DeFi Industry: A new war is looming. Unlike the Curve Wars, which were about stablecoin liquidity dominance, this war is about the future of liquid stake tokens.
The trigger for this upcoming fight?
The Ethereum Shanghai fork is set to take place on April 12, when more than 18 million staked ethers (roughly $34.2 billion) will be unlocked and fronts will be drawn.
I believe Shanghai will spark a period of intense competition between liquid staking protocols that will come to be known as “liquid staking wars” – albeit wars that will ultimately benefit the entire industry.
Those of us who were here at DeFi Summer will well remember the Curve Wars: the ruthless competition between the budding stablecoin protocols that “battled” on the Curve DEX to have the highest liquidity and most diverse liquidity pairings.
Let’s look at the ingredients that started the curve wars:
1) a DEX Automated Market Maker (AMM) specifically designed to trade stablecoins (Curve);
2) a mechanism for protocols to incentivize liquidity providers (LPs) to move from LPing one stablecoin to another (curve incentive contracts);
and 3) a slew of new stablecoin protocols vying for market share (USDC, USDT, DAI, FRAX, LUSD, etc.).
I see striking similarities to the curve wars in the burgeoning competition between protocols offering liquid staking tokens (LSTs) — high-yield tokens that allow holders to stay liquid while enjoying the returns on ETH staking.
We’re already seeing the same ingredients blend together:
1) novel DEX-AMM protocols specifically designed to facilitate LPing of Liquid Staking Token (LST) pairs;
2) Incentive Contracts, which can leverage LST protocols to reward LST LPs; And
3) a cascade of new LST protocols vying for market share.
The Liquid Staking Wars have one last other ingredient – the upcoming Shanghai upgrade, which will allow LPs to easily and cheaply sever ETH from one LST and move it to another LST.
The Liquid Staking Wars will be won by the protocol that can achieve the most TVL and volume for its LST. I believe that the struggle for supremacy of LST will see its first skirmishes in early May and that it will have a lasting impact on the DeFi ecosystem.
With all Ethereum staking unlocked in mid-April, unhedged ETH holders will be incentivized to transfer their ETH from one liquidity staking token solution to another, always on the lookout for the highest potential returns in liquidity pools. LST protocols will also have an incentive to gain market share by having their token the most liquid.
This war – or competition between LST protocols to provide the dominant asset in the crypto space – will reshape all crypto pairs in all DEXs.
Liquidity provider (LP) strategies will also evolve based on the high-yield characteristics of LSTs. DEXs will continue to evolve their offerings to accommodate this new landscape; and the DeFi industry will benefit from a wave of innovation (as we see most times of increasing competition).
Liquid Staking Wars tactics will be the same as Curve Wars
We will see how LST protocols try to differentiate themselves through innovation, usability and yield. The most obvious mechanism will be yield: LST protocols will aim to maximize LPs’ incentives to fund liquidity pools with their LST over any other LST.
Post-Shanghai, there will be high opportunity costs for LPs adding liquidity to ETH-denominated pools rather than LST-denominated pools. The ETH LPs will forego a yield of about 4% without good reason.
Even before Shanghai, we saw huge demand for LST yields: According to DeFiLlama, the Total Value Locked (TVL) of liquid stake tokens has skyrocketed, topping $14 billion as of April 3, 2023, according to DeFiLlama. The LST sector is second only to the current size of all decentralized exchange protocols combined.
Some might argue that Lido – with almost 75% of LST TVL’s market share – won the war before it even started. But while Lido has established itself as a leader, market players such as Frax, Coinbase, Rocket Pool and new protocols that have not yet been launched are vying for position for their LST to become the standout ETH substitute.
As with any war, winners and losers are determined by the strategic use of the right tactics on the battlefield.
This competition – and particularly the associated competitive incentives for liquidity pools – should also benefit other participants across the DeFi ecosystem. LSTs not only have a place when paired with each other or with ETH in pools, but also with other utility tokens. For example, instead of WBTC-ETH being a popular pool on DEXs, I expect WBTC-WSTETH, WBTC-cbETH, or WBTC-rETH.
I anticipate an increase in co-incentive liquidity pool structures combining utility and yield tokens. Long-tail tokens are likely to benefit from these partnerships by providing the liquidity needed to build their businesses, as well as some of the most prominent utility tokens looking to expand their influence.
In addition to maximizing liquidity pool incentives, subtle differences in Automated Market Makers (AMMs) can offer significant benefits to LST protocols — especially considering how LSTs appreciate in value over time through the return on the underlying pledged ETH. This intrinsic growth in value requires LPs to monitor their positions more closely to keep their liquidity active as prices fluctuate. Combining it with an AMM that can, for example, maximize LP capital efficiency for an LST pair can provide significant benefits.
I expect increasing innovations from DEXs, especially regarding the functionality of AMMs. To win the liquid stake wars, protocols need a set of tools to encourage liquidity of their liquid stake tokens through minimal incentives and maximum efficiency. Protocols that increase LP incentives through these types of “surgical incentives” and can provide greater capital efficiency will reduce the capital requirement burden of LSTs. This, in turn, will allow LSTs to maximize their incentive returns and capture a larger market share.
It is important for Stakers and LPs to understand the finances (fees, etc.) before placing any bets or providing liquidity on any given platform. As noted, some existing AMMs are not capital efficient for LST liquidity due to the unique yield structure of LSTs. This is because LSTs and the special liquidity challenges associated with them did not exist at the time these AMMs were developed.
For example, infinite range AMMs such as Sushi, Balancer, and Uniswap v2 are known to have low efficiency on almost every pair. But even range AMMs like Uniswap v3 and related forks can show low efficiency for an ETH-LST pair as the price in the AMM continuously exceeds the LP’s range unless the LP actively manages its position or sets a very large price range. In addition to the incentives offered, LPs need to know these crucial structural details of the protocols before committing their capital.
While I call this next phase of DeFi after Shanghai a “war,” it ultimately results in more liquidity being injected into the ecosystem. And as greater capital efficiency in liquidity pools heralds an era of more “active capital,” those volumes will be used more consistently for the benefit of the entire industry.
Bob Baxley is a technologist, entrepreneur and founder of technology companies. Bob is the core developer of the Maverick protocol, a new decentralized finance infrastructure built to enable the most liquid markets for traders, liquidity providers, DAO treasuries and developers. Bob created Maverick AMM, a revolutionary Dynamic Distribution AMM that offers liquidity providers greater capital efficiency and control.
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