Governor Note: Lido and the Race for L2 Liquidity

Key Insights

• Lido has released a proposal to expand the staked ETH (stETH) footprint to Ethereum’s two largest Layer-2 chains: Optimism and Arbitrum.
• Lido’s Layer-2 strategy faces inherent risks in its use of cross-chain bridges.
• Despite an expansionary roadmap, Lido has recently faced resistance from Layer-2 DAOs due to the protocols staking dominance.

Introduction: Lido, the Merge, and Layer-2

With The Merge scheduled to occur on September 15, 2022, the fundamentals of decentralized finance (DeFi) will inherit a robust yield-bearing primitive in liquid-staked ETH. With Ethereum’s transition to Proof-of-Stake (PoS), liquid staking protocols allow users to stake their ETH in return for liquid staking derivative (LSD) tokens. LSD tokens earn staking rewards while enabling participation in DeFi protocols. To date, Lido represents the largest LSD provider and currently holds one of the most significant total value locked (TVL) metrics of any protocol on Ethereum, with over 4.1 million staked ETH (worth ~$7.34 billion).

The ecosystem's two largest optimistic rollups, Optimism and Arbitrum, have simultaneously led Ethereum’s Layer-2 rollup ecosystem. This scaling infrastructure provides lower transaction fees and the potential for more accessible DeFi. As the legacy protocols of Ethereum mainnet look to expand to Layer-2 chains, they face several challenges. Let’s explore how Lido aims to establish liquidity, security, and dominance across Ethereum's Layer-2 ecosystems.

The Lido Layer-2 Proposal

Victor Suzdalev (also known as kadmil.eth), Core Contributor at Lido DAO, officially proposed expanding Lido DAO’s staked ETH (stETH) footprint across the Ethereum ecosystem. The proposal targets both Optimism and Arbitrum.

To date, the bridging of stETH beyond Ethereum mainnet has been primitive at best, partly due to the difficulties of the token’s yield-bearing properties. stETH accumulates staking yield via rebasing, which periodically attributes balance to the stETH token itself.

Due to the complexity of the stETH token contract, Lido also introduced wstETH, a wrapped version of stETH. wstETH is specifically designed for smart contract integrations. stETH holders can deposit their stETH in the wrapper contract to receive wstETH. wstETH retains a constant balance while the balance of stETH backing the token continues to increase. At any point, the wstETH holder can swap wstETH for an underlying amount of stETH held in the contract balance.

To support wstETH on L2, Lido has successfully built, audited, and deployed bridging contracts for both Arbitrum and Optimism. The bridges will be upgradeable using Aave Governance Cross-Chain bridge contracts. The contracts are currently under audit by ChainSecurity and have been deployed by Lido on both networks.

The greatest risk for Lido’s expansion is likely the protocol’s exposure to bridge attacks. Bridges are a well-documented vector for on-chain attacks. Several bridge attacks have occurred this year, including a Nomad bridge exploit, which resulted in the loss of $190 million of contract funds. As a result, some DeFi protocols have taken defensive measures. Frax Finance recently approved FIP 100, a proposal that ended Frax DAO support for bridge liquidity and swaps for wrapped FRAX and FXS on external chains.

While the Lido dev team multisig currently has the jurisdiction to enable Layer-1 (L1) deposits in the bridge, admin rights will transfer to the Lido DAO via the Aragon Agent App once the bridge is enabled. Once transferred, any actions or changes to the bridges will require explicit Lido DAO approval. For security purposes, the DAO has created Emergency Brakes multisigs with the ability to pause deposits and withdrawals on each network. Once paused, only Aragon Agent may resume bridge operations.

Despite the risks, bridging stETH to Layer-2 will provide a highly demanded asset and the promise of a robust DeFi ecosystem for Ethereum. Looking forward, Lido will aim to continue its operational efficiency to provide ample liquidity across Ethereum's scaling infrastructure.

Liquid Staked ETH and DeFi

The Merge will introduce a robust yield primitive for crypto, with analysts expecting a yield between 7.4% and 13% for ETH. Currently, Lido’s stETH already looms as a core DeFi component across the Ethereum mainnet. stETH accounts for two of the largest yield strategies on mainnet with 579,000 stETH allocated to the stETH/ETH Curve LP and 938,651 stETH allocated to the Aave V2 Lending Pool.

The promise of sustainable yield also offers opportunities for speculative and, admittedly, experimental financial applications. APWine protocol has introduced several novel approaches. These include APR fixed rates, where users can fix rates for a specific period to hedge against volatility, and future yield staking, in which users can obtain future yields without waiting for expected yields to accumulate.

The applications of LSD for DeFi are enticing, and there is proven demand for users to generate additional yield on blue-chip crypto assets. Liquid staking protocols must invest in DeFi integrations and liquidity on the chains where opportunities exist. For Lido, the move to L2 represents a strategic investment in ensuring stETH has an advantage in both areas.

Competing for L2 Liquidity

The current state of LSD liquidity on Layer-2 is virtually non-existent. While Lido has integrated with the zkSync bridge and Argent, only 1,598 stETH/wstETH have been bridged to date, and the application ecosystem of the chain remains nascent. Likewise, a trivial amount of Rocket Pool’s liquid staked ETH product, rETH, has been deployed to Velodrome on Optimism. Given the increased activity across the Arbitrum and Optimism, the race to integrate LSD liquidity on both chains has just begun.

Bridge integration is the first step to establishing Layer-2 dominance. Next, creating robust liquidity across the Layer-2 ecosystems will be essential for adoption. If the draw of lower transaction fees isn’t enough, native token incentives from Layer-2s will likely contribute to the migration of LSDs to Layer-2 chains. Arbitrum has not officially announced the release of a token, but Optimism recently launched their OP token and earmarked nearly 10.8% of the total OP token supply to Optimism network growth.

Despite the dominance of Layer-2s to date, Lido has met resistance from their communities. Rocket Pool, an early entrant and competitor to Lido in the LSD landscape, recently secured an Optimism grant. Rocket Pool received 600,000 OP for liquidity mining rewards for rETH/WETH pools on Balancer/BeethovenX and Velodrome. Lido also applied for a governance fund grant, which was notably snubbed from the voting cycle. While Lido’s grant application received the support of key Optimism delegates, such as Polynya, the application raised concerns around Lido’s dominance as a steward of staked ETH and its safety and security implications for Ethereum Mainnet.

Conclusion

Lido’s announcement to support wstETH on Arbitrum and Optimism was well timed. The protocol is positioned to dominate LSDs on Ethereum Layer-2s. Should the proposal succeed and avoid technical issues, users can expect a surge in DeFi activity for wstETH across both Optimism and Arbitrum.

However, Lido’s political standing continues to be affected by concerns around the DAO’s dominance and its implications for Ethereum security. Ecosystem resistance from Optimism, and potentially Arbitrum, could provide additional incentives for competitors, such as Rocket Pool, to expand their footprint across Ethereum scaling.

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