April 2023

Ethereum's Shanghai Upgrade and the State of Staking

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On 12th April, Ethereum underwent the long-awaited Shanghai upgrade, completing its transition to proof of stake and signalling that the age of staking is truly upon us. The migration to proof of stake has taken Ethereum several years to complete and this upgrade is the most anticipated since Ethereum underwent “the Merge” in September 2022.

This month we will dive into the world of staking, exploring Ethereum’s Shanghai upgrade and reviewing its potential impact. We will also assess the newer liquid staking protocols that have been in hot demand as an alternative way for users to stake without having to lockup tokens. We will dig into the problems that they solve and how they impact network security for chains running on proof of stake.

By way of a quick refresher, there are two main types of consensus algorithm that public blockchains employ. The first is proof of work, used by Bitcoin, whereby miners contribute processing power to secure the network and process transactions. In return, these miners receive block rewards and transaction fees. The second consensus algorithm is proof of stake, whereby token holders can stake (or delegate) tokens to validators. These validators process transactions with the staked tokens acting as collateral and securing the network. Validators receive block rewards and fees, most of which is passed back to the delegator, meaning that as a token holder you can earn a reward over time for locking up your tokens in staking.

On Ethereum, there are several ways to stake ETH. How a user stakes will depend on the amount of ETH that they want to stake and their level of technical sophistication.

Ethereum began its migration to proof of stake in December 2020. Since then, around USD33bn of ETH has been staked on Ethereum in order to secure the network and for those stakers to receive staking rewards. However, none of the staked ETH or the rewards from staking could be withdrawn. This ETH remained locked up. The Shanghai upgrade that happened last week changed this, making this ETH accessible for stakers to withdraw.

One could look at this event as being a risk for the price of ETH. In simple terms, USD33bn of ETH has been locked up and there were over 1 million ETH (USD1.8bn) in rewards that were eligible for withdrawal. Now that staked ETH can be withdrawn, a portion of stakers may choose to withdraw and sell the rewards that they have been accruing and the staked ETH itself. In addition, last month we wrote about global crypto regulation and the fact that the US has been taking an increasingly negative stance on crypto. One risk facing Ethereum is that the SEC may use the Shanghai upgrade to qualify ETH is a security, with profits (staking rewards now claimable) being “derived from the efforts of others” (core developers).

While some investors are concerned about short term ETH price action following last week’s Shanghai upgrade, there are several factors that look to be counteracting any potential sell pressure. In fact, we have already seen the price of ETH go up following the upgrade. Some reasons for this include:

  • The staked ETH is not available all at once. A large portion of locked ETH has not been staked directly by users, but through third parties such as exchanges. Coinbase, for example, has said that it could take up to several months for customers to withdraw their staked ETH from the platform. Therefore, there was not a sudden unlocking event, but a staggered unlock in practice.
  • Many users have staked their ETH through pooled staking offerings. For example, Lido is a liquid staking provider whose ETH stake makes up over 30% of all staked ETH. Other providers include RocketPool, StakeFish, and centralized exchanges. Many of these products give users derivative tokens that represent their staked ETH and there are deep markets for these derivative tokens. This means that users have been able to sell their staked ETH position for a long time already. The unlock from the Shanghai upgrade should have no impact on these users who already have liquidity on their staked ETH.
  • Many stakers are long-term ETH holders and believers. When they staked their ETH, they knew that they would be locked up for years and it was not certain that the transition to proof of stake would even be successful. These are not the type of investors that are likely to trade out of ETH positions because of an unlocking event.
  • As long-term ETH holders, these stakers have also seen crypto cycles play out. It is generally accepted that we are near the bottom of a bear market, which is historically the worst time to exit positions. Sophisticated stakers will be aware of this and may be content to continue staking until market conditions present superior selling opportunities.
  • On the demand side, these types of upgrades are newsworthy and drive demand for ETH. There are also likely investors who have been waiting to purchase ETH until after the Shanghai upgrade. Purchasing power from these investors may counteract the sell pressure coming from the ETH unlock. These investors fall into two camps:
  • Traders who believe the price of ETH will come down as a result of the upgrade. They are waiting to buy the dip and will counterbalance selling pressure.
  • Investors wanting to stake ETH to receive the staking yield, but only looking to do so once they know that they can un-stake. These investors were waiting for the successful Shanghai upgrade to take place before buying and staking ETH.

The move to proof of stake on Ethereum has encouraged a wider staking ecosystem to emerge. The biggest winners to date have been the “liquid staking providers”. The main pain point for stakers is that their staked assets are locked-up, often for at least 3 weeks. This is to prevent against attacks that could be done if un-bonding was instant. This is where liquid staking comes in. Liquid staking providers allow users to stake assets and in return they receive a derivative token that represents the staked token. From a technical perspective, the way this works is that user tokens are deposited into a smart contract. The contract delegates the user’s stake to validators and mints the user a token representing the staked asset. The minted token can be redeemed for the staked asset, meaning that it should reflect the price of that asset.

Liquid staking has proliferated through proof of stake ecosystems. Lido leads the market on Ethereum, although the large exchanges have been catching up with Coinbase now making up 12.5% of all staked ETH today. On Solana, Marinade Finance is the leading liquid staking provider and on Polkadot there is Acala. When it comes to Cosmos, the architecture differs from other networks as Cosmos is not a single network, but an interchain ecosystem of many networks. This means that liquid staking within the Cosmos ecosystem has the potential to unlock constrained value across multiple zones in the Interchain.

In our Digital Asset Fund 4, we were an early investor in Quicksilver which is quickly becoming the leading liquid staking provider in the Cosmos ecosystem. With many different chains and validator sets, liquid staking in Cosmos is unique. Quicksilver is implemented as a sovereign Cosmos-SDK chain and makes use of the interchain staking module, allowing it to onboard other chains. From a technical perspective, Quicksilver generates and controls deposit accounts for onboarded chains (using the Interchain Accounts Module). Users transfer the native asset of an onboarded chain into the deposit account and in return receive qAssets. The protocol stakes on behalf of the user and the Quicksilver protocol becomes the recipient of delegation rewards, which it receives into delegation buckets. At the end of each Epoch (3 days), each delegation bucket will redeem rewards and re-stake them. This compounding is a value-add for stakers.

Liquid staking is becoming extremely popular as there are clear benefits for the user, namely that the user can earn staking rewards whilst also having liquidity and the ability to use the staked tokens in DeFi applications. In addition, there are also benefits for the network. Increasing the amount of staked assets on any chain increases the economic security of the chain. In the fast-paced world of DeFi, it can be challenging for staking rewards to match the return that can be obtained by using base layer assets elsewhere. In a world where better returns can be generated outside of staking, liquid staking boosts the security of sovereign chains by encouraging token holders to stake assets they otherwise would not have.

Ethereum’s move to proof of stake is a huge positive for the blockchain industry. It has reduced the network’s carbon footprint by 99.9%, it has reduced the issuance rate of ETH by 90% as rewards from proof-of-work mining were turned off, and it has paved the way for greater network scalability. It has also helped foster a new ecosystem of staking products and services. The Shanghai upgrade is the final step in completing this move to proof of stake and has attracted significant media attention. We anticipated that increased attention on Ethereum would boost demand for ETH and counter-act sell pressure from the ETH unlock. As a result, we maintained our ETH position throughout this event. While we are only a few days in, the price of ETH has risen following the upgrade. Markets have a habit of pricing in events of this nature, and the ETH unlock here has not led to a sell-off that some investors feared.

Over the long run, our view remains that ETH is undervalued and that proof of stake networks and staking ecosystems present excellent investment opportunities. The Merge dramatically decreased the rate of ETH inflation (ETH is currently deflationary) and at some point this will cause a supply shock, pushing the price of ETH up. Liquid staking protocols will remain popular and grow to become core infrastructure for proof of stake networks. We are excited to have invested in Quicksilver and we will continue to look for leading liquid staking protocols to support across different base layer public blockchains. These protocols support proof of stake blockchains and over the long run will help to create more secure, sustainable and stakeholder-friendly crypto networks.