Article Author: ValHolla
Article Translation: Block unicorn
Everyone knows that the Ethereum merger will have a positive impact on DeFi, but in less than a year, it has exceeded the wildest bullish expectations. The best example of this is LSDfi – the DeFi world based on liquidity staking derivatives is constantly evolving. This narrative has been around for a while now, so it’s worth exploring where it came from and, more importantly, where it’s headed.
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In this article, I will divide the evolution of LSDfi into three stages and take a look at some cutting-edge projects in the LSDs’ potential applications. It is certain that there are many things in our vision, and what we see is just the beginning.
Stage One: Liquidity Staking Protocols
Entering 2023, one of the hot areas in the cryptocurrency field is LSD providers like Lido and Rocket Pool. You may know that these protocols allow users to stake their ETH on smart contracts to help secure the network. In return, users receive LSDs like stETH or rETH – liquidity tokens representing the ETH they have staked. The result is a tradable and lendable liquidity token that still accumulates the staking rewards of ETH itself.
Earlier this year, many people believed that these protocols would benefit from the increase in staking demand, especially after the launch of Ethereum network staking withdrawals. I think it is safe to say that this trend has developed in an extremely bullish manner. Just look at the increase in the number of validators:
Similarly, the amount of ETH staked is also increasing rapidly:
LSD providers have played an important role in encouraging users to feel comfortable staking their Ethereum by maintaining the liquidity of staking tokens. However, the protocols that issued this first wave of LSDs are not the only ones benefiting from it. If you think of these staking protocols as the primary beneficiaries of LSDfi, we can delve deeper into the truth.
Once LSDs are released, it is logically necessary to find a way to keep them tied to their underlying assets. The last thing we need is a repeat of last summer’s situation when the largest ETH LSD, stETH, became unpegged due to forced liquidations by 3AC and others. Therefore, protocols like Curve and Balancer saw a significant influx of funds into ETH LSD-related pools, amplifying their TVL.
Now, Curve’s stETH/ETH pool is the most prominent LSD pool in DeFi, with a TVL of approximately $740 million. They also have over $164 million in the frxETH/ETH pool, making it their fifth-largest fund pool on the mainnet.
Balancer – Of their top 4 pools on the mainnet, 3 are related to LSD, with a TVL of over $136 million, accounting for over 13% of their total TVL.
Looking ahead, we can see that LSD has actually become the largest source of TVL for all DeFi:
When you put this in context, it becomes even more impressive: now, there are about 10 million ETH deposited in liquidity staking protocols. This number has grown over 5 times since the beginning of 2022!
During the same period, almost everything else in DeFi and the broader cryptocurrency universe has already crashed, so if LSDfi has experienced this kind of growth, it must clearly offer some real innovation. With this in mind, let’s move on to the second phase.
Phase Two: LSD as Collateral
The second phase of LSDfi consists of a series of projects with similar underlying concepts: users lock LSD in a CDP (collateralized debt position, where collateral is liquidated when the collateral price drops), then mint and borrow stablecoins.
You may be tired of seeing so many stablecoin products supported by LSD, but don’t let the number of protocols using this model diminish its importance. Personally, I think so many protocols are doing this because it’s a product that can have a tremendous impact.
It not only further expands the utility of LSD, but also contributes much-needed decentralization to the existing stablecoin market. In addition, LSD earns its underlying assets by performing certain tasks, such as providing security for PoS blockchains. The APR for staking is usually higher than the interest paid by most money markets for deposits (unless there is a high incentive), so you already have an advantage there. Essentially, using income-generating tokens as collateral turns each CDP position into a self-repaying loan.
So far, Lybra, Curve, and Raft are the biggest beneficiaries of the second phase.
Lybra has now been on CT for several months, and for good reason. Its eUSD stablecoin, backed by ETH and stETH, has reached a market cap of $177 million. Among decentralized stablecoins, only DAI, FRAX, and LUSD have a higher market cap.
And in less than 3 months, according to defillama data, Lybra has accumulated a TVL of $345 million, making it the third-largest CDP protocol on Ethereum, behind only MakerDAO and Liquity – a very impressive LSD protocol!
Curve’s CRVUSD stablecoin is backed by wstETH, WBTC, sfrxETH, and ETH.
In total, these assets have over $120 million deposited as collateral, but over 80% of it comes from the two LSDs in the list (wstETH and sfrxETH).
As a result, there is now nearly $80 million of crvUSD in circulation, which has grown more than 7 times since June 7th.
Compared to the previous two protocols, Raft and its stablecoin R have not been widely discussed and noticed. However, they have still made impressive progress so far. In a few weeks, Raft’s TVL has increased from $1 million to $55-60 million, with the current data being $57.7 million.
So far, over 99% of the support for the R stablecoin comes from stETH collateral. However, they also accept Rocket Pool’s rETH as collateral, and there may be more forms of collateral in the future.
Currently, Lido’s stETH accounts for the majority of collateral for these Phase 2 protocols. I think there are two ways this situation could change: one way is that smaller LSDs will occupy more of the collateral market share.
This will come in the form of CDP protocols offering different collateral options and DeFi users being more willing to purchase smaller LSDs and use them as collateral. We have recently seen some projects gaining attention in this area (besides crvUSD), such as Gravita, which accepts both stETH and rETH. So far, Gravita is an exception as a significant portion of their stablecoin (GRAI) is minted through rETH rather than stETH.
Another way is through the most common path for LSD providers. So far, Lido’s stETH has captured nearly 75% of the market.
I believe that with the development of LSDfi, more LSD options will gain market share. In fact, by the end of 2024, I wouldn’t be surprised to see stETH’s market share drop below 50%. After all, only 17% of the ETH supply has been staked so far, and less than half of it is through LSD providers. So, this game is far from over.
Phase 3: Diversification of Collateral
So, if Phase 1 is LSD and Phase 2 is LSD-based lending, what does Phase 3 entail?
Due to the underlying trend of the entire process being the second largest asset in the cryptocurrency, ETH’s LSD, the natural direction of development will be further expansion through other composable assets. This can be achieved through the use of LP tokens, stablecoins, money market deposits (such as Aave’s aUSDC), etc. Just imagine: what if you could do everything that phase two protocols like Lybra do with ETH, but with other types of cryptocurrency tokens that you hold, or with your investment positions in other projects (i.e., your investment share or equity in other projects)?
A good example of an emerging DeFi project seeking to implement this strategy is Seneca. Although their product has not been made public yet, they are building a protocol that will be able to unlock credit for various types of DeFi users.
While you can earn decent returns through LP tokens, LSD, deposit receipts, etc., there is always a search for more and more capital efficiency. Seneca will enable these tokens to be used as collateral for their native stablecoin: senUSD. This way, liquidity is unlocked while collateral holders can still earn returns on their assets.
Another project pioneering in this direction is EraLend, which is the precursor for the zkSync money market.
EraLend has several features that set it apart. First, they are already in the process of executing phase three by accepting SyncSwap’s USDC/WETH LP tokens as collateral. This may be the first of many alternative assets used as collateral on EraLend—the catalyst for expansion being their upcoming P2P lending product. Not much is known about this product yet, but I believe anyone could use any type of token (LP tokens, LSD, debt receipts, NFTs, etc.) as collateral.
EraLend has gained traction in recent weeks, as their TVL has skyrocketed from $3.9 million on June 1st to $24.35 million (latest data from their website, defillama data is delayed):
With the rising narrative of zkSync, this is definitely a project worth paying attention to—in fact, it already ranks third in terms of TVL on zkSync.
Lastly, another interesting feature of EraLend is that any token can be used to pay for gas, hinting at the possibility of account abstraction for this young protocol in the future.
Even if you are confident that Tether and Circle have the assets they claim to have, the ideal scenario would be to see a native DeFi stablecoin with traceable on-chain collateral (without excessive exposure to traditional stablecoins) eventually surpass them as the leader. At this point, the most obvious approach would be to create a model like Seneca’s.
Looking ahead, some reserve system in DeFi is necessary as it allows for doing more with less resources. In fact, I would argue that DeFi can easily optimize such a system. First, code is law in DeFi, meaning that parameters like collateral requirements are fixed and cannot be adjusted in special circumstances. Additionally, unlike traditional finance, DeFi is inherently composable, making it easier to integrate new forms of assets and provide use cases for these assets. DeFi is also inherently transparent, making use cases like LSD- and LP-backed stablecoins more attractive compared to traditional stablecoins like USDT and USDC.