The DETH of Ethereum

Imagine you own an asset. It’s called ETH and it’s something of a digital commodity (some even say ETH is money). You plan to own it for a long time, because you both expect it to become more useful and expect that more people will hear about and also find it useful.

In the meantime, it would be nice if you could put your ETH to work. Today, you can lend it out to earn interest using an Open Finance (also known as Decentralized Finance or DeFi) protocol, like Compound, dYdX, or bZx.

But soon, instead of just lending your ETH, you’ll be able to stake it (well, technically, you’ll do a one-way conversion to ETH2 and stake that) and increase your holdings while contributing to the security of Ethereum by validating transactions. That means earning yield with the added benefit of warm-and-fuzzies for helping to secure the network — even better!

But what if the yield for staked ETH is lower than the yield for loaned ETH? How much are those warm-and-fuzzies really worth to you?

For most people, with apologies to Jessie J, I think we can all agree it’s going to be all about the money.

Haseeb Qureshi of Dragonfly Capital wrote a nice summary of Tarun Chitra’s paper, both making the case that DeFi lending yields will be higher than staking yields and that this will cannibalize Proof-of-Stake (PoS) security over time due to low staking rates.

However, this assessment makes one critical assumption: that owners of ETH must choose between either lending their assets or staking them.

I have just one question:

The Superfluid Collateral thesis

Earlier this year, I predicted that a major trend in DeFi would be the emergence of “superfluid collateral.” The overall thesis of superfluid collateral is that the ability to use the same assets in multiple protocols simultaneously is both inherently attractive and can serve to counteract the capital inefficiencies of overcollateralization required by permissionless credit protocols. As suggested, Compound did indeed announce and release the now widely-used cTokens (cDAI, cETH, etc) representing claims on assets supplied to their protocol. On the other hand, Uniswap pool shares have not yet become a popular form of loan collateral — I still think their day will come, but clearly I was overly optimistic on the timeline.

As the native asset for DeFi, ETH is perhaps the most obvious and important target for superfluidization (sorry, not sorry). Anybody wanting to both stake their ETH and also use it for another purpose — such as lending, market-making — should be able to do both simultaneously rather than having to choose one or the other.

Superfluid Collateral: Giving ETH superpowers

How would this work? Similar to how Compound issues cTokens that represent claims on assets supplied to their protocol, services such as exchanges and staking pools that stake ETH on behalf of users could issue a token that represents a claim on the staked assets and the accrued yield. While there are various types of derivatives of staked assets that can be created, let’s call this most basic form DETH, or Derivative ETH.¹

Much like CHAI ensures DAI owners always earn the Dai Savings Rate (DSR) without having to lock and unlock DAI for every transaction, DETH ensures ETH owners always earn staking rewards without having to futz with depositing, withdrawing, or managing to have exactly 32 ETH bonding their validator. However, unlike the DSR which truly is the equivalent of a risk-free rate for DAI (earning it requires no additional risk over just holding DAI), earning validation rewards with DETH does require taking on both slashing risk (if the validator node goes offline or makes a mistake) and custodial risk (you’re trusting that the staking service won’t steal your ETH, lose their keys, or get hacked).

As such, not all DETH will be created equal and there won’t be just one kind of DETH; each staking service will have their own version. One implementation of DETH has already been proposed by Stake Capital, in the form of LETH, what they call a Liquid Token or LToken. I imagine we’ll see BinanceDETH, CoinbaseDETH, and a myriad of others, each issued at the click of a button. Coinbase and Binance have already begun staking certain assets such as XTZ (Tezos) on behalf of their customers, as well as issuing tokenized derivatives of USD deposited by their customers (i.e., the stablecoins USDC and BUSD). It seems inevitable that these companies will eventually want to issue tokenized representations of staked deposits.

Now, voilà: instead of plain, boring, vanilla ETH that requires you to run a validator node to earn your network-given right to rewards and then wait 18+ hours if you want to unstake it and use it for something else, you have super awesome, easy, flexible DETH that constantly compounds every single block, even when it’s being lent on Compound or providing liquidity on Uniswap.

OK, I’m sold. What’s the downside?

What, you don’t believe in a free lunch? Good, you’re a smart cookie.

Much staking, very centralize, wow

Staking does not inherently have network effects or meaningful returns to scale. That is, by default there are no financial incentives that would enable one person with a lot of ETH get a higher yield from staking or that would encourage many people to converge on using the same staking service. Despite this, wealth concentration is hard to prevent and people have a tendency to default to using whatever services they see their peers using. As a result, most protocol designers actively implement mechanisms that seek to decentralize token ownership (and therefore staking) or at least encourage greater diversity in validation infrastructure.

Unlike staking, liquidity has strong network effects and can create a powerful moat. Look at how much (supposed) volume Tether still has, even after revelations that it was only 74% backed — does anyone think it’s because traders think Tether is better, more stable, or less risky than USDC, TUSD, etc? Liquidity begets liquidity, as shown by the fact that Tether has not only survived, but thrived. The stickiness of liquidity is also a big reason why Initial Exchange Offering (IEO) platforms are so strategic to exchanges: early batches of tokens are distributed to traders on the sponsoring exchange, thus starting the liquidity flywheel for the new token.

Staking derivatives like DETH change the game by introducing liquidity’s network effects to staking. Even if the yield for BinanceDETH or CoinbaseDETH is the same as SmallIndependentStakingServiceDETH, the increased liquidity or inclusion in more DeFi lending and trading protocols will lead it to be more widely used. No one wants to fracture ETH borrowing liquidity on Compound or trading pair liquidity on Uniswap across some huge number of DETH variations, and of course MKR holders don’t want to use their shiny new MCD features to manage stability fees, collateralization ratios, and debt ceilings across variations of their sole original collateral asset.

The most likely scenario is that liquidity will accrue to the DETH instances issued by 2–3 of the largest exchanges or custodians (Coinbase, Binance… and one other?). Once that flywheel starts turning, all DeFi users will be incentivized to deposit their ETH with those services to make it maximally liquid and useful. Pretty soon, that 32-ETH validator staking requirement will seem pointless, as the majority of ETH will be custodied (and transactions on the Ethereum network validated) by even fewer entities than control our financial and communication networks today.

But what about…

The most common observation raised in response to this thesis is that DETH will trade at a discount to ETH due to slashing risk.

I don’t think it will.

First of all, it’s just as reasonable to assume that DETH would trade at a premium due to the aforementioned advantages over vanilla ETH.

However, assuming staking services don’t charge a fee for wrapping/unwrapping (I don’t see why they would), any difference in price between staked ETH derivatives and ETH should be arbitraged away nearly instantly by anyone with an account at the staking service. Anyone with a Binance account and a brain (or a bot — brains not required) would buy cheap BinanceDETH, unwrap it, sell the ETH, buy more BinanceDETH, and wash, rinse, repeat until the price is 1:1 (note: there might be some delay on withdrawals depending on how much unstaked ETH the service keeps on hand). On the flip side, if BinanceDETH trades at a premium, that same person/bot would wrap ETH into BinanceDETH, sell BinanceDETH, and buy more ETH until the cows come home (or until the price is 1:1).

In my view, regulation — and KYC requirements in particular — are the biggest potential barrier to DETH. If validators are forced to KYC the owner of every address that receives staking derivatives, it would likely crush this usage (and a host of other potential use cases). However, as long as custodial fiat-backed stablecoins are a thing (JP Koning makes a good case for why the current dynamic may not be, ahem, stable), I don’t see why staking derivatives shouldn’t be possible.

Wrapping things up

1. Any asset that can generate yield via a homogenous, automated activity can and will be wrapped — This applies to ETH and staking (hence, DETH), but not something like REP and reporting on Augur markets (thus, DREP, while possible, is less likely). However, both ETH and REP can just as easily earn yield from being lent and thus exist in wrapped forms as cETH and cREP.
2. Wrapped, yield-generating assets are attractive for use in DeFi because they enable the underlying asset be used simultaneously for multiple purposes, without increasing protocol complexity — In an ecosystem largely built around overcollateralized lending, superfluid collateral maximizes yield and reduces capital inefficiencies. While protocols can be architected to apply superfluid principles natively (see: InstaDApp’s Giant CDP proposal or Compound’s plans to earn the Dai Savings Rate on unlent DAI), wrapped, yield-generating assets allow those protocols to simply add the new asset as they would any other ERC20 token without making fundamental changes to their architecture.
3. Wrapped, yield-generating assets create incentives for centralization due to the network effects of liquidity — Because liquidity has such strong network effects, the top issuers of these assets will become magnets for capital and thus major points of centralization within their respective networks and ecosystems, e.g., Coinbase and Binance with DETH for Ethereum, Compound with cTokens for DeFi lending.

Buckle up: 2020 is shaping up to be a particularly wild year, even by crypto standards.

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