Demystify the new chapter of DeFi and explore the evolution of LSDFi in depth

Author: ValHolla

Original compilation: Block unicorn

Everyone knew the Ethereum merger would have a positive impact on DeFi, but in less than a year, it has surpassed the wildest bullish expectations. The place where we can see this most is LSDfi - the DeFi world based on liquid collateralized derivatives is constantly developing. This narrative has been around for a while at this point, so it’s worth exploring where it came from and, more importantly, where it’s going.

In this post, I’ll break down the evolution of LSDfi into 3 phases, and then take a look at some projects that are at the forefront of possible applications of LSDs. To be sure, there is a lot on our horizon, and what we see is just the beginning.

Phase 1: Liquidity Staking Agreement

One of the hot spots for cryptocurrencies heading into 2023 is LSD providers like Lido and Rocket Pool. As you probably know, these protocols let users stake their ETH on a smart contract, and then stake the ETH to help secure the network. In return, users receive LSD like stETH or rETH — liquidity tokens that represent the ETH they’ve staked. The result is a liquidity token that can be traded, borrowed and borrowed, and still accrues staking returns in ETH itself.

Earlier this year, many believed that these protocols would benefit from increased staking demand, especially since staking withdrawals were enabled on the ethereum network. I think it’s safe to say that this trend is developing in an extremely bullish manner. Just look at the increase in the number of validators:

Similarly, the amount of staked ETH is increasing rapidly:

By keeping staked tokens liquid, LSD providers play an important role in encouraging users to feel comfortable staking their Ethereum. That being said, the protocols issuing this first wave of LSD are not the only ones to benefit from it. If you think that these staking agreements are the primary beneficiaries of LSDfi, we can continue to dig deeper to understand the truth.

Once LSDs are released, it is logically necessary to find a way to keep them pegged to their underlying assets. The last thing we need is a repeat of last summer when the largest ETH LSD, stETH, was de-pegged due to forced selling by 3AC et al. As a result, protocols like Curve and Balancer saw massive inflows into ETH LSD-related pools, amplifying their TVL.

Right now, Curve’s stETH/ETH pool is the most prominent LSD pool in DeFi with a TVL of about $740 million. They also have over $164M in the frxETH/ETH pool which is their 5th largest pool on mainnet.

Balancer - 3 of their top 4 pools on mainnet are LSD related, and their TVL is over $136M, which is over 13% of their total TVL.

Looking around, we can see that LSD has actually become the largest source of all TVL in DeFi:

It’s even more impressive when you put this in context: Right now, there are roughly 10 million ETH deposited into the liquid staking protocol. This number has increased by more than 5 times since the beginning of 2022!

In the same time frame, almost everything else in DeFi and the wider crypto universe has collapsed, so if LSDfi is experiencing this kind of growth, obviously it has to offer some real innovation. With that in mind, let’s move on to the second stage.

Phase 2: LSD as collateral

The second phase of LSDfi is a series of projects with a similar basic concept: users lock LSD in CDPs (collateralized debt positions, which are liquidated when the collateral price falls), and then mint and borrow stablecoins.

You may be tired of reading about new LSD-backed stablecoin offerings, but don’t let the sheer number of protocols using this model diminish its importance. Personally, I think the reason so many protocols are doing this is because it’s a product that can do amazing things.

Not only does it further expand the utilization of LSD, but it also contributes a much-needed level of decentralization to the existing stablecoin market. Beyond that, LSD by definition earns the yield generated by its underlying asset by performing certain tasks (for example, providing security to a PoS blockchain). Staking APR is usually higher than most money markets pay for deposits (unless there is a high incentive), so you already have an advantage there. Essentially, each CDP position is turned into a self-repaying loan using yield-generating tokens as collateral.

So far, Lybra, Curve, and Raft are the biggest beneficiaries of the second phase.

Lybra

Lybra has been on CT for a few months now, and for good reason, of course. Its eUSD stablecoin, backed by ETH and stETH, has reached a market cap of $177 million. Among decentralized stablecoins, only DAI, FRAX, and LUSD have the highest market capitalization.

And in less than 3 months, according to defillama data, Lybra has accumulated a TVL of 345 million US dollars, making it the third largest CDP protocol on Ethereum after MakerDAO and Liquity-this is a very good LSD protocol!

Curve

Curve’s CRVUSD stablecoin is backed by wstETH, WBTC, sfrxETH and ETH.

In total, over $120 million has been deposited as collateral for these assets, but more than 80% of that comes from the two LSDs on the list (wstETH and sfrxETH).

As a result, there are now close to $80 million in crvUSD in circulation, an increase of more than 7x since June 7th.

Raft

Compared to the previous two protocols, Raft and its stablecoin R have not been widely discussed and followed compared to other protocols, but they have still made impressive progress so far. In a few weeks, Raft’s TVL increased from $1 million to $55-60 million, and the current figure is $57.7 million.

To date, more than 99% of R stablecoins are backed by stETH collateral. However, they also accept Rocket Pool’s rETH as collateral, with more forms of collateral likely in the future.

Lido’s stETH now makes up the vast majority of collateral for these Phase 2 protocols. There are two ways I think this will change: One way is that smaller LSDs will take more of the mortgage market share.

This will come in the form of CDP protocols offering different collateral options, and DeFi users being more willing to buy smaller LSDs and use them as collateral. We’ve seen some of these projects gain traction in this space recently (in addition to crvUSD), such as Gravita, which accepts rETH in addition to stETH. Gravita is an exception so far as their stablecoin (GRAI) is largely minted via rETH compared to stETH.

The other way is the most common path for LSD providers. Lido’s stETH has captured nearly 75% of the market so far.

I think more LSD options will gain market share as LSDfi grows. In fact, by the end of 2024, I wouldn’t be surprised to see stETH’s market share drop below 50%. After all, only 17% of the ETH supply has been staked so far, and less than half of that is through LSD providers. So, the game is far from over.

Phase 3: Collateral diversification

So, if Phase 1 is LSD and Phase 2 is LSD-based lending, then what is Phase 3?

Since the underlying trend throughout this process has been LSD over ETH, the second largest asset in cryptocurrency, the natural direction of development will be further expansion through other composable assets. This can be achieved through the use of LP tokens, stablecoins, money market deposits such as Aave’s aUSDC, and more. Think about it: what if you could do all the things that Phase 2 protocols like Lybra do with ETH, you could do it with other types of cryptocurrency tokens you hold, or your investment position in other projects (that is, your investment share or equity in other projects)?

A good example of an emerging DeFi project that is looking to implement this strategy is Seneca. While their product is not yet public, they are building a protocol that will be able to unlock credit for a variety of different DeFi users.

While you can earn pretty good yields with LP tokens, LSD, deposit receipts, etc., there are always ways to seek higher and more capital efficient. Seneca will enable these tokens to serve as loan collateral for their native stablecoin: senUSD. This way, liquidity is unlocked while collateral holders can still earn yield on their assets.

Another project pioneering the way forward in this regard is EraLend, the forerunner of the zkSync money market.

EraLend has several features that make it stand out. First, they are already in the process of executing phase three by accepting SyncSwap’s USDC/WETH LP tokens as collateral. This may be the first of many alternative assets used as collateral on EraLend - the catalyst for the expansion is their upcoming P2P lending product. Not much is known about this product, but I believe anyone could potentially put any type of token (LP tokens, LSD, debt receipts, NFT, etc.) as collateral.

EraLend has exploded in recent weeks as their TVL has skyrocketed from $3.9 million to $24.35 million since June 1st (latest data from official website, defillama data delayed):

**As the zkSync narrative heats up, this is definitely a project to watch - in fact, it already ranks 3rd for zkSync in terms of TVL. **

Finally, another interesting feature of EraLend is that any token can be used to pay for GAS, which bodes well for account abstraction in the future of this young protocol.

Even if you are convinced that Tether and Circle have what they claim to own, the ideal scenario would be to see a native DeFi stablecoin with traceable on-chain collateral (without much exposure to traditional stablecoins) eventually replace them as the leader. At this point, the most obvious approach is to create a model like Seneca’s.

Going forward, a fractional reserve regime in DeFi is necessary because it enables doing more with less. In fact, I would argue that DeFi can be easily optimized for such a system. First, code is law in DeFi, meaning parameters such as collateral limits are fixed and cannot be adjusted in special cases. Additionally, unlike traditional finance, DeFi is inherently composable, making it easier to integrate new forms of assets and provide use cases for those assets. DeFi is also inherently transparent, which makes use cases like LSD- and LP-backed stablecoins more attractive than traditional stablecoins like USDT and USDC.