LSDs: RocketPool
How the Ethereum Proof of Stake transition impacts Liquid Staking Derivatives like Rocket Pool
0 Introduction
This article is a deep dive about how the switch from Ethereum proof-of-work to proof-of-stake creates second order effects for investment opportunities. First, we will examine the existing Ethereum staking environment and then project how it will evolve in a few months to a few years. Then we zero in on one particular protocol, Rocket Pool, and analyze how it is positioned to take advantage of the new Ethereum landscape.
There are four main uncorrelated drivers for the thesis.
ETH staking percentage will increase
LSD (Liquid Staking Derivative) dominance will increase
LSD is not winner take all and more oligopolistic in nature
Rocket Pool percent of LSD will increase.
1 Proof of Stake
Ethereum launched on mainnet on July 30th 2015 and for the past 7 years has been running on a proof-of-work (POW) consensus mechanism where miners secure the network and receive block rewards in return. In the middle of September 2022, ETH successfully switched from POW to proof-of-stake (POS). There are a few major benefits of POS like lower barriers of entry, more decentralization, and more security for the chain. Two important second derivative effects are the substantial issuance decrease and the subsequent drop of ETH spot liquidity (remedied with the rise of liquid staking).
1.1 Staked ETH
The beacon chain launched in December 2020, and was the original POS blockchain to make sure the staking consensus mechanism worked properly before the merge. We can see the amount of staked ETH grow to over 15.8 million deposited which is around 13.2% of all ETH.
It is worth noting that this is by far the lowest rate compared to other POS chains, which seem to be clustered from 30% to 60% staked. Over time, I expect the ETH staking rate to grow and creep higher, towards the bottom end of that spectrum. One of culprits of the low ETH staking rate is that stakers are currently unable to unstake their ETH. The protocol requires a hard fork for withdrawals and there were conflicting timelines for when withdrawals would be enabled.
This issue has been recently resolved. A recent Ethereum core developer call confirmed that withdrawals will be in the next update (Shanghai), currently projected around March 2023.
1.2 Higher Yield
The higher the yield difference between staking and holding, the faster the holders get diluted and the more people gravitate towards staking. The default staking rate since the merge has been around 4.5%, while nodes capturing MEV boost have yielded around 5.5%, over 20% more than the default. 2023 will bring another source of higher staking yield: EigenLayer.
Eigenlayer is a marketplace for decentralized trust which builds upon Ethereum to help other protocols and applications create new systems that require validation. Potential use cases include lightclient bridges, oracles, and faster settlement. Eigenlayer achieves this through a primitive called restaking: node operators can opt-in to Eigenlayer smart contracts and validate additional applications on Ethereum. In return, stakers generate a higher yield and similar to MEV this additional yield will be a substantial boost with minimal extra output1.
2 Liquid Staking
Currently Ethereum has a variety of use cases in the modern day DeFi landscape such as collateral in borrow lend protocols and as liquidity in decentralized exchanges. However when Ethereum is staked, it can no longer be rehypothecated inside these various protocols, so holders of Ethereum have to make a tradeoff between generating staking yield (and keeping up with protocol inflation) or DeFi usage.
Enter liquid staking: ETH holders can deposit ETH into a staking contract and receive a tokenized derivative of their assets. In an ideal world, this tokenized derivative can be used in various DeFi protocols just as seamlessly as ETH while still clipping the staking yield, double dipping and getting the best of both worlds.
With withdrawals, there will be little remaining reason to prefer ETH or wETH in DeFi, when an LSD in the same role will consistently outperform.
2.1 Staking Breakdown
Liquid staking is slowly becoming the dominant method of staking, with over 44% of all deposits going towards a liquid staking protocol. In a fully efficient market, this should trend higher as it is the superior form of yield generation. In fact, many of the centralized entities have started to offer their own forms of liquid staking.
2.2 LSD growth
Buoyed by strong incentive programs which generated much higher yields than default staking, liquid staking took the Ethereum world by storm rapidly capturing most of the market share in 2021 until April 2022 where the growth has stagnated due to bad market conditions. When withdrawals are enabled the liquid staking portion category will continue to increase, with a terminal state somewhere north of 75%.
3 Oligopolies not Monopolies
Five protocols make up over 99% of the liquid staking, Lido, Rocket Pool, Ankr, Stakewise, and StakeHound2. Currently, Lido has a stranglehold on liquid staking with around 90% of all liquid staking followed by Rocket Pool around 6.5%. This advantage is in large part due to how early Lido was, as well as a very successful tokenomics incentives program.
3.1 Game Theory
At first glance, it is game theory optimal for there to be one liquid staking protocol, because this enables maximum interoperability in DeFi and centralized exchanges. However, as we saw with stablecoins, the market tends to create more of an oligopoly structure, where USDT (30%), USDC (30%), and BUSD (20%) reign supreme. The same thing will happen naturally with Ethereum staking: everything eventually converges to liquid staking where a few liquid staking protocols achieve escape velocity and oligopolies form.
3.2 Centralization Risks
In fact, there are strong centralization tail risks associated to the Ethereum protocol when one entity controls over 1/3 of the staked Eth. Danny Ryan, a Ethereum foundation researcher, writes about the potential to cartelization of block space with coordinated MEV extraction, block-timing manipulation, and censorship. He specifically targets liquid staking protocols, but the same risks (minus governance attacks) can be extended to all the staking services. Ryan then suggests for protocols to self impose 25% (of staked ETH) limits to avoid this black swan scenario.
Currently, Lido holds around 30% of all staked ETH, but this amount has been decreasing due to stETH3 depegging in bad market conditions and centralization concerns. Scrolling to the liquid staking time series chart, we can see that Lido's dominance has been basically flat for over a year and is on a current downtrend. This gives a lot of room for the other liquid staking protocols to grow and capture market share.
3.3 Projecting Staking/LSD
The ethos of Ethereum is decentralization and that will carry through in staking. In the steady state, there will be multiple protocols/CEXs each getting north of 15% but less than 30% of the staking pie.
4 Rocket Pool
Chapter 4 provides background information of Rocket Pool and introduces the two tokens rETH and RPL. It concludes a summary of future upgrades that will rapidly scale the protocol. For those interested in the tokenomics model skip to chapter 5.
Since the merge, node operators replaced miners and run software to broadcast messages throughout the chain. In non technical terms, node operators (set up nodes of 32 eth and) get paid rewards to help validate transactions. If the nodes break specific rules deemed to harm the Ethereum protocol, the operators get punished and their stake gets slashed.
Rocket Pool essentially takes individual node operators and registers them with the Rocket Pool smart contract. This setup is superior to running individual nodes because the operators get additional yield in ETH and RPL over solo staking.
4.1 Background
Solo stakers are required to deposit 32 ETH inside a validator, but each Rocket Pool minipool only requires a 16 ETH deposit. The other 16 ETH is taken from the deposit pool and the depositors receive rETH (Rocket Pool’s LSD). rETH holders effectively get ETH staking yield, MEV rewards and priority fees so the ratio of rETH to ETH will increase over time (as opposed to a rebasing 1:1 peg which is worse for tax implications). rETH holders pay a commission (~15%) and the Node Operators receive that commission.
4.2 rETH Performance
So how does Rocket Pool stack up against other ETH staking services? One way to look at performance is an effectiveness rating which incorporates proposal effectiveness, attestation effectiveness, and slashing record. However there is no consensus agreement on the weightings of each metric and a more quantifiable solution is just to look at yield. How much staking yield can one get with each staking service4?
Below we can compare the performance of three liquid staking services (Rocket Pool, Lido, Coinbase) and three staking solutions (Stakefish, Staked, Blockdaemon) from the ETH POS merge to today. We see that Lido's wstETH has the highest yield and Rocket Pool comes in second, better than all of staking solutions and cbETH. This is very impressive performance from Rocket Pool and shows that rETH is a competitive and viable solution for staking yield5.
4.3 Usage
Rocket Pool is the second largest decentralized liquid staking protocol with over 335k ETH deposits in the protocol, translating to 2% of all staked ETH (6% of liquid staked ETH). There are three major periods of rocket pool growth, visually categorized by the graph below.
First we have the initial launch in November 2021, at the peak of the bull market where people were locking ETH up to get any semblance of extra yield. Deposits grew exponentially during this phase in tandem with the general crypto sentiment. The market started its downturn in April with the Luna UST debacle. Leverage wound down and liquidity dried out so people were less likely to stake their ETH given no one knew when withdrawals would occur. This period is marked by the slow portion of the rETH supply increase from April to September 2022. Since mid September6, we have seen an exponential increase in growth which should continue until the next Ethereum protocol upgrade when withdrawals are allowed.
4.4 RPL
RPL is the governance token to Rocket Pool but it also serves as collateral for penalties, giving it inherent value tied to the usage of the protocol. This tokenomics model is similar to an insurance collateral model (like Chainlink or Pyth).
Currently a minipool consists of 32 ETH, 16 from the node operator and 16 from the deposit pool (rETH minters). In order to participate in the protocol, the node operator must also put (a minimum of) 10% of their ETH stake in RPL tokens to act as secondary insurance. A vote was recently contentiously passed which capped the maximum effective stake (ie, stake that gets RPL rewards) at 150% of their ETH stake7.
This ratio puts a lower bound on the value of RPL tokens because the entire market of RPL will at a minimum be equal to 10% of all ETH locked in the protocol. More on the price projections in the following section, but an easy way to think about it is: the more rETH the higher the RPL price.
4.5 Scaling Issues
Currently, the deposit pool is capped at 5k idle ETH waiting to be added to validators, because the node operators are constrained by their inventory (they need ETH and RPL to start new minipools). To use the ETH in the deposit pool, node operators must also put up the same amount of ETH and 10% RPL (in ETH terms). 1x leverage for ETH staking is not that efficient and many of the node operators do not have the pockets or risk appetite to buy RPL, they simply want ETH exposure.
These two issues are tackled in upcoming protocol improvements, Atlas and SaaS, which will work in tandem to scale Rocket Pool by producing more rETH.
4.6 Atlas
The next protocol upgrade is Atlas, with a major improvement, LEB8s. LEB8s reduce the amount of ETH a node operator needs to deposit from 16 to 8, effectively giving node operators 3x leverage on yield as they will put up 8 ETH and the deposit pool will supply 24 ETH. Overnight the node operator will be able to triple the amount of ETH borrowed from the deposit pool. From the team:
We are looking forward to deploying our Atlas protocol upgrade later in Q1. It will provide a significant boost to Rocket Pool's capital efficiency and scalability and further lower the barrier to entry for decentralized Ethereum staking. Testing and audits are progressing well, with the first round from Sigma Prime completed and resolved, and Consensys Diligence on track to complete their review later in the month
4.7 SaaS
SaaS (Staking-as-a-Service) was originally scheduled for Atlas but has been pushed back. SaaS creates a supernode “reduces the ETH and RPL custody requirements for node operators” as there will be four independent entities per supernode:
Supernode operator who is the controlling entity for the SaaS business
RPL capital providers who provide the RPL collateral requirement
ETH capital providers who provide the ETH per minipool requirement
Node operators who take care of the actual running of a validator
From the team regarding timelines:
We want it to be quite close after withdrawals are implemented. The ideal situation is quite quickly after we have released Atlas.
These upgrades alleviate two of the largest pain points to rETH growth and should be a strong step towards gaining market share in the LSD wars.
5 RPL Price Projections
In this section, we look at valuation models to value RPL and future price predictions based on upcoming catalysts. For the majority who are just interested in the price and not the math, please skip ahead to the projections section.
5.1 Model
The way RPL is used as penalty collateral for the node operator makes it possible to roughly back the fundamental value (in ETH terms) with a few inputs. There are a few models floating around, but I will be using Marceau's model as it is simple yet elegant and inclusive.
This formula states that the market cap of RPL is the rETH supply multiplied by the RPL collateralized in each minipool divided by the % of RPL staked. In layman's terms, the numerator is the value of all RPL staked (in ETH) while the denominator adjusts this value to account for the unstaked ETH8.
5.2 rETH Supply
The primary method the RPL token accrues value is through the adoption of rETH. The collateral rate and the staking rate will ebb and flow based on internal protocol adjustments and incentives, but rETH supply is more free flowing and at the mercy of the market. This variable in turn can be broken down by the following equation:
The amount of rETH is the total number of ETH staked, multiplied by Rocket Pool's market share. Finally, a small adjustment needs to be made, because not every ETH in Rocket Pool is rETH; the proportion of ETH a node operator puts up is not.
5.3 Present Day
Currently, there is around 15.9m ETH staked, Rocket Pool has a 2.1% market share and each node operator puts up 16 ETH for a minipool, so the rETH supply is around 167,000. Then we multiply the rETH supply by the collat rate which is 75% and divide by the staking rate of 40%, giving us a market cap of 313,031 ETH. There is around 18.8m RPL, so the RPL/ETH ratio comes out to be 0.0166, right around the current market value of .0165.
5.4 Projections
Since the merge, more and more people have flocked to staking as a way to generate Ethereum yield; around 20k ETH is being staked daily. Below there is a table that compares the current RPL price with future projections in April 2023 (withdrawals enabled), December 2023 (EOY hopefully LEB4), and DEC 2024 (2 year projection, maybe LEB2). This table takes the important variables from the above model and lists them in a more readable format.
By April 2023, the Atlas upgrade for Rocket Pool and withdrawals will be live. Atlas will usher in LEB8s dropping the ETH collateral to 8 per validator while SaaS will increase the staking rate. The ETH staking rate will continue to increase at a similar rate leading to around 14% or 17.6m staked. After withdrawals, independent solo stakers will switch to Rocket Pool for higher yield than running their own systems.
The December 2023 and December 2024 projects are more hazy as more things can change between now and then. Timelines in crypto are notoriously fickle. However LEB4s and LEB2s are on the roadmap and theoretically sound910. ETH staked creeps towards the 30% lower bound of other proof of stake protocols, the LSD market share drifts from 45% to over 80%, and Rocket Pool's market share of the staking market nears 20%.
6 Conclusion
In this article we examined the current state of Ethereum staking, compared it to the historical beacon chain, other L1s and L2s, and projected various potential outcomes. Then took a deeper dive into the liquid staking world and why structural reasons prevent it from becoming a monopolistic field, but rather how the game theoretical outcome is more an of an oligopoly. With this in mind, Rocket Pool is strongly positioned to capture these multiple tailwinds due to a clever economic design, increasing incentives, and a strong/active community.
It is rare for alts to outperform ETH and one of the on going jokes is that DeFi is straight down especially in ETH terms. There are a myriad of reasons for this, but the three glaring issues are that a majority of the protocols lack product market fit, need to offer ridiculous incentives to generate inorganic and unsustainable demand leading to high inflation, and oftentimes there is no reason for a token. Liquid staking has clear product market fit, RPL has low inflation rate, and RPL has a use case in the form of penalty insurance.
Note: Nothing in the article constitutes professional and/or financial advice. Ape if you want to ape. Special shout out to those who helped with data sourcing or answering questions. Most of the staking data was provided by hildobby_ and you can view his dune analytics page which has a bunch of other interesting data tables. Rocket Pool specific data and questions were answered by Drworm.eth, Marcaeu, Jasper, Valdorff, and Nick Ashley in the Rocket Pool discord.
7 Appendix
7.1 LSD Yield Comparison
There are three main deltas that explain the difference between wstETH yield and rETH yield:
Commission difference: Rocketpool takes 15% while Lido takes 10%.
Deposit pool has 5k ETH not being used, which is 2.8% of the ETH not being staked.
Node operators have less effectiveness as they are not professionals. (Not all are running MEV boost)
Running the numbers, we have 0.0592*(.85/.9)*(.972)*(.98)=0.0534, any other difference is due to large MEV rewards and should balance out given time. The Atlas upgrade targeted in February, drops the commission to 14% and will solve the extra ETH not being used. In addition, post withdraws, MEV-boost will be a requirement so I expect the yield to rise to around 5.6% after the changes. If Rocket Pool is still lacking in market share (<10%) after withdraws, then dropping the commission rate even further to increase yield even further will be on the table.
The extra yield requires the operator to take on additional slashing conditions. Eigenlayer effectively gives higher risk + higher reward and lets individual Node Operators build the reward profile they want in accordance to their risk tolerance, similar to a Sharpe ratio.
Not including Coinbase's new cbETH or fxsETH.
Lido's staked ETH where 1stETH = 1ETH
A specific breakdown of the differences between rETH and wstETH yield can be found in the appendix
Merge is denoted with a blue vertical line
Node operators may want to stake more RPL than the minimum because the current rewards emission is in proportion to the amount of RPL staked and they believe that RPL will not underperform ETH. This is also why the average collateral is around 80%, much higher than the minimum of 10%.
A refresher from the previous section is that the collateralization rate is just the value of RPL in each minipool compared to the value of ETH
LEB4 would allow node operator to put up 4 ETH while the deposit pool puts up 28 ETH while LEB2 would be node operator putting up 2 ETH and staking pool putting up 30
In addition lower LEBs result in lower commission, LEB8 is 14%, LEB4 is 12%, and LEB2 is 11%. This will make the rETH yield more competitive with stETH.