Bankless Writer: Jack Inabinet
The moment has arrived: withdrawals are finally being enabled!
Last September, Ethereum developers implemented the Merge, hot-swapping out the original proof-of-work (PoW) consensus layer for the proof-of-stake (PoS) Beacon Chain that had been running in parallel to the canonical chain since its launch in December 2020, reducing ETH issuance by 88% and energy consumption by 99.95%.
Post-Merge, Ethereum is secured by stakers, instead of miners.
Stakers each post a 32 ETH bond to the Beacon Chain to store network data, process transactions, and add blocks in exchange for ETH rewards for securing the network. Stakers, however, have been unable to withdraw accrued consensus layer rewards or their initial 32 Ether collateral from the Beacon Chain. That paradigm changes today.
For everything you need to know about this historic network upgrade for Ethereum, check into yesterday's Bankless newsletter.
With Shapella unlocking such a massive amount of ETH, Crypto Twitter has been awash with immediate-term market price predictions. Yet, the flows and their impact on price are only a portion of the story.
Today, we take a look at why you should care about the Shapella upgrade:
The Great Derisking
Staking is being derisked, the age of the Internet Bond is upon us, and crypto will never be the same.
Solo staking and staking-as-a-service (SaaS) offerings allow crypto participants to generate yield on Ether, however, users’ stake remains locked and is unable to be sold or transferred.
Liquid staking derivatives (LSDs), including Lido’s stETH and Coinbase’s cbETH, are an attempt to solve this problem of illiquidity. LSDs have captured over $14.5B in total-value-locked and enable ETH holders to earn yield while retaining liquidity on staked ETH.
Subpar Stand-Ins
For many Ethereians, LSDs have become the de facto method of staking, representing 42% of all ETH staked.
Despite improved liquidity offered by LSDs, these instruments are popularly misunderstood as being "pegged" 1:1 to ETH like stablecoins are supposed to be pegged to the value of a dollar. But LSDs can be inherently less liquid than the underlying ETH collateral.
This flaw was on full display during periods of a credit crunch. During the liquidations of 3AC and Celsius stETH positions beginning in May 2022, stETH depegged by 6% over the next month and a half, creating a crisis of confidence for LSD holders who, without withdrawals enabled, had little more than a promise of eventual future redeemability to maintain the peg.
Tax Headaches
Staking derivatives also pose numerous tax and regulatory hurdles for many sophisticated institutional investors. Take Lido’s stETH, for example. This go-to staking derivative, representing 74% of the ETH LSD market, is a rebasing token and creates a taxable event for its holder every time a rebase occurs. For tax-sensitive investors, this is a non-viable option.
While investors may consider ETH to be a commodity, the conclusion cannot be easily drawn for many forms of staking.
Many crypto exchanges, decentralized protocols, and SaaS providers pool staking returns to provide consistent yields to investors. This imbues their programs with security-like properties, a feature the SEC was keen to kibosh in their recent Kraken settlement.
Further muddying the regulatory waters, protocols like Lido and RocketPool have previously chosen and continue to incentivize liquidity on their LSDs. An argument can be made that these incentives further contribute to the security-like properties of the derivatives, as maintenance of the peg is partially dependent on token emissions.
A Magical Solution
For the first time since the inception of the Beacon Chain, SaaS and solo staking solutions are viable options for ETH holders looking to retain liquidity of stake. All it took was two Ethereum Improvement Proposals (EIPs) plus an Ethereum hard fork! Enabling withdrawals is a game changer for sidelined institutions and hardline "not my keys, not my crypto" users.
As put by the CTO of a London-based staking firm, institutions are finally able to access liquidity on their stake while retaining control, and no longer must argue “with the taxman that [they’ve] sold [their] Ether and swapped it for magic beans.”
And just like magic, avoiding complicated tax headaches and potential SEC enforcement actions -- while earning risk-free yield at the protocol level and retaining liquidity on staked ETH -- is now easier than ever. Not only do today’s upgrades provide liquidity of stake outside of LSD solutions, they also allow the market to begin to reallocate stake and chip away at Lido’s massive 31% control of the validator set.
Shapella empowers stakers and is a crucial step to further the decentralization of network security.
Internet Bond
Gigabrains have long drawn parallels between Ethereum staking and fixed income instruments in TradFi.
In exchange for providing 32 ETH as validator collateral (principal), stakers accrue rewards (interest). This relationship does not depend on any party’s ability to repay the loan and is instead backed by the future economic activity of Ethereum, in the form of fee revenue. Essentially, staking on Ethereum is an indefinite perpetuity with zero risk of default.
Moving to Market
For a finance nerd like moi, Shapella is a huge development. Lending rates in traditional financial markets are often calculated as a spread over a risk-free rate (typically represented by specific maturity US Treasury yields).
The spread between the risk-free rate and cost of borrowing is intended to capture additional risks (particularly default risk) of lending to borrowers other than the U.S. Government. Treasuries trade daily, with yields respondent to supply and demand forces, intersecting at the market rate. Sadly, despite having near-zero default risk (similar to US Treasuries), ETH staking yield has failed to gain traction as crypto’s risk-free rate as it has fallen short of being a market rate.
The yield paid out by the network on Ether is a function of two variables: Number of Validators and Fees Generated. As the number of validators increases, fees are distributed to an increasingly large validator set, decreasing the expected revenue of a given node, somewhat subsidized by a higher rate of ETH issuance.
Currently, the market can only respond to increases in relative attractiveness of the ETH staking opportunity. As ETH holders see staking yields increase in attractiveness relative to alternative yield sources, more market participants are willing to stake. In theory, the market responds to attractive staking rewards by increasing the number of validators, arbitraging away the temporary opportunity.
Until now, we have been unable to respond to decreases in the relative attractiveness of staking, resulting in artificially low yields during periods of limited block demand or when enticing investment alternatives surface. Capital flight from staking has not been an option; post-Shapella, this dynamic changes. Stakers can now withdraw their 32 ETH from the Beacon Chain to chase yield or run for the exit when the risk-free rate is no longer sufficiently attractive.
Due to the constraints of PoS consensus, necessary withdrawal and exit queues limit rapid exodus from staking. Similar mechanisms exist in traditional finance, with circuit breakers halting asset trading at predefined bounds. While not a perfect “market rate,” with Shapella, Ethereum has taken its final step to establish itself as the internet bond.
The question “how much does money cost?” is the basis of finance, and the risk-free rate of return is the backbone of that system. Shapella transforms Ethereum’s staking rewards rate into something more closely resembling a market risk-free rate.
If Ether is to become a money, having a native US Treasury-like, risk-free rate serving as the cornerstone for loan pricing and financial valuation will go a long way in fostering adoption, especially among the finance professionals and institutional investors the space has had limited success in attracting.
Historic Moment
Forget the flows, over the long term, enabling withdrawals will serve as a major derisking moment for a variety of crypto market participants for whom LSDs simply didn’t cut it.
And no matter what happens in the immediate-term, today will go down as a pivotal moment in crypto history: Ethereum’s Shapella upgrade represents the largest step towards establishing a crypto-native monetary system since the launch of the Beacon Chain.
