Proof of stake blockchains like Ethereum or Solana rely on economic staking instead of computational Proof of Work to execute transactions and secure the network. The problem is, staking makes funds illiquid when they are locked-in for this purpose.
Lido Finance, a staking platform, offers one remedy for this problem. Lido tokenizes users’ staked funds into “st-token” assets, which are pegged to the underlying staked asset in a one-to-one basis, the same way a stablecoin is pegged to the dollar. This makes the original staked funds indirectly liquid, to be used in a DeFi ecosystem.
Lido Origin and Purpose
Lido Finance was launched in December 2020, just a couple of weeks after Beacon Chain went online. This is no coincidence. Beacon Chain was an experimental, Proof of Stake Ethereum network designed to pave the way for The Merge.
After The Merge was executed on 15 Sep. 2022, the old PoW Ethereum docked with the Beacon Chain PoS chain and became, in effect, Ethereum 2.0. In runup, users staked their ETH into Beacon Chain.
By doing so, validators not only secured the network but also gained staking rewards for their decentralized service, just like in other PoS networks such as Solana. But not everyone can meet Ethereum staking requirements.
To generate new blocks, validators have to stake 32 ETH as the minimum requirement. They are randomly assigned to produce new blocks as data transactions are added to the blockchain. They are responsible for countering double-spending, which is why the minimum requirement is so high.
Moreover, even for non-block-generating validators, all Ethereum staked funds are locked in. Meaning, they can’t be withdrawn to be used for something else. Ethereum’s Shanghai upgrade will at some point in the future unlock them.
In light of these staking limitations, Lido Finance supplies a solution to two problems:
Get involved with staking at any staking amount.
Circumvent locked funds by collateralizing them with a staking token.
How Does Lido Work?
To make PoS staking funds available for use in dApps, Lido platform tokenizes those funds as staked tokens. Different networks have different staked tokens. They are named by adding “st” prefix to the tokenized network’s token.
For Ethereum (ETH) – stETH
For Polygon (MATIC) – stMATIC
For Polkadot (DOT) – stDOT
For Kusama (KSM) – stKSM
For Solana (SOL) – stSOL
Just as stablecoins USDT or USDC are pegged to the dollar in a 1:1 ratio, so are these staked tokens pegged to their respective native tokens. Although this means that 1 stETH is equal to ETH in value, it could happen that a staked token’s price wobbles because of the secondary market’s supply and demand.
This happened during the market crash in the summer of 2022, after Terra (LUNA) collapse triggered market contagion.
It is important to understand that Lido is a mediator. All tokens that users deposit into Lido are actually staked on their respective PoS networks. In turn, Lido’s smart contract sets staking rewards and manages staked token withdrawals, plus the 10% fee from staking rewards.
Likewise, Lido’s smart contract issues tokenized versions as “st,” proportional to the amount deposited. In turn, those staked tokens can be used as a collateral on DeFi dApps like Aave or Curve. Lido users receive dual rewards:
One from Lido’s own staking with the original tokens on a respective network.
One from users’ own DeFi ventures in various lending dApps.
Lido noted that this secondary DeFi market, especially the leveraged portion, created the stETH-ETH peg wobble, but it doesn’t affect long-term stETH holders. According to Nansen research, 45 stETH token holders created an outflow of 116,000 worth of ETH across their leveraged positions during the Terra fallout.
In other words, although stETH is 100% backed by ETH, leveraged exposure had to unwind for the peg to return to its original one-to-one ratio.
Lido DAO and LDO Tokenomics
To further decentralize Lido, the platform launched a DAO. Lido DAO allows LDO token holders to vote on how the protocol operates.
This includes how much rewards liquid staking protocols yield, in addition to managing Lido fees. Because Lido runs its own network of validator nodes, as it stakes users’ funds, LDO token holders can also vote on their removal or addition of new ones.
Lido DAO’s token has a maximum supply of 1B, as an ERC-20 token used for exerting proportional voting weight in the Lido DAO. The treasury holds 36.32% of LDO tokens, while 22.18% is reserved for validators. The rest is reserved for developers, venture capitalists, and future employees.
This series article is intended for general guidance and information purposes only for beginners participating in cryptocurrencies and DeFi. The contents of this article are not to be construed as legal, business, investment, or tax advice. You should consult with your advisors for all legal, business, investment, and tax implications and advice. The Defiant is not responsible for any lost funds. Please use your best judgment and practice due diligence before interacting with smart contracts.