LST Design Choices: the User-Focused Edge of Liquid Staking Tokens Over Validator NFTs

Understanding Validator NFTs, and how LSTs support liquidity and market adoption.

• Validator NFTs were created to solve for the liquidity of ETH staking. They represent the ownership and withdrawal credentials of an Ethereum validator, and can be traded to make the validator transferable.
• Our research into design models while building Liquid Collective found that liquid staking tokens (LSTs) offer a superior model for liquidity, market adoption, and provide a user-focused edge over Validator NFTs.
• Validator NFTs have poor price discovery, which limits their liquidity. Finding counterparties that understand how to price Validator NFTs represents a challenge.
• Drawing a parallel between LSTs and commodities like grain, gold, or pork bellies, LSTs may present a less risky regulatory profile than Validator NFTs.

---

We continue to see evolution in Ethereum’s staking solutions. Over the last 6 months, a variety of new protocols, primitives, and solutions have been developed to meet the needs of ever-more-diverse market participants, a clear signal of ETH staking’s continued growth. As a builder, it’s invigorating to be able to research and evaluate new technical developments—and, in my role as CPO at Alluvial, to evaluate these innovations in light of designing systems that empower institutions to participate onchain.

While not a new concept, Validator NFTs have hit the market over the last two quarters with the promise to solve for the liquidity of staked ETH (particularly for those staking in increments of 32 ETH+). However, our research has shown that the solution falls short for a number of reasons.

While designing the Liquid Collective liquid staking protocol we explored a number of different design options, including the concept of Validator NFTs. Our research found that liquid staking tokens (LSTs) offer a superior model for liquidity, market adoption, and provide a user-focused edge over Validator NFTs.

Understanding Validator NFTs and liquid staking tokens

Validator NFTs were created to solve for the liquidity of ETH staking. To register a validator node on Ethereum, one must deposit 32 ETH into the network’s deposit contract. Given the technical complexity and the need for secure, well-maintained infrastructure to operate these nodes, many participants staking 32+ ETH—equivalent to operating one or more validators—opt to use staking-as-a-service providers as their node operators. Validator NFTs are specifically designed to cater to this segment of users.

Once the withdrawal credentials are set on an Ethereum validator, they can’t be changed. This is one of Etheruem’s security features, but it effectively makes the ownership of active validators non-transferable. Validator NFTs solve for the use case where one party wants to transfer ownership of their validator to another party by minting a NFT that represents the ownership and withdrawal credentials of the validator, which can be traded to make the validator transferable.

The Validator NFT approach allows the transfer to occur without the staked ETH going through Etheruem’s activation and exit queues, a lengthy process during which the funds can’t be accessed and aren’t receiving ETH network rewards. As a user, if I want to stake 32 ETH and maintain transferability, I can deposit my 32 ETH to a smart contract, and get a Validator NFT back in return. I could also purchase a Validator NFT from another seller.

Validator NFTs have been touted as a potential solution for the Ethereum ETP and ETF markets by allowing for validator ownership with the potential to access liquidity. An exchange or custodian might use a Validator NFT internally to manage their validator ownership while avoiding Ethereum’s entry and exit queues.

“While Validator NFTs do ultimately add transferability to the validator, that transferability doesn’t necessarily equate to liquidity.”

In contrast, LSTs (like Liquid Collective’s LsETH) are ERC20 tokens programmatically minted when a user stakes their tokens via a liquid staking protocol. LSTs serve as a blockchain-based document of title certifying that the holder has staked the corresponding token, retains ownership of the staked token, and can present the LST to withdraw the staked token according to network parameters. This LST can be traded or transferred, transferring ownership of the staked ETH and ETH network rewards it represents. The liquid staking protocol can also automatically stake ETH network rewards received across validators in its active set, a compounding feature that’s manual and time-intensive to achieve with Validator NFTs.

When considering optimal design choices for enterprise-grade liquid staking in the early days of building LsETH, we looked at how different markets evolved historically to inform our perspective. Many traditional commodity markets have adopted standardized contract specifications that guarantee a specific quality of the underlying asset or commodity, as opposed to customizable agreements between the parties involved. While each Validator NFT can have varying degrees of quality, LsETH holders have ownership rights to enterprise-grade staked ETH via a streamlined, standardized token.

Liquidity, market adoption, and the importance of standardization

While Validator NFTs do ultimately add transferability to the validator, that transferability doesn’t necessarily equate to liquidity. Each Validator NFT is different (non-fungible) because they each represent unique withdrawal address ownership. This means that each can be priced differently, and finding counterparties that understand how to price them also represents a challenge, as the lack of standardization across Validator NFTs also makes it difficult to value Validator NFTs from different providers.

Because Validator NFTs are non-fungible, if I want to acquire a Validator NFT as a buyer, the first thing I need to do is understand how much I should pay for the NFT. The simplest thing might be to take the balance of the Validator NFT (staked ETH + ETH network rewards, or, maybe, staked ETH - slashing penalties) and pay that amount. However, that approach to pricing ignores some critical aspects for developing a risk-adjusted evaluation, such as:

• Who is running the validator, and what is their performance track record?
• What geographical region is the validator running in?
• Which execution and consensus layer clients is the validator running, and how diversified are those clients across the network?
• What slashing mitigation conditions does the node operator have in place?
• What are all of the factors that might lead to a Validator NFT with these above attributes being slashed?

“When price discovery suffers, it has an impact on the liquidity and stability of markets. This ultimately influences the adoption of a product that requires scale, standardization, and network effects to drive its adoption and success.”

Because the industry currently lacks objective standards to evaluate node operator risks and performance (though Liquid Collective is leading the innovation on this front), it’s very hard for everyone who wants to buy staked ETH to reason about these considerations, and thus difficult to value the Validator NFTs.

Other factors that limit the price discovery for purchasing Validator NFTs include that they require transacting in 32 ETH chunks, which limits the number of buyers who will participate. The Validator NFT may only be supported on certain platforms (many custodians don’t support NFTs), and not all exchanges support the trading of NFTs. Purchasers also need to consider how to exit the NFT, including whether it can be unstaked directly from a custodial account, or if it is only accessible through a non-custodial dapp.

When price discovery suffers, it has an impact on the liquidity and stability of markets. This ultimately influences the adoption of a product that requires scale, standardization, and network effects to drive its adoption and success.

In contrast, LSTs are standardized, leading to deeper liquidity because price discovery is made easier. With liquid staking, any user can stake in amounts less than 32 ETH, or can buy an LST on any exchange that supports token transfers. Users can easily see their ETH network rewards because the LST is backed by one rate for all users. Because LSTs follow a standardized token model, they facilitate easier price discovery and wider market adoption overall.

From a regulatory perspective, LSTs are more comparable to bailments

One of the touted benefits of Validator NFTs is that their legal structure might be cleaner as the user knows the exact validator node they are staked to. While that may make sense topically, digging deeper, the same guarantees of beneficial ownership hold with an LST that has a user agreement in place to clearly define users’ rights.

Those offering Validator NFTs may also claim that the ‘pooling’ of LSTs make them more of a regulatory risk. In fact, this claimed regulatory risk has been widely debunked. As legal analysis from industry experts including the Proof of Stake Alliance (POSA) has shown, LSTs should not be considered securities. POSA’s landmark whitepapers on the legal and tax considerations for liquid staking tokens in the US emphasize that tokens gathered as fungible bulk for staking in 32 ETH batches via a liquid staking smart contract does not constitute an investment contract, a view supported by recent court rulings and established case law, particularly in the context of service provider relationships.

Drawing a parallel between LSTs and commodities like grain or pork bellies, LSTs are comparable to bailments and warehouse receipts, which are legal mechanisms used in the commodities market. These receipts, similar to LSTs, represent ownership and can be traded, without the need for physical transfer of the underlying commodity. Liquid staking protocols in this lens are akin to technical service providers, with network rewards generated by the Ethereum blockchain rather than any efforts of the liquid staking protocol supporting the accumulation of value to the LST.

The path forward

While Validator NFTs are an interesting technical concept that may provide flexibility to a specific segment of users, overall, LSTs have many advantages over Validator NFTs in promoting a liquid, universally accessible staking environment. LSTs offer users rights to a specific grade and quality of staked ETH—backed by Validator Performance SLAs, in Liquid Collective’s case—and there is more clarity around LSTs’ analogy to traditional instruments like warehouse receipts.

When evaluating design choices for building Liquid Collective, while we liked the transferability of the Validator NFT, we felt that introducing a Validator NFT would fragment liquidity of the market with a product that faces many challenges, including:

• Requirement to stake 32 ETH or transact in 32 ETH chunks
• Less liquidity and difficulties with pricing, which may bring additional regulatory risk
• No autostaking of ETH network rewards received
• Slashing has a dramatic impact on rewards relative to a single-owner NFT
• Unpredictable rewards flow for a single validator vs. an LST with socialized rewards

Overall, participants should consider the long-term benefits of adopting and supporting liquid staking solutions that enhance, rather than fragment, the staking ecosystem. A stronger and more resilient Ethereum ecosystem can be developed by prioritizing solutions like LSTs that align with the broader goal of global participation and market-efficiency in staking.

---

---