Why the Ethereum Shanghai Upgrade Will Lead to War

DeFi industry: There is a new war on the horizon. Unlike the Curve Wars, fought over stablecoin liquidity dominance, this war will be fought over the future of liquid staking tokens. 

The catalyst for this upcoming battle? 

The Ethereum Shanghai fork, set to take place on April 12, when more than 18 million in staked ether (~$34.2 billion) will become unlocked and battlelines will be drawn.

I believe that Shanghai will provoke a period of intense competition among liquid staking protocols that will come to be known as the “Liquid Staking Wars” — albeit wars that will ultimately benefit the entire industry.

Those of us who were here for DeFi Summer will remember the Curve Wars well: the ruthless competition between the emerging stablecoin protocols, who “fought” on the Curve DEX to have the deepest liquidity and most diverse set of liquidity pairings. 

Let’s review the ingredients that precipitated the Curve Wars: 

1) a DEX Automated Market Maker (AMM) especially designed for trading stablecoins (Curve); 

2) a mechanism for protocols to incentivize liquidity providers (LPs) to move from LPing one stablecoin to another (Curve incentive contracts); 

and 3) a bunch of new stablecoin protocols jockeying for market share (USDC, USDT, DAI, FRAX, LUSD, etc).

I see striking similarities with the Curve Wars in the burgeoning competition between protocols that offer liquid staking tokens (LSTs) — yield-bearing tokens that allow holders to stay liquid while enjoying the yield from staked ETH. 

We already see the same ingredients coalescing with:

1) novel DEX AMM protocols especially designed to facilitate LPing liquid staking token (LST) pairs; 

2) incentive contracts that LST protocols can use to reward LST LPs; and

3) a cascade of emerging LST protocols vying for market share.

The Liquid Staking Wars have one last different ingredient — the imminent Shanghai upgrade that will enable LPs to easily and cheaply unstake ETH from one LST and move it to another LST.

The Liquid Staking Wars will be won by whichever protocol can capture the most TVL and volume for their LST. I believe that the battle for LST supremacy will see its first skirmishes by early May and that it will have a lasting impact on the DeFi ecosystem. 

After all staked Ethereum becomes unlocked in mid-April, unstaked ETH holders will be incentivized to move their ETH from one liquidity staking token solution to another, always seeking the highest potential returns in liquidity pools. LST protocols will likewise be incentivized to capture market share by having their token be the most liquid. 

This war — or competition between LST protocols to provide the dominant asset in crypto — will reshape all crypto pairs across all DEXs. 

Liquidity provider (LP) strategies will also evolve based on the yield-bearing characteristics of LSTs; DEXs will evolve their offerings to accommodate this new landscape; and the DeFi industry will benefit from a wave of innovation (as we see in most periods of increased competition).

The Liquid Staking Wars’ tactics will mirror those of the Curve Wars

We will see LST protocols attempt to differentiate themselves through innovation, usability and yield. The most obvious mechanism will be yield: LST protocols will seek to maximize the incentives for LPs to fund liquidity pools using their LST over any other LST. 

Post Shanghai, there will be a big opportunity cost for LPs who add liquidity to ETH-denominated pools instead of pools denominated in an LST. The ETH LPs will be foregoing ~4% return for no good reason. 

Even pre-Shanghai, we have seen a massive demand for LST yield: Liquid staking tokens have skyrocketed in total value locked (TVL) to account for more than $14 billion, according to DeFiLlama as of April 3, 2023. The LST sector is second only to the current size of all decentralized exchange protocols combined. 

Some may claim that Lido — with a near 75% of LST TVL market share — has won the war before it has even begun. But while Lido has established itself as a leader, entrants such as Frax, Coinbase, Rocket Pool, and new protocols that have yet to launch are jockeying for position to have their LST become the preeminent ETH replacement. 

As with any war, the winners and losers will be defined by strategically deploying the right set of tactics on the battlefield.

This competition — and specifically the competitive incentivization of liquidity pools it will entail — should also benefit other participants across the DeFi ecosystem. LSTs have a place not just paired with each other or with ETH in pools, but also with other utility tokens. For example, instead of WBTC-ETH being a popular pool on DEXs, I expect to see WBTC-WSTETH, WBTC-cbETH or WBTC-rETH. 

I expect a groundswell of co-incentive liquidity pool structures pairing utility and yield tokens. These partnerships should benefit long-tail tokens by providing the liquidity required to build their businesses, as well as some of the most well-known utility tokens seeking to expand their influence.

In addition to maximizing incentives into liquidity pools, subtle differences in Automated Market Makers (AMMs) can provide significant advantages to LST protocols — especially considering how LSTs gain value over time from the yield of underlying staked ETH. This intrinsic value-growth dictates that LPs will need to more closely monitor their positions to keep their liquidity active as prices move. Pairing with an AMM that can maximize LP capital efficiency for an LST pair, as an example, can provide significant benefit. 

I anticipate increased innovation from DEXs, specifically around the functionality of AMMs. To win the Liquid Staking Wars, protocols will need a set of tools to incentivize the liquidity of their liquid staking tokens using minimal incentives and maximum efficiency. Protocols that can boost LP incentives through this type of “surgical incentivization” and provide greater capital efficiency will ease the capital requirement burden from LSTs. This will in turn enable the LSTs to maximize their return on incentives, and capture a greater market share.

For stakers and LPs, it’s essential to understand the financials (fees, etc.) before they stake or provide liquidity on a particular platform. As mentioned, due to the unique return structure of LSTs, some existing AMMs are not capital efficient for LST liquidity. This is because LSTs and the unique liquidity challenges they represent did not exist when these AMMs were developed. 

For instance, infinite-range AMMs like Sushi, Balancer, and Uniswap v2 are known to have low efficiency for almost any pair.  But even Range AMMs like Uniswap v3 and related forks can have a low efficiency for an ETH-LST pair, because the price in the AMM will continuously exceed the LP’s range unless the LP actively manages their position or stakes a very wide price range. In addition to the incentives offered, LPs must be aware of these crucial structural details of the protocols before they deploy their capital.

Even though I am calling this next phase in DeFi after Shanghai a “war,” what it’s ultimately leading to is more liquidity injected into the ecosystem. And with greater capital efficiency in liquidity pools ushering in an era of more “active capital,” these volumes will be more consistently utilized to the benefit of the entire industry.

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