6 min read
The top implications of Ethereum's Shanghai Upgrade
The next Ethereum upgrade, Shanghai, is just around the corner. With the recent narratives in real yield and liquid staking derivatives, we look at the implications for Ethereum and liquid staking derivatives.
The Shanghai Update
Ethereum has undergone several upgrades, each aimed at enhancing its performance, security, and scalability. The next significant upgrade, the Shanghai upgrade, will go live in March 2023. The Shanghai upgrade promises to introduce substantial changes to the Ethereum ecosystem. The Shanghai upgrade will introduce critical updates and fundamental changes to Ethereum's EVM (Ethereum Virtual Machine) functionalities.
One of the primary benefits of the Shanghai upgrade is that transactions on the Ethereum blockchain could become faster and cheaper. This is because the promotion will reduce gas fees. This reduction in gas fees will make Ethereum more accessible and attractive to users previously deterred by the high transaction costs.
Another crucial feature of the Shanghai upgrade is the withdrawal of staked ETH. This upgrade will allow validators to withdraw their staked ETH from the Ethereum 2.0 contract. This will significantly increase the flexibility and usability of staked ETH, making it easier for users to manage their investments in Ethereum.
Lastly, the Shanghai upgrade will update smart contract facilities, making Ethereum one of the most elaborate smart contract-capable blockchain networks. These updates will enable Ethereum to stay ahead in development and crypto trends, making it a more attractive platform for developers and users.
Liquid Staking Derivatives
The Shanghai upgrade will include a list of Ethereum Improvement Proposals (EIPs). While all the EIPs included in the upgrade are noteworthy, the most significant one is undoubtedly EIP-4895, which will enable staking withdrawals. This upgrade means that all the staked ETH in the Ethereum 2.0 contract can be withdrawn and potentially sold.
At the time of writing, over 17 million ETH is staked in the contract, translating to roughly $28 billion in value. When the Shanghai upgrade goes live, all this ETH will be available for withdrawal. This presents an interesting situation for the Ethereum community and investors as it is still being determined how this influx of ETH into the market will impact its price and overall market sentiment.
When Ethereum staking was first introduced in December 2020, it was viewed as a promising way to secure the network while allowing users to earn rewards by participating in the consensus mechanism. However, the participation requirements were high, creating a significant entry barrier for many potential users. Individuals needed to hold 32 ETH and possess the technical knowledge to operate a validator. Furthermore, stakers had to lock up their tokens indefinitely. There was no concrete timeline for when withdrawals would be enabled, creating uncertainty for investors. To address these issues, liquid staking derivatives (LSDs) were developed.
LSDs provide an easier way to stake and retain the liquidity of the tokens despite being locked on the blockchain. The protocols behind LSDs enable users to stake any amount of ETH and provide a liquid market for claims on the locked ETH. With liquid staking protocols, individuals can stake less ETH and receive a collateral token. This token is a proxy for the locked ETH, representing the principal and yield.
The growing popularity of liquid staking derivatives has led to the acceptance of these tokens as collateral on protocols such as Aave, making LSDs an appealing option for traders seeking exposure to ETH and the staking yield of the network.
Additionally, it’s essential to recognize some of the risks associated with LSDs. The staked ETH has not yet been withdrawable. The peg between staked ETH and ETH is based on confidence in enabled withdrawals. While it should theoretically remain at 1:1, there is no mechanism to enforce it algorithmically. Suppose confidence in the withdrawal process were to falter. In that case, the value of staked ETH could deviate from its peg and potentially create losses for investors.
Ethereum Staking Post Shangai
Despite the potential benefits of Ethereum staking and the development of liquid staking derivatives, the percentage of total ETH staked still needs to be higher than other popular blockchains. Ethereum ranks in the bottom 10 of Proof of Stake platforms regarding staking percentage, despite having the largest staking market cap. This is a surprising finding, given Ethereum's popularity and the potential rewards associated with staking.
According to data from Staking Rewards, as of February 2023, the staking percentage for Ethereum is approximately 15%, which is significantly lower than other Proof of Stake networks such as Solana (72%), Avalanche (55%), and Cardano (71%). Even networks with smaller market caps, like Cosmos and Internet Computer Protocol, have staking percentages above 60%.
The low staking percentage for Ethereum may be due to several factors:
- The high minimum requirement of 32 ETH to participate in staking creates a barrier to entry for many potential users.
- A concrete timeline for when withdrawals would be enabled may have caused uncertainty for investors.
- The transition to Proof of Stake was repeatedly delayed for several years before launching in 2022. This may have led to scepticism among potential stakers.
However, the upcoming Shanghai upgrade may lead to a significant increase in Ethereum staking. The upgrade is expected to enable withdrawals, increasing investor confidence and incentivizing more users to participate in staking. Given that a substantial portion of users on other Proof of Stake networks stake their tokens, it is possible that Ethereum staking may see a significant increase after the upgrade.
While the upcoming Shanghai upgrade may lead to an increase in Ethereum staking, there is also the possibility that the staking percentage may decrease following the upgrade. Many stakers may want to withdraw their tokens and realize their rewards after locking up their capital for over two years.
A significant portion of staking is done via LSDs. These derivatives allow users to retain the liquidity of their tokens and are more attractive to investors who want to avoid committing to long-term staking. As a result, it is reasonable to assume that many stakers have already exited their positions to other potentially longer-term holders. This may mitigate the potential sell-off of staked ETH following the Shanghai upgrade.
Furthermore, the Ethereum network has a queue system for validators to protect the network against a mass exodus. This means that validators must wait for their turn to withdraw their staked ETH, which can take up to several weeks, depending on the size of their stake. This mechanism ensures that the network remains stable even if a large number of validators decide to withdraw their staked ETH at the same time.
The Shanghai Update for Liquid Staking Derivatives
LSDs have become the way for investors to participate in staking without worrying about the technical aspects of running a validator node or the risks associated with holding a large amount of cryptocurrency for an extended period. LSDs allow users to lock their ETH tokens in a smart contract, which generates a liquid token that can be traded on exchanges. The smart contract then stakes the locked-up ETH and earns staking rewards. The flexibility offered by LSDs is desirable to investors looking for a way to earn staking rewards while still having the ability to trade their tokens on the market. This flexibility also means that the percentage of staked ETH could increase significantly after the Shanghai upgrade as more investors turn to LSDs as a staking solution.
Investors may acquire LSD protocol tokens in anticipation of increased demand for staking services following the Shanghai upgrade. The recent price increases indicate that investors see LSDs as an essential and growing part of the Ethereum ecosystem and are willing to invest in the governance tokens to have a say in the protocol's future.
As Ethereum moves towards the upcoming Shanghai upgrade, scheduled for March, more ETH is expected to be staked on the network. One of the most significant benefits of this upgrade is the reduction of risk and uncertainty associated with Ethereum staking yield. The staking yield for ETH currently ranges from 4%-9%, primarily generated by transaction fees. This yield is a major attraction for investors looking for a sustainable way to earn passive income from their investments.
Furthermore, removing withdrawal restrictions may also lead to an increase in risk-adjusted exposure to ETH. This means that investors are more willing to hold ETH for an extended period, which could increase demand for the asset and drive its price. This increased staking activity is likely to generate more revenue for LSD protocols and push prices higher. As the Shanghai update approaches, the likelihood that this becomes a sell-the-news event becomes less probable as large investors have likely hedged their risk exposure.
Subscribe to Flagletter
Get content like this in your inbox
Disclaimer: Nothing on this site should be construed as a financial investment recommendation. It’s important to understand that investing is a high-risk activity. Investments expose money to potential loss.