at the time of compiling this article), the minimum deposit requirement of 32 Ethereum is becoming increasingly out of reach for the average user. Finally, in order to achieve the transition to Ethereum 2.0 in a safe and controlled manner, staking has an illiquid lock-up period of 18-24 months.

Taken together, these restrictions can prevent less sophisticated users from entering the “lucrative” Ethereum 2.0 staking market.

How do staking pools solve this problem?

This is where Ethereum 2.0 staking pools come in. They source Ethereum from multiple users and perform Ethereum 2.0 staking operations on their behalf, allowing any participant to earn staking rewards regardless of their skill level or deposit size.

Additionally, they attempt to ease lengthy liquidity requirements by issuing Ethereum mainnet tokens that represent users’ deposits and rewards earned on the Ethereum 2.0 chain. These staking tokens provide holders with the opportunity to unlock liquidity, allowing users to trade Ethereum 2.0 staking tokens for Ethereum native tokens on secondary markets such as Uniswap to exit staking early, as well as the ability to participate in DeFi (e.g. as collateral in Aave) using their staked tokens.

However, the implementation models of staked tokens are different between different pools, which will undoubtedly bring some serious impacts to users. For example, Lido's third-party staked token (stETH token) is different from StakeWise's third-party token, so the pricing on the secondary market should be different. At the same time, Rocket Pool's rETH token is also different from stETH implementation, CREAM's crETH2, Stkr's aETH, etc.

In short, there are many differences in the mechanics of tokens from different staking pools that can lead to confusion and undesirable consequences for end users. However, these differences can be categorized and evaluated in order to discover the pros and cons of the respective staking pools. In addition, this comparative analysis can show the price efficiency of different Ethereum 2.0 staking tokens.

In this article, we will demystify the principles of Ethereum 2.0 tokenization and provide examples of how the tokenization of different staking pools works.

Staking Token Model

Based on the token structure, two different structures can be distinguished: one is a single token design that aims to capture both the initial deposit and income deposited in one token; the other is a dual token design that treats the pledged deposit and the return as two different tokens.

Single Token Design

The single token structure is based on the concept of rebalancing or re-pricing tokens. This is the most popular design and most staking pools use this strategy, probably due to its simplicity. By issuing a single token when a user deposits, staking pools seek to achieve the rights and responsibilities of rewards and penalties in the same token. This can be achieved in two ways:

1. Change the quantity: The rewards and penalties in the Ethereum 2.0 staking contract are reflected by changing the token balance. In the 1.5 token circulation phase, each staked token will be exchanged for ETH in the pool at a ratio of 1:1;

2. Changing prices: The rewards and penalties in the Ethereum 2.0 staking contract are reflected in the token mark price. In the 1.5 token circulation stage, the redemption amount of each staked token fluctuates according to the rewards from the staking pool.

Let’s understand it with a simple diagram:

1. The method of changing the number of tokens. Representative projects include: Lido and Binance.

2. Changes in the way prices are represented, Rocket Pool, Cream, StaFi, and Stkr.

Despite using different mechanisms to reflect the accumulation of rewards, the single token design has one thing in common: deposits and rewards are bundled into the same token. This means that whenever you buy or sell tokens on the market or get tokens from depositors, you will receive/sell both the deposit and any rewards accumulated to the pool in the past.

Dual Token Design

In contrast, the dual token structure is based on the concept of two rebalancing tokens that reflect deposits and rewards, respectively.

In contrast, the dual token structure is based on the concept of two rebalancing tokens that reflect deposits and returns respectively. Taking the stakewise token as an example, the deposit and return tokens are stETH and reETH respectively.

When holding a staked token with a dual-token design, the stETH token representing the staked Ethereum will not grow, while the rwETH (reward ETH) token that accumulates rewards at a 1:1 ratio will reflect the growth of the share of the earnings in the staking pool. Together, the sum of these tokens constitutes the overall earnings status and can be freely transferred between the Ethereum network and used in smart contracts in the same way as a single token.

As long as the staked token is held, it accumulates reward tokens. As the reward pool grows, the balance of the Ethereum token stETH representing the deposit remains unchanged, but the holding address receives reward tokens reETH.

The sum of deposited and rewarded Ethereum tokens is always equal to the amount of Ethereum in the pool; the exchange rate of both tokens remains 1

The dual token structure allows for the creation of a dynamic new hybrid model similar to bonds, but different in that it splits the stake into two parts with different accrual values ​​and cash flow expectations (principal and interest), enabling more efficient and flexible management of individual stakes.

Details of staking tokens

When it comes to the core workings of Ethereum 2.0 staking tokens, the design choices of different pools become more subtle, but can still make a significant difference.

Off-chain Oracles

In order to be an effective solution to liquidity stagnation, the token must accurately reflect the value of the staked tokens held. This requires placing the correct amount of Ethereum in the staking pool to support the corresponding staked token. To achieve this, the staking pool needs to track their node balances in the Beacon Chain and issue tokens against them.

But it is important to know that the contract responsible for issuing tokens and the balance of the validator node are not on the same blockchain (Ethereum 1.0 VS Ethereum 2.0).

Unfortunately, the ERC-20 contract responsible for issuing tokens is not on the same chain as the node balance (ETH1 vs ETH2). The token contract on the Ethereum 1.0 chain cannot directly synchronize the balance from the beacon chain verification node. The staking pool needs to bypass this limitation by using an off-chain oracle, which works in a similar principle to the now ubiquitous Chainlink.

Off-chain oracles can obtain beacon chain data in the following way: First, an oracle computing node must run both Ethereum 1.0 and Ethereum 2.0 nodes in order to interact with both chains at the same time. Once both nodes are started, the oracle will collect information about the validators belonging to a specific staking pool from the beacon chain and transfer it to the ERC-20 smart contract on the Ethereum 1.0 chain. Once the information from the beacon chain is submitted to the ERC-20 contract, the token amount will be updated (or the exchange rate will be changed to issue new tokens) based on the changes in the validator balance. This change can be up or down, depending on whether the balance is increasing (i.e. receiving rewards) or decreasing (i.e. incurring penalties/).

Unfortunately, off-chain oracles bring a disadvantage: the entity that controls the oracle effectively controls the update of the token. To alleviate this problem, staking pools require multiple oracles to submit the same information at the same time in order to update the token information through a consensus mechanism, and distribute oracles to achieve a certain degree of decentralization.

Staking token balance refresh rate

Each token balance update in the ERC-20 contract involves gas fees. To optimize gas fee expenditure, most service providers prefer to update token balances every day. Most people think this is enough because the daily returns are low (ranging from 0.005% to 0.063% per day), making more frequent updates insignificant.

However, in the case of large-scale slashing, daily updates may not be enough. Slashing occurs as long as the validator makes a mistake that incurs a slashing penalty, which can cause the validator to lose money within a few minutes. If the frequency of updating balances is less than 24 hours, it will have catastrophic consequences.

The problem here is that any user can track the amount of Ethereum in the validator nodes monitoring the staking pool through epochs (via the beacon chain explorer) and "foresee" the upcoming reduction in their balance before the tokens update their balance. Once users realize the potential loss is about to occur, they will execute the ERC-20 smart contract in advance and sell the tokens on the secondary market to reduce their losses, causing unsuspecting liquidity providers to suffer impermanent losses and hold a large position in the slashed staking pool.

To avoid this, staking pools can adjust their ERC-20 contract refresh frequency to a higher frequency, increasing the gas fee cost to prevent the risk of balance mismatches when slashing. In reality, staking pools are unlikely to update token balances more frequently (let alone every epoch). Instead, they are more likely to reduce the risk of slashing by improving security procedures, or be prepared to increase the frequency of updates only if a slashing event does occur.

Therefore, it is recommended that users and liquidity providers (LPs) of staking pools monitor the balances of the validator nodes of the staking pools they hold or provide liquidity to prevent being front-run by untimely slashing penalties.

Summarize

Hopefully, the research and understanding of Ethereum tokenized staking design will inspire in-depth discussions in the Ethereum community about the pros and cons of different staking pools, improve efficiency for the already tokenized Ethereum staking market, and protect stakers who may be harmed by unintended consequences of using poorly understood products.

Some of the concepts discussed in this article warrant further analysis and discussion, and could have far-reaching implications for the annualized rate of return (APR) derived from Ethereum 2.0 staking pools.