• Liquid staking is one of the few sectors in crypto in which protocols have achieved a unique product market fit due to their ability to solve the capital efficiency problem faced by token holders of Proof of Stake (PoS) blockchains. This has resulted in the sector having the largest TVL ($22b) in DeFi. If the capital efficiency issue of PoS chains remains, there will be perennial demand for liquid staking solutions.

• The liquid staking market is large as it grows together with the value of the chains that the protocols service. Today, liquid staking protocols on the top 5 smart contract chains generate over $800M in annual revenue. Furthermore, the quality of earnings of the sector is superior to that of other DeFi sectors due to their recurring and non-volatile nature.

• Lido is well-poised to capture the growth of the industry due to the strong network effect it has built around stETH, as well as strong track record of reliability and move to incorporate decentralized validator technology using SSV and Obol.

• We see a potential 3x opportunity in Lido revenue in medium term primarily driven by 1) Ether market cap increasing, 2) Rising Ethereum staking ratio post-Shanghai 3) Increased market share of decentralized liquid staking protocols 4) continued Lido dominance.

Liquid staking protocols have achieved solid product market fit due to their ability to solve the capital efficiency problem faced by stakers.

Today, the top smart contract-enabled chains by TVL all run on Proof of Stake (PoS) or a variant of PoS — eg. Delegated Proof of Stake, Proof of Authority etc.

Such blockchains allow users to stake their tokens, allowing them to earn rewards in return for boosting the security of the network. However, stakers’ tokens are typically subjected to unbonding periods which range from days to weeks depending on the protocol. This presents a key issue of capital inefficiency for stakers.

Enter liquid staking protocols, which allow users to stake their tokens in return for a receipt token, which represents their claim on their staked assets and the corresponding staking rewards. This receipt token can be freely transferred and used in DeFi activities like trading, liquidity pools as well as borrowing and lending.

Most importantly, liquid staking protocols presents stakers with two key value propositions — 1) the ability to generate yield and 2) liquidity on the staked asset, which together solve the capital efficiency problem. Owing to this, the liquid staking sector commands $22b TVL, the highest sector by TVL.

We think that this product market fit is unique to the liquid staking sector — If PoS-style chains remain in favor, capital efficiency would remain a pertinent issue, giving rise to the long lasting demand for liquid staking solutions.

Liquid staking protocols serve a large market with recurring revenue streams.

From a top-down perspective, the potential size of liquid staking revenue is dictated by four growth drivers.

Put together, these drivers give rise to a sector that produces millions of dollars of revenue annually. The top 5 PoS smart contract platforms* alone produce $893m of rewards annually that accrue to liquid staking protocols.

Additionally, the quality of this revenue stream is a notch higher that of other blockchain applications given its recurring nature. For instance, decentralized exchange (DEX) revenues are cyclical in nature and highly dependent on the market environment. In general, DEX volumes are buoyant during bull markets and taper off during bear markets. This gives rise to an inconsistent revenue source at the protocol level. Unfortunately, this is the case for many other blockchain applications — NFT marketplace revenues fall during NFT bear markets and money market revenues fall as the demand for leverage wanes. Thus, we believe that the liquid staking sector’s consistent revenue source is an often-overlooked strength amidst a volatile and reflexive market.

The quality of the sector’s revenue can be easily illustrated by contrasting Uniswap’s monthly revenue with that of Lido — the respective market leaders in the DEX and Liquid Staking sectors. Uniswap’s monthly revenue saw two local peaks in May ’21 and Nov ’21, coinciding with market tops during those two months. Monthly revenue then saw a slow bleed as volume and liquidity faded away during the ensuing bear market.

In stark comparison, Lido’s revenue has been consistent with no major fluctuations over the past couple of years. This demonstrates the stickiness of staking revenue — regardless of market sentiment, liquid staking protocols would continue to generate revenue as long as the blockchain continues to function. We believe that an important implication of this phenomenon is that liquid staking protocols deserve higher valuation multiples compared to other protocols with cyclical businesses.

Lido will continue to benefit from industry tailwinds and solidify its position as market leader.

Lido is currently the market leader in liquid staking, with almost $15b in TVL. In fact, it is also the largest DeFi protocol by TVL across all chains. stETH, Lido’s ETH receipt token, is also the most liquid staked ETH token with the greatest composability. We are confident that Lido will move from strength to strength and continue to leverage the network effect it has built to entrench its market share.

When examining the merits of a particular liquid staking protocol, we layer on two additional parameters — 1) its market share and 2) its take rate on staking rewards. In the following section, we outline our rationale for the growth of each driver and how each would drive Lido’s continued success.

1. Layer 1 (L1) Token Market Cap Growth

Lido will benefit from the growth of the underlying L1s that it serves as its dollar denominated TVL is linearly correlated to the price of these L1 tokens. Lido currently actively services three chains — Ethereum (98.9% of TVL), Polygon (0.7%) and Solana (0.4%). If these chains continue to grow, their tokens should price in these fundamentals. Thus, Lido’s dollar denominated TVL will continue to expand even if its token denominated TVL does not.

Notably, Ethereum’s growth has an outsized impact on Lido’s fundamentals. Ethereum is by far the largest smart contract L1 chain, with a market capitalization that is 6x that of BNB Chain and 23x that of Solana. ETH also makes up the largest share of Lido TVL.

In that regard, we are especially bullish on Ethereum’s long-term prospects, having witnessed the success of major protocol upgrades such as the London Upgrade (EIP-1559 — improving UX around transaction fees and ETH tokenomics), Paris (PoS — reduces energy consumption and sets the foundation for scalability upgrades) as well as Shanghai/Capella (ETH withdrawals). From an adoption standpoint, Ethereum remains the go-to platform for secure L1 DeFi activities, with applications like Aave and Uniswap allowing users to trade and borrow/lend with ease. Meanwhile, it continues to serve as the secure settlement layer for a myriad of scaling solutions ranging from zkRollups (Polygon zkEVM, zkSync, Starknet) to Optimistic rollups (Arbitrum, Optimism) which enables cheap and fast transactions while contributing ETH transaction fees. Therefore, we believe Lido will benefit substantially from this home ground advantage.

Moreover, we view Lido’s multichain operations as a call option on the growth of alternative L1s. We remain open to the notion that developers and users have varying needs which can be served by other chains. From Lido’s point of view, servicing these chains is a prudent means of diversifying their business.

2. L1 Staking Ratio Growth

We believe that Ethereum’s staking ratio will continue to rise, especially after the success of the recent Shanghai/Capella upgrade. When Ethereum first implemented staking on the Beacon chain, early stakers were risking their capital by depositing their ETH without full assurance of the technical feasibility and timeline of withdrawing their assets. This resulted in Ethereum’s staking ratio being substantially smaller compared to other PoS chains. This risk factor has largely been mitigated with the completion of the Shanghai/Capella upgrade, serving as a critical catalyst to the growth in staking ratio. In fact, ETH staking ratio has been steadily increasing from ~15% around the time of the Shanghai/Capella upgrade to ~20% today.

We expect this growth in staking ratio to benefit the liquid staking sector as while staking is de-risked, users still face the same problems of capital efficiency. By converting to Lido’s stETH, vanilla ETH holders, which make up most of the ETH supply, can now enjoy real yields on ETH while retaining a substantial portion of on-chain composability.

3. Staking Yield Growth

We acknowledge that all things equal, staking yield would compress as staking ratio increases. However, current levels of on-chain activity pales in comparison to historical bull market levels. Any pickup in on-chain activity on Ethereum, such as NFT mints and a surge in DEX volumes, would drive up transaction fees and MEV. This would help mitigate the compression of base rewards and contribute to the consistency of Lido revenue.

4. Liquid Staking Market Share Growth

We expect the liquid staking sector to benefit from the increased regulatory scrutiny of staking services provided by centralized players. Year to date, the top three centralized staking service providers have ceded 9.6% of market share, which has since been partially absorbed by their decentralized counterparts. Notably, Lido has been the largest beneficiary of this trend, gaining 2.9% in market share. We believe that this demonstrates that stETH remains one of the top choices the majority of stakers due to its liquidity and composability in DeFi.

5. Lido Market Share Growth

On the back of industry tailwinds, we believe that Lido would be able to continue dominating market share given the unique network effect that it has built around stETH. As it stands, Lido commands 86% of liquid staked ETH market share, almost 6x that of the second largest decentralized player (rETH).

This is due to the power law dynamic that centers around the liquidity and utility of the stETH token. stETH is the most liquid staked ETH derivative on DEXes. On Ethereum alone, there is ~$700m of liquidity of stETH/wstETH liquidity (paired with WETH and ETH), ~8x that of rETH. Thus, it can be said that out of all the alternatives, Lido has best achieved the primary goal of liquid staking protocols — which is to provide the best liquidity for stakers.

Decentralized ETH Derivative Liquidity Pools (Ethereum Mainnet WETH/ETH Pairs)

This liquidity moat of stETH is further enhanced as more utilities of the token become unlocked once a sizeable liquidity foundation has been built. An example of this is the use of liquid staked ETH as collateral in money market protocols. Liquidity is a key parameter in assessing the suitability of an asset to be used as collateral asset liquidations can only be effectively processed with sufficient liquidity depth. It should therefore come as no surprise that stETH is also the most widely used staked ETH derivative used as collateral in money market protocols.

Decentralized ETH Derivative Collateral Value (Ethereum Mainnet)

6. Lido’s Value Capture

Currently, Lido implements a 5% take rate on staking rewards that directly accrues to the DAO treasury, which is governed by $LDO token holders. This enables us to easily get a sense of Lido’s potential revenue given certain parameters.

Looking at all of Lido’s value drivers in totality, we think there is still substantial room for Lido’s fundamentals to grow in the medium term. We outline some rough numbers below to illustrate Lido’s potential market opportunity.

• We expect Ethereum staking ratio to hit 30% within the next 12 months as users start to digest the de-risking of withdrawals.

• In such a scenario, staking yield is expected to fall to ~4%.

• Over time, we also believe liquid staking protocols can take 50% of the market as users demand capital efficiency on their assets.

• Furthermore, if ETH returns to all-time highs of $4k ($500b Market Cap), it implies $3b run-rate revenue from the Ethereum liquid staking sector alone.

• Assuming Lido share of the Ethereum liquid staking market increases slightly to 90%, Lido DAO’s annual revenue could hit $135m on a 5% take rate.

• This implies a 13.5x forward FDV/Revenue ratio at Lido’s current $1.8b fully diluted valuation

Final thoughts

To reiterate, we are sanguine about the prospects of the liquid staking sector as the leading projects offer a unique value proposition to the large, growing market that they serve. We have further outlined the four key drivers that underpin the growth of the industry and detailed how each metric could further expand.

We also argue how Lido will continue to dominate market share due the strong network effects that it has built around stETH, driven by the liquidity and composability of the token. If our views of the industry’s medium-term growth turn out to be accurate, we demonstrate how Lido has a 5x revenue growth opportunity from here.

In the short term, the market seems to have moved on from the initial hype surrounding the Shanghai/Capella narrative. This is evident from Lido’s TVL and revenue run rate trending up while its valuation multiples compress. We believe such deviations in valuations and fundamentals will not last forever and LDO offer some of the best risk-adjusted return in crypto now.

Author: Bryan Tan

IMPORTANT NOTICE: This document is intended for informational purposes only. The views expressed in this document are not, and should not be construed as, investment advice or recommendations. Recipients of this document should do their own due diligence, taking into account their specific financial circumstances, investment objectives and risk tolerance (which are not considered in this document) before investing. This document is not an offer, nor the solicitation of an offer, to buy or sell any of the assets mentioned herein.