What is Lido?

Introduction

In the world of cryptocurrencies, proof-of-stake is a common consensus mechanism. Users stake their cryptocurrencies in the blockchain to obtain a passive income and at the same time help secure the network. For new users who don’t understand staking yet, staking can be compared to fixed deposits in the traditional banking system. Basically, stakers allow a protocol to hold their cryptocurrencies so that they can obtain rewards with low risk.
However, there is a downside to staking. First of all, staked cryptocurrencies cannot be retrieved before the staking period ends, which could cause inconvenience. In addition, different blockchain networks have different requirements for staking. For example, Ethereum 2.0 requires at least 32 ETH to be staked for validator nodes. That is obviously not an easily affordable sum for many users, and the nearly 2-year staking period also makes many people hesitate.
Lido is a protocol that provides liquid staking services. Through Lido, users can participate in liquid staking on multiple blockchains such as Ethereum, Solana, Polkadot, Polygon, and Kusama to obtain token derivatives. These token derivatives can also be traded on the market and therefore are liquid. Lido makes staking easy and is considered by many to be a rising star with huge potential in the coming Ethereum 2.0 era.

Lido’s History

Lido was founded in October 2020 by Konstantin Lomashuk, Vasiliy Shapovalov, and Jordan Fish. Konstantin holds a Ph.D. in finance and is also the founder of P2P Validator, a company that provides services to run validator nodes on proof-of-stake blockchains. Vasiliy is an engineer with ten years experience in software development who served as the CTO of P2P Validator in 2020 and developed third-party services for Beacon Chain. These third-party services eventually evolved into today’s Lido Finance.

A few weeks after the Beacon Chain launched the staking contract, Lido testnet was launched at the end of November 2020. All services became officially available later in December. One of Lido’s blogs pointed out that there are a few issues in Beacon Chain staking.

1. Early staking commitment
   The Ethereum 2.0 upgrade consists of multiple stages. Even though the smart contract for staking is already live, the complete transition to PoS may still take a long time, which means that the staked tokens will be subject to an indefinite period of lock-up, possibly even more than 3 years. During this lock-up period, these assets cannot be moved, traded, or spent.

2. Illiquidity
   Before ETH 2.0 became reality, staked ETH were non-transferable and illiquid and would remain so even after, because of the adversarial incentives. Users will have to choose between staking rewards and DeFi yields.

3. Staking 32 ETH multiples
   Say the ETH price is US$1,600, the value of 32 ETH would exceed US$50,000. Even at the launch of Lido, the staked ETH value must exceed US$10,000 for the staker to become a validator on the Beacon Chain, making it impossible for many users to participate.
   Lido aims to solve these issues by providing non-custodial staking services, and is supported by quite a few well-known staking service providers in the crypto industry. By issuing stETH, Lido in a way makes the staked ETH liquid. Users can participate by staking any amount of ETH. Lido not only eliminates users’ concern for an indefinite staking period but also solves the problems of capital inefficiency and illiquidity.

The advantages of Lido are directly reflected in the growth of Total Value Locked (TVL). In just one year, the amount of ETH staked through Lido increased by nearly 700 times, which has attracted investment from many VCs such as Alameda Research, Coinbase Ventures, Jump Capital, Paradigm, etc., as well as the support of well-known figures such as Rune Christensen (founder of MakerDAO) and Kain Warwick (founder of Synthetix).

Thanks to its great success on Ethereum, Lido is currently expanding to other blockchains, including Terra (since March 2021), Solana (since September 2021), Polygon, Kusama, and Polkadot. The Terra Luna crash in May resulted in the price of Luna falling to almost zero, making Lido’s TVL decrease sharply by more than 30%. Lido’s staking services on Terra had to be suspended.

How Lido Works

In PoS blockchains, users must stake a certain amount of crypto in a smart contract to become a validator. Validators verify transactions on the chain, create new blocks, and get rewards. Staked assets cannot be withdrawn until the end of the staking period. Setting up a node requires professional knowledge. If there is a disconnection or an attack on the network during the staking period, the staked assets may be slashed as a punishment.
In order to give the staked ETH liquidity, Lido issues stETH, which is an ERC-20 token. Through a smart contract, for every ETH staked, one stETH will be automatically issued to the user. When Ethereum 2.0 comes and both staking and trading of ETH are launched, users can redeem the same amount of ETH according to the number of stETH they hold through Lido’s smart contract. Every redeemed stETH will be burnt to maintain the 1:1 peg between staked ETH and stETH.
ETH staked through Lido goes into a smart contract called “Lido staking pool”, which is responsible for deposits and withdrawals, minting, burning stETH, delegating funds to node operators, distributing staking rewards, and accepting updates from the oracle contract. Node operators are staking service providers authorized by Lido DAO, with professional teams and hardware to guarantee smooth operation 24/7. The ETH in the staking pool is evenly distributed to each node. And for every 32 ETH allocated, a group of nodes will be set up to verify transactions on the Beacon Chain. The staking pool contains a list of node operators, their keys, and the logic for distributing rewards between them.

Source: Lido blog post

Oracle is a set of smart contracts that dynamically track the staked ETH balances of validators on the Beacon Chain. Balances can go up because of reward accumulation and can go down due to slashing and staking penalties. The oracle provides an accurate balance of stETH tokens for users. stETH will be minted along with rewards for node operators. 90% of the stETH are allocated to stETH holders, 5% to node operators, and 5% to Lido DAO’s insurance and development fund.

Source: Lido blog post

How do stETH and staked ETH maintain a 1:1 peg?

1. Arbitrage of traders
   Every stETH is generated by staking ETH. When the price of stETH is lower than ETH, traders can sell ETH to buy stETH and get more ETH after the Ethereum upgrade is completed.

2. Liquidity mining rewards
   On decentralized exchanges such as Curve and 1inch, users can add liquidity to the stETH/ETH pool and get rewards.

3. Demand for stETH
   At the end of 2021 and in early 2022, two leading lending protocols on Ethereum, MakerDAO and AAVE, both publicly announced that they support stETH as collateral. Since stETH itself is an interest-earning version of ETH, it is perfect as collateral.

Essentially, stETH is an ETH financial derivative. Although stETH cannot be used to pay gas fees, it makes staking on the Beacon Chain easier. Apart from removing the minimum 32 ETH threshold, Lido also does not require users to have professional knowledge and hardware. Staked assets can be flexibly used in other decentralized financial protocols.

About the LDO token

As a decentralized liquid staking protocol, Lido Finance has had the goal of community governance since its inception. LDO is the governance token of Lido DAO. LDO holders can vote to make all decisions within Lido DAO, which makes every member’s voice heard, promotes the decentralization of the protocol, and helps to build a trustless liquid staking platform.
After its launch in December 2020, Lido DAO has minted a total of 1 billion LDO tokens. The initial token distribution is shown below:
DAO treasury - 36.32%
Investors - 22.18%
Initial Lido developers - 20%
Founders and future employees - 15%
Validators and signature holders - 6.5%
In addition to the DAO treasury, all LDO tokens have a 1-year lock-up period and will be released/emitted within one year after the lock-up.

After 2021, Lido had two more rounds of institutional funding. In May 2021, Lido attracted investments from various VCs led by Paradigm, raising $73 million. In March 2022, Lido Finance received another $70 million from A16z in investment and helped A16z stake some of its ETH holdings on the Beacon Chain. Subsequent institutional investments were performed via the purchase of LDO tokens for 21,000 ETH directly from the Lido DAO treasury, under the approval of the Lido DAO community. Same as the initial distribution of LDO, newly subscribed LDO tokens must first go through a 1-year lock-up period, and will then be released within one year.

The purpose of LDO is to give LDO holders the right to govern Lido DAO. Anyone holding LDO is a member of the Lido DAO and can decide the parameters of the protocol, add or remove nodes, use Oracle lists and vote for upgrades, etc. All members can initiate proposals and the voting weight of each member is proportional to the number of LDO tokens she/he holds. To be considered a valid pass, proposals must be approved by more than 50% of voters and more than 5% of the total supply of LDO. Lido uses Aragon for on-chain voting. As of 2022, more than 100 proposals have been voted on. The Lido DAO is quite active, with new proposals and discussions almost every week.

Features

Lido solves many problems of Beacon Chain staking and is the pioneer in liquid staking.

1. Users can get staking rewards without having their funds fully locked.

2. Lido removes the minimum staking threshold for users. On the Beacon Chain, users can participate by staking an amount of less than 32 ETH.

3. Since the staked tokens are handed over to professional service providers, users are not required to have professional knowledge or the necessary hardware for operating nodes, which reduces the risk of capital loss due to node failure or malicious attacks.

4. Lido provides token derivatives as building blocks for other applications and protocols. For example, stETH can be used as collateral for lending or liquidity mining, or in other DeFi projects to generate rewards.

5. Lido can be an alternative to individual staking, exchange staking, or other semi-custodial staking.

6. Lido gathers the scattered liquidity in the market, and actively encourages users to participate in staking and other DeFi services. Lido helps maintain the security of blockchain networks while activating cash flows on the networks.

7. With Lido DAO’s governance, Lido’s ecosystem is stable, and the risks of third-party failures and single points of failure can be avoided.

Compared with individual on-chain staking and centralized exchange staking, Lido has the following advantages:

Users who stake ETH through Lido can obtain stETH tokens (ERC-20). MakerDAO and AAVE both accept stETH as collateral.
If a user stakes 10 ETH and obtains 10 stETH, he/she can use these 10 stETH as collateral to borrow 5 ETH from lending protocols (the amount that can be borrowed depends on the LTV ratio). If these 5 ETH is staked to Lido, the user will get 5 more stETH and can stake these 5 stETH to lend more ETH. As long as the annualized rate of return of stETH is higher than the interest rate of ETH loans, users can obtain a larger amount of stETH with a smaller amount of ETH, earn higher staking rewards, and pay only a small amount of borrowing interest using this strategy. This way, the total yield can be increased by as much as 50%.
The biggest risk of getting loans is that borrowers can be liquidated and forced-sell of the collateral to repay the loan if there is a big drop in the collateral’s price. Since every stETH circulating in the market is guaranteed to be able to exchange 1 ETH after the Ethereum 2.0 upgrade is completed, even if the price of stETH falls so much that it is no longer 1:1 pegged to the price of ETH, there will be arbitrage space to boost the price of stETH and put it back in line with ETH.

Controversy

Lido has undoubtedly been successful since its inception. Judging from on-chain data, both the number of independent addresses using Lido and the TVL are hitting new highs. However, like all DeFi applications, Lido’s liquid staking is not without risk.

No matter how stable the price peg between the token derivative (e.g. stETH) and the staked token (e.g. ETH) is, the two are not the same thing after all. stETH is an ERC-20 token, while ETH is the native token of Ethereum. ETH’s use cases and functions are inherently irreplaceable. You can never use stETH to pay for gas fees. Why people are willing to hold stETH comes from the belief that 1 stETH can always be exchanged for 1 ETH. If this trust is broken, stETH will lose its value.
In June 2022, stETH faced a crisis of unpegging from ETH. As Celsius was reported to have lost 35,000 ETH due to the loss of the private key, Celsius staked 44% of the ETH obtained by the user stETH. Users then began to fear that they would be unable to withdraw their funds. In addition, a crypto whale sold 19,998 stETHs at once on Curve, which caused the exchange rate of stETH/ETH to drop by nearly 10%, provoking even more panic in the market.

Although the current exchange rate of stETH/ETH has returned to 0.97, it does not mean that there are no further risks. A code vulnerability in the Lido protocol was discovered in a security audit in October 2021, putting 20,000 ETH at risk. In March 2022, an error on Lido’s web page occurred. With Ethereum 2.0 coming, Lido will have to update its current smart contract codes. No matter how good the development team is and how many audits Lido has passed, there is still no guarantee that there will be no more errors. The staked ETH must be kept perfectly safe to keep stETH’s value.
Another problem with Lido is its governance, Lido DAO is a fairly centralized DAO. This can be told from the token distribution of LDO. The founders, development teams, and investors own more than half of the total LDO supply. Due to the sheer amount of ETH staked on the Beacon Chain through Lido, if Lido Finance continues to grow at the current speed, Lido is likely to become the governance layer of Ethereum.
At present, the proportion of ETH staked through Lido accounts for about 30% of the total amount of ETH staked on the Beacon Chain. Although it has not yet reached the threshold to initiate a 51% attack, the demand for liquid staking in the market is still on the increase. Once Ethereum transitions from PoW to PoS, Lido’s node operators may threaten the security and reliability of Ethereum 2.0.

In order to eliminate the possibility of Lido and LDO holders substantially monopolizing Ethereum 2.0, a governance scheme about LDO + stETH dual tokens has been proposed recently. Under the new governance model, LDO holders can still propose and vote like before, but stETH will be given veto power over Lido domain-specific proposals. This means that stETH holders can veto proposals they consider to be harmful to the Ethereum network, providing a check and balance for LDO governance. However, because ether does not have the governance rights and stETH can influence Ethereum through Lido, this will make more users support Lido and stETH, leading to more centralization on Ethereum.

Conclusion

Lido has made great achievements so far. By providing liquid stake services, users can stake any amount of cryptocurrencies to Lido’s nodes who verify transactions and collect staking rewards. Users will obtain derivatives of their staked tokens, which can be easily exchanged for other tokens in the market.

Lido solves the problem of liquidity in staking and improves capital efficiency.

In a sense, Lido is a great example of a sharing economy. Most people face technical, financial, and temporal difficulties in staking, and Lido node operators are designed to help with these. Sharing staking rewards makes it a win-win for users and nodes. Not only capital efficiency can be improved, but more people participating can also increase the security and decentralization of the network.

Lido’s success could imply monopoly. Many competitors are coming.

The success of Lido is a coin with two sides. The proportion of ETH staked through Lido accounts for more than 30% of the total staked ETH on the Beacon Chain. Although Lido DAO implements measures to prevent collusion among nodes and monopoly on Ethereum, due to the conveniences of liquid staking, it is very likely that in the future more users will turn to Lido. Although Lido has competitors such as Rocket Pool and pStake Finance, if Lido’s market share continues to grow, Lido DAO’s influence on many blockchains may become bigger than it should.

The risks of unpegging and regulatory uncertainty.

Token derivatives in liquid staking are always at the risk of unpegging from their underlying assets. If hackers spot loopholes in Lido’s smart contracts, staked tokens can be stolen, and then token derivatives will lose all their value. Certain aggressive strategies to maximize returns from liquid staking and large runs on lending protocols can cause liquidations. In recent years, many countries classify these token derivatives as “securities” and put them under regulation. In response, Lido has restricted its services from certain countries/regions. Although this list of unsupported countries/regions appears to be limited to countries sanctioned by the United States and its allies, it undoubtedly makes many people question if Lido is actually “decentralized”, “trustless”, and “permissionless” as it claims to be.

Diversified development and commitment to providing liquid staking solutions for various digital assets.

Although Lido has the above-mentioned controversies and problems, it is a great innovation in all fairness. It contributed to the increase of staked ETH as Ethereum 2.0 is on its way. Lido is also expanding its territory, shifting its focus from Ethereum to other blockchains such as Solana, Polkadot, Polygon, and Kusama. The Lido DAO is also actively planning to provide Near, Avalanche, and Cosmos protocol with staking services. Many well-known VCs are also optimistic about Lido and LDO tokens. Let’s wait and see how the future of Lido will be.