Slowly but steadily, staked ether (stETH) is emerging as a standard for the entire on-chain economy.
A recent report from investment management firm ARK Invest highlights how Ethereum’s monetary policy has transformed staked ether into a distinctive asset, akin to sovereign bonds. More on this can be found in a new report.
“The ETH staking yield serves as an indicator of smart contract activity and economic trends within the digital asset realm, resembling the fed funds rate in traditional finance,” stated Lorenzo Valente, a research associate at ARK Invest.
Ethereum is structured to allow ether (ETH) holders to stake their tokens, effectively locking them within the network in return for a yield. As of this writing, the yield on staked ether is generating an annualized return of 3.27%, based on data from CoinDesk CESR.
Additionally, there is a liquid staking token known as stETH, provided by the Lido project, which allows Ethereum stakers to reinvest their holdings into DeFi protocols.
The yield produced by staked ether positions the asset as a counterpart to sovereign bonds, which are debt instruments issued by governments for funding purposes. Investors can purchase this debt and accumulate interest over time.
However, according to the report, staked ether is distinct from bonds in several key ways.
Some of the differences are beneficial. For instance, while government entities can fail to meet their debt commitments – as Argentina demonstrated in 2020 – Ethereum is structured in a way that prevents it from defaulting on staked ether. The network is designed for users to have access to their funds whenever they wish, and the yield continues to be generated regardless of circumstances, though the interest rate may fluctuate based on on-chain activity. A significant risk for bonds is inflation; if a government issues excessive amounts of currency, and the inflation rate exceeds the bond yield, investors face a decrease in their purchasing power.
Ether can also be impacted by inflation (as seen in the current scenario) if network activity declines to the extent that ether issuance surpasses the ether burn rate – a system that eliminates a portion of ether with each transaction. Nevertheless, on-chain data offers a clearer perspective on ether’s inflation rate. Data aggregator ultrasound.money illustrates, for instance, that over the past 30 days, the supply of ether has increased at a rate of 0.33% per year.
However, investing in staked ether involves its own set of risks. Staked ether might be at risk of being lost by the network if the validators involved – the entities where investors stake their ether and who are responsible for processing transactions – experience an operational failure or act in ways harmful to the network. This situation is referred to as “slashing.”
Although government bonds carry political and regulatory risks, they aren’t subject to being eliminated by an automated system if something goes wrong.
One of the key advantages of sovereign bonds is their inherent stability. When issued by a stable country, these bonds are typically regarded as low-risk investments and can even be seen as cash equivalents. In contrast, Ether exhibits significant volatility; at the moment, it has appreciated by 65% over the past year. As a result, investors are unlikely to categorize staked Ether in the same low-risk tier as bonds.
The report highlighted that “both types of investments can be affected by factors like inflation, interest rate shifts, and currency devaluation, but the nature of these risks and their consequences can differ greatly.” Furthermore, staking Ether introduces distinct risks associated with network security, validator actions, and potential smart contract vulnerabilities, which do not find a counterpart in traditional sovereign bonds.
In general, investors have two prominent options for staking their Ether: they can either establish their own validators or utilize specialized DeFi platforms such as Lido (LDO) or Rocket Pool (RPL). These services collaborate with reputable validators and manage all the technical components of staking on behalf of their users.
Crucially, these platforms also offer liquid staking tokens (LSTs), which symbolize the amount of Ether that an investor has staked within the network. This is a significant advantage, as investors can utilize their stETH tokens (the most widely used LST) for other purposes while their Ether is committed to generating yield, such as using it as collateral in lending platforms.
The advantage is significant enough that stETH is starting to take over as the preferred collateral in the DeFi landscape.
“As of now, stETH accounted for approximately 2.7 million supplied as collateral in DeFi, which is about 31% of the total stETH supply,” the report indicated, highlighting the asset’s popularity among investors due to the “capital efficiency it provides for users, liquidity providers, and market makers.”
“At present, the leading collateral on Aave V3, Spark, and MakerDao includes 1.3 million stETH, 598,000 stETH, and 420,000 stETH, respectively, locked within these platforms and utilized as collateral for generating loans or crypto-backed stablecoins,” it mentioned.
With stETH being extensively leveraged across major DeFi protocols, the report suggested that staked ether is gradually prompting a reorganization of the wider crypto financial ecosystem.
Projects must persuade investors that, when adjusted for risk, their assets will yield better returns than merely staking ether and reaping the compounded benefits.
“If the ETH yield stands at 4% after compounding for seven years, a closed-end fund must surpass ETH by over 31% in that timeframe, not even considering price appreciation,” the report indicated.
This is one of the factors driving competing Layer 1 projects – such as Solana (SOL) and Avalanche (AVAX) – to offer elevated interest rates to entice investors who stake their tokens. This suggests that such assets carry greater risks and volatility, necessitating higher yields to motivate investors to hold onto them for the long term.
Additionally, the rising interest in staked ether has been pressuring DeFi protocols involved in lending stablecoins, as noted by ARK Invest.
For instance, Sky {{SKY}} (previously known as MakerDAO) had to raise the interest rate on locked DAI (the native stablecoin of the protocol) due to considerable selling pressure and a drop in its circulating supply, as stated in the report. Additionally, on Aave (AAVE) and Compound (COMP), investors are experiencing higher rewards for lending stablecoins. This is because users tend to prefer lending stETH and borrowing stablecoins rather than lending stablecoins directly.
This means that as stETH begins to gain more market share, the crypto economy will start to make decisions based on the yield from staked ether. Consequently, staked ether could serve a similar function in the crypto world as the Federal Reserve’s funding rate does in the global financial landscape.
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