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The Future of Ethereum, Logically

Jun 9, 2023

After three long years, the Ethereum network recently underwent the Shapella hard fork allowing validators to withdraw their long-staked Ethereum from the Beacon Chain. In the first week we saw more than a million ETH unstaked by validators but from the second week onward we started to see some of those validators return to stake their ETH. 

With more flexibility, comes more demand, and under a longer-term equilibrium state we should continue to see more validators come to Ethereum than before. This realization is the manifestation of an economic theory known as Liquidity Preference Theory (LPT). The gist of it is that, there is higher demand for a product with near-term liquidity than there is for longer-term liquidity. Alternatively, if you were to lock up your capital for a longer period of time you would require a higher yield than if you were to lock it up for a short period of time. 

When LPT is considered in the absence of other information, it generally holds true. In reality however, it may not hold for short periods of time of market stress or dislocation as currently seen within the USD fiat markets and the inverted yield curve. 

How these LPT preferences stack up, and the spectrum upon which investors would lock up their capital, and the associated yields are otherwise known as the Yield Curve. 

Source: Infinity

If you consider that Ethereum is a standalone economy or sovereign nation then staking is equivalent to government debt and the yield is equivalent to a sovereign yield or risk-free rate. Keeping the analogy, protocols, by extension, might be equated to being ’corporates’ which carry additional credit risks vis-a-vis the sovereign entity (for the avoidance of doubt, protocols are not corporates). While Ethereum is not a sovereign nation, and staking performs a core validation function to the network, we will use the terms ‘yield’ and ‘interest rate’ interchangeably for the purposes of this article and ease of reading.

The problem with staking yields is that they’re unpredictable, or volatile depending on factors both intrinsic and extrinsic. Internally, there are goals and tradeoffs between sufficient decentralization and # of validators. Externally, there are a multitude of market factors that would drive supply/demand for ETH yields vis-a-vis everything else there is to invest in in the broader world.

Source: Dune, 3 May 2023

We get asked the question, how do we envision staking yields comparing to yields on Infinity? How can we operate in a system where ETH yields already exist? For this answer, we need to consider non-arbitrage arguments, and the mathematical proofs that bind financial markets.

How will staking rates change vs floating or short-term rates on Infinity?

Infinity is an overcollateralized lending and interest rate trading protocol that offers a full yield curve from floating rate to fixed rates across (potentially) any maturity. Infinity uses conservative overcollateralization to mitigate the credit risk ensuring that there is always enough collateral to insulate the protocol against severe jumps in asset prices. 

Staking yields are floating rate in nature changing every block, and when triggering an unwind or redemption, require a window of ~1-36 days to fully receive your proceeds back. For this reason, we look to compare staking yields vs floating or short-term interest rates on Infinity.

In periods where the Staking yields are higher than Infinity yields, we expect investors to either:
i) Lend/Stake with Ethereum directly; or
ii) Borrow from Infinity, and Lend/Stake with Ethereum (by using Staked ETH as collateral to borrow additional ETH on Infinity)

The first method is capital intense, and for each $100, you would need to shift $100 of positions on Infinity to Ethereum. For the second method however, $100, could be levered perhaps 10x to $1,000 (since Infinity accepts staked ETH, for example, Lido's stETH or Rocketpool's rETH as collateral) causing a rapid increase in Infinity’s ETH yields to align with Staked ETH yields as seen in the chart below.

Depending on the overall size of Infinity’s market vs that of Ethereum’s validators, the rates on both protocols will adjust proportionately. In Infinity’s early stages, we expect to have little influence on overall staking yields, but as Infinity grows in size, we expect it to have a more significant impact on yields. 

Conversely, if staked ETH rates are lower than Infinity’s, we expect Infinity’s rates to drop to a point that align roughly with staked ETH rates. 

Unlike Scenario 1 however, one cannot ‘borrow’ from the base layer (i.e. being a negative validator of sorts), and so the only option is for users to shift their capital from Staking ETH to Lending ETH on Infinity in an unlevered form to capture the higher rates on Infinity. As more capital seeks the higher lending rate on Infinity, the lending rate will slowly decline (since there is no way to ‘borrow’ from the base layer). Let's explore this notion of 'borrowing from the base layer' further though. Borrowing from the base-layer is effectively a short-staking position which could otherwise be replicated by 'selling' or loaning my staking position to someone else. That's not easily done when considering staking in a conventional sense, but it works when considering liquid or tokenized staking positions like stETH and rETH.

While Infinity can accept these tokens as collateral, we will (soon) allow these tokens to also be borrowed from Infinity enabling participants to engage in short stETH or short rETH positions. Why would someone borrow these tokens? Well in this case where staked ETH is yielding less than Infinity's ETH rates as is the case in this example, one could borrow staked ETH, convert it to ETH (through the spot market at Curve, or unwinding at Lido / Rocketpool), and then lending ETH on Infinity at a higher rate thus driving these rates back to parity. As rates come back to parity, the borrower then restakes the ETH, and then returns it as collateral.

Together, we see that when Infinity’s rates are lower, they will rise rapidly to equilibrium and when Infinity’s rates are higher, they will drop slowly to equilibrium. These equilibrium states which are established theoretically by non-arbitrage theory, and practically by bots and yield-farmers will logically bind Infinity’s short-term rates to the base layer. Any deviations will be a function of market timing, credit risk, the cost of staking (e.g. server costs, bandwidth, etc..), liquidity or otherwise idiosyncratic risks.

The Future of the Ethereum Economy?

What is it that drives staking yields? Is it the price of ETH vs USD? Vs BTC? Is it the total stablecoins in crypto? Is it the Fed? The weather? Issues or opportunities on the back of the complete ETH2 rollout? There are countless variables that impact staking yields which begs the question, how do we eliminate this volatility and lock in fixed rate staking yields?

Synthetic ETH Fixed Rate Yields

Fixed rate staking doesn't exist and while it may exist in the future, the closest thing to fixed rate staking is fixed rate lending on Infinity.

Interest rates enable market participants to trade, hedge, and speculate on the future. Given a diverse set of market participants this then provides the best estimation or forecast of future yields based on a dollar-weighted risk-adjusted manner.

With an array of interest rates both floating and fixed, Infinity enables investors to choose equally between lending/borrowing on an on-demand floating basis or doing so on a fixed rate basis. Importantly, infinity enables you to trade between these rates using positions at one part of the yield curve as collateral against positions at other parts of the yield curve.

Curve-related, or duration-trading isn't possible today in crypto - at least, in a form that aligns with theoretical finance and non-arbitrage pricing. While ERC20 tokens are composable by their nature, the risks associated with them can't easily be hedged and thus require significant work for protocols to evaluate them both on an upfront and ongoing/real-time basis. For example, you can't use Aave tokens as collateral on Compound, and vice versa. Furthermore, you can’t take tokens on floating rate protocols (e.g. Aave and Compound) and use them as collateral on fixed rate protocols (e.g. Element and Notional) and vice versa. These protocols, and their markets - interest rates- are thus, not interoperable.

Infinity is market complete, with a capital efficient yield curve. On a standalone basis, if floating rates are too low or too high, you can choose fixed rates, and vice versa. On a relative value basis, you can also borrow at the floating rate and lend at a fixed rate. 

This fluidity and seamless interaction across different maturity dates enables the ETH yield curve to accurately reflect both today’s reality as well as expectations about the future of the Ethereum economy/staking. 

Coming back to staking, if the floating rates on Infinity and the Base Layer are driven to parity, then, with the seamless connectivity across the curve, it infers that the fixed rates on Infinity are the closest estimations of fixed rate staking yields for a broad set of fixed maturity dates. And voila, we have synthetic fixed rate staking yields that you can both lend and borrow at. Of course, the proceeds in fixed rate positions are not directly staked in the base layer - although they could be based on risk-neutral pricing. 

Source: Infinity

Alongside this, we can use the ETH yield curve to mathematically estimate (based on market expectations) the future or forward- spot ETH staking yields (again, it ignores any basis risk or credit risk differentials).

Phew… that was a lot

We've now synthetically replicated fixed rate ETH yields which are logically tied to expected base layer staking yields - but, we live in the real world, where our paychecks, mortgage, and entire life is based on USD and yet here, we are still exposed to the ETH market risk.

What can Infinity do for USD-Based Investors Who Like to Stake ETH?

Many of us price or base our financial decisions in USD and when investing need to consider that conversion back to USD. If you're a real money account with USD, to mitigate the price and yield volatility of ETH staking, you can now forecast (as best as possible) future interest payments and hedge each cash flow back to USD by selling each expected ETH cashflow forward in the futures market.

If you're a hedge fund, you could borrow USD paying USD rates, buy ETH spot, earn fixed rate ETH yields, sell ETH interest payments and principal forward. This is a currency swap and although it’s theoretically possible, it’s not (yet) practically possible as the Spot/Futures trades would be at one location, and the interest rates hedges would be at another (Infinity). Although there would be some basis today between the capital locked up at other FX/Futures exchanges vs the rates on Infinity...give us time, we'll get to this shortly (and reach out if you want to be involved in this). 

This is known as a Currency Swap, and the pricing of each component: Spot, Futures, and Interest Rates, are bound together through non-arbitrage conditions otherwise known as Interest Rate Parity. The return you're getting net-net in USD should be no different than if you had just lent USD stablecoins at a fixed rate over that same period. If there is any difference, this represents an arbitrage profit and / or some type of basis risk that may persist or disappear based on various conditions

We have thus presented a method for USD based investors to invest in ETH staking having eliminated both ETH staking yield risk AND ETH price risk. Importantly, it presents what's called a non-arbitrage condition or mathematical binding between the USD stablecoin yield curves, ETH yield curve, and ETH futures prices.

What if I'm a Bitcoin miner? Does the same logic apply? Yes, reach out to run some pilots with us.

What does this all mean?

The crypto markets aren't "complete" in the sense that while they are loosely connected, they are not logically or mathematically connected. This is what interest rates and yield curves do.

Now, when USD stablecoin rates change, the ETH futures prices and ETH interest rates change immediately driving trading volume equally across both markets. And vice versa, if there is some problem or opportunity that arises within the Ethereum community, it will have an immediate and direct impact on both USD stablecoin rates. 

Basically, whenever there is new information in either the ETH spot market, the ETH futures market, the ETH rates market or the USD stablecoin rates market, all markets will shift and adjust accordingly with a flurry of trades across all products.

The future of Ethereum is therefore, logically, Infinity.

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