This op-ed was originally published in Blockworks on April 11, 2023. You can read the original article here.
We stand on the eve of Ethereum's Shapella upgrade, which will unlock staking withdrawals of 18 million ether for the first time since the Beacon Chain launched in December 2020.
This upgrade marks another significant milestone in Ethereum's development and is anticipated as the final step in pulling off the move to proof-of-stake consensus.
What has received less attention as the Shapella upgrade nears is a single protocol parameter: the churn limit.
This underappreciated facet of the upgrade has the potential to create a significant entrance queue for staking—and could result in new stakers waiting days to weeks before they can start earning rewards.
I believe that the conversation around the Shapella upgrade is focusing on the wrong things, only emphasizing concerns over a possible mass exodus of ETH withdrawals. Instead, the conversation should consider how a spike in staking demand could result in a long first-come-first-serve line of stakers waiting to start earning network rewards.
The churn limit puts a hard cap both on how much ETH can be staked and on how many withdrawals can be initiated per day, representing just a fraction of the circulating supply that may now seek to participate in staking.
The time to stake is now, or be ready to wait in line.
It's no secret that Ethereum's current staking participation rate lags dramatically behind that of most proof-of-stake networks.
While only 15.04% of the ETH supply is staked at the time of writing, the top 35 staking protocols by market cap mostly range from 40% to 75% staking participation.
The ability to withdraw staked funds is widely seen as a significant de-risk for stakers. If the staking rates on other PoS networks are any indication, knowing that one's stake will not be indefinitely locked could make many more ETH holders comfortable participating. Similarly, the institutional market that has been sitting on the sidelines as a result of stricter participation mandates on withdrawals and exit liquidity is expected to ramp up swiftly.
Some experts estimate that the post-Shapella staking demand could exceed 40% of the circulating supply.
A recent Kiln survey of over 100 participants with over $10 billion in assets under management revealed that 68% plan to start staking or compound their stake after Shapella upgrade (the all-encompassing term for the upgrade of both the Shanghai execution layer and the Capella consensus layer). 70% will stake immediately, and only 9% plan to unstake. Coinbase Chief Financial Officer Alesia Haas stated that institutional staking of crypto assets could become a "phenomenon" once the market overcomes its liquidity lock-up.
These estimates show how swiftly ETH that's currently sitting on the sidelines may simultaneously attempt to enter the activation queue.
Much of the analysis covering the Shapella upgrade has focused on withdrawal timing and exit queues—will everyone just withdraw all of their staked ETH all at once?
Rate-limiting entrances and exits is undeniably an important security feature for the network's stability as withdrawing staked ETH becomes possible.
Ethereum's churn limit stabilizes validator activations and withdrawals per epoch, adjusting programmatically based on the number of active validators. At present, eight validators/epoch (≈1,800/day) can be activated, a fraction of the potential 40%+ of circulating ETH supply that may seek to participate in staking post-Shapella.
For every 65,536 additional validators that become active on the Ethereum network (or for every $3.9 billion onboarded to Ethereum staking at today's value) the number of validator activations and exits that can be processed per epoch increases by just one validator.
As we've already seen, a number of factors can lead to a spike in validators waiting in the activation queue, including participation from major market entrants and the general market sentiment toward staking, which the Shapella upgrade is expected to accelerate. Many validators entering the activation queue at once creates a backlog as they hit the churn limit.
When the number of active validators increases because of the newly activated stake, so does the churn limit—assuming more validators enter than exit.
But as independent crypto researcher Tripoli noted in a recent analysis modeling potential post-Shapella upgrade scenarios, a balanced ratio of incoming stakers with withdrawals from exiting stakers could lead to an effectively “locked” churn limit at eight validators/epoch post-Shapella. This means that the same number of validators may be able to activate per day, regardless of spiking demand to participate.
If the number of validators looking to enter versus validators looking to exit are equal, this could increase the likelihood of a significant staking bottleneck resulting from staking demand spikes post-Shapella.
Assuming the current churn limit stays locked at eight, only ≈0.04% of the ETH in circulation can be staked per day.
Some experts estimate that the post-Shapella staking demand could exceed 40% of the circulating supply, which could greatly outweigh the churn limit's cap. This may result in a significant waiting time for new participants to start earning staking rewards.
If just 10% of this predicted post-Shapella staking demand tried to come online at once following the upgrade (representing 4% of the circulating supply), it would take over 83 days for that stake to become active on the network and eligible to earn rewards, representing nearly three months of illiquidity and missed rewards.
The pressure to access liquidity will be felt on both sides of the staking table. According to historical deposit data, we have already witnessed daily deposits exceed 10x+ daily activation capacity and activation queues of nearly three weeks. Post-Shapella, these activation queues are expected to increase even further, with some estimating that the line to start staking could reach up to five months. However, some recent analyses project the withdrawal queue on Ethereum to exit staking will range from about four days to up to 60 days, depending on the percentage of validators that opt for partial or full withdrawals and other network dynamics.
Following the Shapella upgrade, liquid staking tokens (LSTs) like LsETH will likely rise in popularity as they offer a way for stakers to access liquidity: If the queues to both enter staking and exit staking are long, participants will be looking for more flexibility and optionality in entering and exiting staking positions.
Staking early to avoid a growing activation queue can benefit those who are looking to participate in Ethereum's network security and earn timely rewards for doing so. Regardless of the queue length, LSTs offer the Web3 ecosystem the flexibility to participate in staking with access to liquidity and increased capital efficiency.
The data from other PoS networks tells the story of much higher participation rates when withdrawals are enabled. If Ethereum experiences similar participation rates, ETH holders on the sidelines could find themselves choosing between staking without earning rewards for an undefined period of time... or minting LSTs at a premium.
Mara Schmiedt, CEO of Alluvial, oversees business, operations, and strategy. She previously worked at Coinbase as Head of Sales for Coinbase Cloud, managed Business Development at Bison Trails, and served as Strategy Manager at ConsenSys, focusing on Codefi. Mara is a board member at Obol Labs, a leading DVT provider, and a strategic angel investor in over 15 projects. Passionate about open-source technology, she has published research on liquid staking and led a working group with the Ethereum Foundation that developed the Ethereum Launchpad and the first DVT proof of concepts.
This post should not be construed as investment, financial, tax, legal advice, or any other sort of advice. This post is intended for informational, educational, and entertainment purposes only. You are solely responsible for determining whether any investment, investment strategy, or related transaction is appropriate for you based on your personal investment objectives, financial circumstances and risk tolerance.