Shanghai: Ethereum’s Withdrawal Symptoms

As we close out the first month of 2023, we have seen a healthy rally across crypto assets. Part of this rally has been due to an improving macro environment (falling inflation, stronger-than-expected economy, rate hikes slowing), and part came from a resolution to the DCG / Genesis / Gemini saga (Genesis filed for Chapter 11 bankruptcy).​

Looking ahead, we continue to believe that ETH staking withdrawals, enabled at the Shanghai hard fork in March / April, will be a major ETH catalyst. ​

The rally in crypto assets has been broad based, with several altcoins, which were oversold in the December bloodbath of liquidations and year end selling, bounced back most strongly. Tokens like Solana, Aptos, Lido, Optimism, etc. are up 100%+ off their lows.    ​

When looking at the major bellwether crypto assets, Ethereum is up 34% YTD and Bitcoin is up 40% YTD. This is counterintuitive, as Ethereum has historically acted more as an altcoin and outperformed Bitcoin during rallies. ​

One explanation for ETH’s underperformance could be the potential upcoming sell pressure overhang from staking withdrawal unlocks. In our Jan 4 report, we identified Shanghai as a major catalyst for 2023, and in our Jan 11 report, we outlined potential high-level scenarios that could play out with Shanghai.​

In the next set of ETH reports, we will do a deeper dive on the mechanics of ETH staking withdrawals, its impacts, and an analysis of potential price impact.​

Withdrawal Symptoms - Ethereum Staking Snapshot

• Why are Ethereum withdrawals such a large potential catalyst? The simple answer is that staking was first enabled in December 2020, when the first phase of Proof of Stake was initiated. Since Dec 2020, sending ETH to the staking contract was a one-way transaction that could not be reversed.​
• In addition, since December 2020, we saw the end of a pandemic, the injection of a historical level of monetary stimulus, and the subsequent removal of that monetary stimulus – resulting in a brutal bear market. We also saw several crypto-related collapses and bankruptcies that shook confidence in the sector throughout 2022.​
• Throughout this macro and crypto volatility, ~16mm ETH ($25bn of ETH) has been locked in the staking contract and will be free for withdrawal this year.​

Withdrawal Symptoms - Staking Entity Composition

• Typically, if staking withdrawals had been available immediately, it is likely that the staking holder base would have turned over through the crypto and macro vol of the last 2 years. However, due to the staggered withdrawal upgrade, there is likely pent-up demand for early stakers to unstake and regain liquidity.
• Note that in this report, we will not make predictions on potential sell pressure or potential price impact (that is a topic for the next upcoming reports). Instead, we will lay out specific factors that could create volatility around Shanghai.
• One notable factor is the portion of ETH staking locked in liquid staking tokens like Lido vs exchanges and illiquid services (Coinbase, Kraken, etc.).​

Withdrawal Symptoms - Are ETH Stakers in Profit?

• The ETH that has been staked via liquid staking providers like Lido (the biggest staking depositor) are more likely to be sticky and not withdraw, as holders of liquid staking tokens have been able to trade their staked ETH representations on the secondary market. ETH staked on exchanges may see more withdrawal requests.​
• Another major factor that could drive unstaking behavior is the amount of ETH stakers that are in profit. While this is an assumption, it is possible that stakers that are in profit are more likely to sell immediately after withdrawals are enabled than later ETH stakers – who may be more likely to hold out for higher prices to recoup losses.​

Withdrawal Symptoms - Rush to the Exits? No!

• The biggest misconception around ETH staking is that there will be a “mad rush” for the exits. The Ethereum protocol spec around Proof of Stake has a programmatic limit on how many validators can stake and unstake in a day. This is known as the “churn limit.”​
• Why would Ethereum limit the daily onboarding / offboarding of validators? Because validators are critical to the security and decentralization of ETH, much like miners are critical to the security of Bitcoin. The churn limit helps guard against a mass exodus of validators, which could leave the Ethereum chain open to attack.​
• By the time Shanghai is enabled, the “churn limit” is likely to be 8 – meaning 8 validators can withdraw every 6.4 minutes. What does this look like?​

Withdrawal Symptoms: Worst Case Scenario?

• It does not look like a mass exit event! A churn limit of 8 would mean a maximum of 1,800 validators could exit the withdrawal queue every day.​
• There are 32 ETH in each validator, meaning a maximum of 57,600 ETH could be unstaked daily At a current ETH price of ~$1,600, this would mean that a maximum of $92mm of unstaking ETH could be sold daily (only if we assume that all the unstaked ETH immediately sells to USD.​
• While this could create a stressed scenario in isolation, it still protects the health of Ethereum. Even if every validator opted to exit the day withdrawals went live, it would take 283 days for full offboarding.​
• During that period, is is very likely that new validators would enter the ETH staking ecosystem. Why? We see below that the fewer validators that stake, the higher the staking yield. Staking yields of 8-10% could attract new capital.​

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