Yield Wars: US Treasury Bonds VS stETH Staking
TLDR: The yield on long-term US Treasury bonds has been rising (and prices of bonds falling) at the same time as the yield received by staking ETH through liquid staking services such as Lido has been falling. A little after the one-year anniversary of the Ethereum Merge we saw the Lido staking APY has dropped more than 100 basis points below the yield on treasuries as investors have doubled the amount of ETH staked through Lido from the time the Merge happened. This represents an interesting dichotomy between the DeFi and TradFi markets. Investors in the DeFi markets are increasing their investments in the base layer of Ethereum while investors in the TradFi markets are demanding higher yields to invest in the least risky and foundational asset classes because they have a comparatively pessimistic outlook on future economic performance. The yield of these two asset classes moving in opposite directions, represents the different investor sentiment on future economic outlook and performance between the DeFi and TradFi sectors. While TradFi investors are preparing for economic uncertainty, DeFi investors are doubling down on the foundational level of Ethereum, representing a belief in increased blockchain adoption in the future.
Recently, there has been a lot of news around the 10-year US Treasury Yield as the yield has shot up to a multi-year high and conversely, bond prices have gone down to a multi-year low. As we can see below, the yield on these long-term treasuries is the highest it has been since 2007, around the time of the last great financial crisis. As the US is the world's largest reserve currency and is also the nation with the largest amount of external debt, raising yields on long-term debt has massive downstream effects on the global economy whilst also being a signal of market expectations. This recent rise in yields reverses the inverted yield curve we have seen for the past year, which has many speculating that we are heading towards a recession. The 10-year Treasury yield factors in the market expectations surrounding long-term interest rates, confidence in the market at large, and the general sentiment of risk that exists through the market. This recent rise in yields seems to indicate that investors are expecting higher interest rates to persist beyond the short term, making it more costly for companies to borrow money, which affects their ability to grow and give competitive returns to their shareholders. Other factors such as persistent inflation, the US credit rating downgrade, the stagnating performance of the equity markets, and the US Federal Reserve signalling they are not done with interest rate hikes have all led to investors demanding higher yields in order to tie up their cash in long term bond investments.
In the world of magic internet money we call crypto something interesting also happened right before treasury yields went up and that was the 1 year anniversary of the Ethereum “Merge” on September 15th, 2023. A year ago, the Ethereum blockchain went from a Proof of Work (PoW) consensus mechanism to a Proof of Stake (PoS) consensus mechanism allowing ETH token holders to stake their ETH, helping the blockchain validate and secure on-chain transactions while earning a return on their staked ETH in the process. Like treasury yields, the return on ETH staking is a benchmark rate for all other investment opportunities, because they are considered to be the least risky asset to invest in. Traditionally, this is referred to as the risk-free rate of return, but in reality, no investment is risk-free, even the US Treasury yield (evidenced by the fact that there is a credit rating for it). It has been a full year where the Ethereum blockchain has been secured by nothing else than users staking their ETH for a rate of return that fluctuates based on a variety of market considerations, much like the yield on 10-year Treasury bonds. Given this milestone, it is an opportune moment to look back at the performance of ETH staking as an investment strategy, how it works, how one can access these returns and compare ETH staking to its tradFi counterpart; the yield on long-term US treasury bonds.
What is Ethereum Staking and how does it work?
All blockchains require independent validators to verify the contents and order of all events that happen on the chain. This is required so everyone can have the same knowledge of what transactions took place, what transfers of tokens happened, and how much balance everyone has. In order to keep validators honest when they participate in this process, they must have a strong incentive to tell the truth and not lie. The PoW consensus mechanism does this by having validators invest increasing amounts in computing resources which can only be financially sustainable if validators act honestly, otherwise, they will have spent a large amount of computational resources with no rewards to compensate them. This is still how the Bitcoin blockchain is secured and Ethereum was secured like this until September 2022. A PoS consensus mechanism has validators lock in their assets such as ETH instead of spending money on increasing computational power. Each validator has a strong incentive to stay honest if they want to earn a return generated by the gas fees on Ethereum. There is also a strong incentive to stay honest because validators who try to break the rules will be forcefully removed from the validator network and a large part, if not all of their staked ETH is “slashed”. Given the security of the blockchain will increase with more validators and the strong incentive against acting dishonestly, the return on staked ETH is the closest an investor can get to a risk-free rate of return in the DeFi space, making it the de facto benchmark rate, like the US long term treasury yield.
Another question that arises is how to stake ETH as an investor seeking that base rate of return. There are four different ways to stake ETH:
You can stake 32 ETH of your own by using your own computer and Ethereum Node.
You can stake 32 ETH of your own using the Staking as a Service option which allows you to delegate away the trouble of operating your own node.
You can stake any amount of ETH you would like using a decentralized liquid staking pool such as Lido. In return, you would get a staking derivative asset that can be used just like ETH on the blockchain.
You can stake any amount of ETH on centralized exchanges using their validator pools.
We will be focusing on the experience and return received as an investor staking on Lido as it is the largest pooled staking provider that is decentralized, liquid and does not require a user to have 32 ETH.
What is Lido and is it safe?
Two of the major pitfalls of staking on your own are the fact that you would need 32 ETH (which most people do not have) and once that ETH is locked for staking, it cannot be used for anything else in the DeFi ecosystem. On top of that, if you want to withdraw your staked ETH, there can be a delay as you have to wait for the ETH to be “unlocked” and go through the exit queue. This is a purposeful piece of the staking design, as staked tokens are meant to be there for a long time. For most investors, the best way to stake ETH would be through a service like Lido, as they offer the ability to stake as much ETH as you like and get a derivative asset in return that is valued at 1:1 of ETH. Just like bond markets have ETFs for investors who want exposure to bonds, but don't want the hassle of holding them, Lido provides short-term and long-term exposure to the staking yield, without having to manage any part of the process itself. They issue stETH, a derivative of ETH that is backed 1:1 and allows the user to stake without the opportunity cost of not being able to use your staked ETH for other DeFi investments. stETH is just as liquid as ETH as there is 9M ETH staked through lido (⅓ of total ETH staked on chain) with just as many stETH tokens existing in the secondary markets. As we can see below the price of stETH tracks the price of ETH very closely, with most price deviations coming before the merge or due to large exits from Lido by defunct companies such as Alameda and Celsius.
Lido is also one of the safest methods to stake ETH as an average investor. The Lido protocol is decentralized, open source and managed by a DAO which votes on major changes to the protocol. This affords a level of transparency and security that is not available to those who may choose centralized exchanges to stake ETH. The trade-off is the user is responsible for self custodying the asset if they choose to stake with Lido, whereas centralized exchanges will custody assets for their users. As mentioned above, stETH has also proven to be a safe asset as secondary markets have been able to keep the price of stETH very close to the price of ETH, but it does seem to trade at a slight discount to the price of ETH. The discount was more pronounced before the Merge but it still seems to hover around 99% of ETH price. One of the reasons for the discount after the merge was the fact that validators could not withdraw staked ETH until the Shanghai Upgrade in April 2023 and the Lido protocol would not be able to process those withdrawals until a protocol upgrade in May 2023. Even after the Lido protocol upgrade, there still is a slight risk to stETH holders as it can take 1 to 5 days for the protocol to process the withdrawal request due to the chain limiting the amount that can be withdrawn in each block. That represents a liquidity risk to stETH holders in the rare event there is a run on deposits. Due to that risk taken on by stETH holders, the token trades at a 1% discount.
Lido APY VS 10-Year Treasury Yield: How do they compare?
As mentioned before, the yield rising on 10-year treasury bonds means falling bond prices, lower investor confidence in the macroeconomic conditions, and investors accommodating for a riskier and costlier environment to conduct business. In the TradFi world, increasing yield on long-term US treasury bonds has a downward effect on reducing money being invested in equities and other securities which offer less or the same return for more risk. The treasury yield is the safest asset one can invest in, so it makes no sense for investors to purchase securities that they do not think will offer better returns than these treasury bonds. Remember, treasury yield is a benchmark rate for all other asset classes, and capital will exit from markets where the return is less than the benchmark rate (hence why a rise in treasury yields often precedes a recession, they cause a loss of capital for other businesses). Conversely, falling treasury yields often communicate the opposite; investors tend to be more willing to invest in other markets, they are comfortable lending at lower yields because they believe the investment is less risky, and inflation is usually low enough to not eat away at their gains.
As a benchmark, the APY from staking ETH is very similar to the yield on long-term treasury bonds. It is the lowest-risk investment one could currently make within the DeFi space excluding the risk from the USD price of ETH. Price volatility notwithstanding, staking ETH, if done correctly, is very safe for an investor to generate yield on their ETH tokens. It is very much in that sense putting money into long-term government bonds. Both are considered base layer investments, their rate of return is the default benchmark rate of return, and they are regarded as the safest form of investment in their respective spaces. Although US bond markets have a rich and long history, ETH staking has officially been around for just over a year. It is worthwhile to note some of the interesting trends over the past year. Taking a look at the APY since the Merge, we see an immediate increase in the APY due to the fact that all the gas and block subsidy rewards going to PoW miners are now going to the PoS validators. The APY jumps around a lot but stays between 4% - 6.5% with occasional jumps to above 8% up until May. Ever since the end of May, the APY has been on a steady downward trajectory with the spikes in APY getting smaller and further apart. The staking yield is a function of two variables; the amount of validators staking ETH and the amount of gas fees being paid by users.
If the APY is a function of those two variables, it is reasonable to assume that these spikes and long-term trends in APY are caused by large liquidity changes in the amount of ETH staked and the amount of gas paid. In order to explain these short-term spikes in APY and the downward trend, it is important to overlay the APY with the amount of ETH in the validator pool. As we can see below, the amount of ETH in the validator pool has not decreased at all, in fact, it has nearly doubled since the Merge with almost 9 million ETH tokens being staked with the Lido validator pool, up from 4 million at the time of the Merge. The recent downward trend in APY can be attributed to the great increase in investors depositing their ETH in Lido in the past few months. The continued increase in ETH being staked also tells us that the short-term increases in APY were due to time periods when the Ethereum chain was experiencing higher transaction volume and users were paying more in gas to get the transactions validated.
Another interesting chart to look at is the Lido APY and the yield on long-term US treasuries. As of October 13, 2023, the yield on long-term treasury bonds is 4.63% and the Lido staking yield has fallen to 3.47%. This is the first time since ETH staking has been available that the staking APY is lower than what an investor could get from buying treasuries in the traditional finance space.
This is a remarkable occurrence, especially since according to the laws of finance, the staking yield should never drop below the yield offered by long-term treasuries. Capital will always flow to the asset that is offering the most return for the least amount of risk, which for the past 100+ years has been long-term government treasuries, specifically US treasury bonds since the 1950s. The fact that investors are pouring their money into ETH staking despite treasuries offering a better yield is very interesting and says something about the traditional finance space, the DeFi space and the relationship between them. Given the volatility of crypto denominated in USD, many will think that it is a foolish decision to invest in ETH staking when fixed-income securities, which are USD-based, are paying a higher yield. That could be true, but what also could be true is that this is one of the first instances where we are saying DeFi decoupling away from TradFi with each market having its own investor sentiment and outlook. If the yield increase on US treasury bonds reflects a more pessimistic outlook on the future, with higher costs and fewer opportunities for exceeding returns, the opposite could be true for the DeFi space when the staking yield drops significantly.
We saw above that as we reached the one-year anniversary of the Merge, the amount of ETH staked in the Lido validator pool continued to increase. When the Merge officially happened, many people had doubts about how smoothly the Ethereum chain would be able to shift its consensus mechanism. As the one-year anniversary of the Merge approached and there were no major issues with ETH using a PoS consensus mechanism, investors seemed to have gained confidence in the validator staking layer. Along with the Shanghai upgrade that allows validators to withdraw their ETH from staking pools, more and more investors are likely realizing the very minimal risk of losing their principal ETH if they choose to stake. As this general risk sentiment is lowering, more resources are being dedicated to securing the Ethereum chain, which represents a market sentiment toward long-term growth and optimism in the Web3 space. Investors staking ETH right now are also probably expecting the price of ETH to increase in the future, thus why they are choosing to get a yield that is paid out in ETH as well. Whether it comes or not, it does seem like some investors are betting on increased blockchain adoption, and they want to contribute by helping validate transactions even if it means accepting a yield less than what is offered by the safest asset in the traditional financial markets.
Conclusion
The movement of the 10-year Treasury yield and ETH staking yield in opposite directions represents two different outlooks on the future of growth and economic activity. In the world outside of Web3, there is an air of economic uncertainty due to the rising interest rates, persistent inflation and stagnating economic performance. A lot of companies are looking to tighten their belts as they recognize their operating costs are going to go up, which also has led to many organizations laying off some portions of their workforce. The macroeconomic conditions also have an impact on the Web3 & DeFi space but in that space, there seems to be a sentiment of optimism towards the foundations of decentralized technologies. Investors are doubling down on the future of blockchain technology through ETH staking despite a worldwide capital crunch and a very turbulent time for Web3 since 2022. There are many things that can generate major growth for the Web3 space in the coming years as builders have been busy working on optimistic and zero knowledge roll-ups, better user-facing products, more versatile DeFi protocols, bringing real-world assets on chain, increased staking security through re-staking technology, making blockchain data more readable and understandable for everyone, and so much more! The investors staking their ETH are definitely doing it because they believe the price of ETH will inevitably increase from where it is now, but some of them are also probably doing it because they believe the next generation of technology will offer some major unlocks. Whether the Web3 investors turn out to be right or not, the opposing market sentiments of Web3 markets and the rest of the financial world are very interesting and noteworthy.
