Lido Finance: How the Largest Liquid Staking Protocol Works

The shift of Ethereum from proof-of-work to proof-of-stake in September 2022 created a new category of DeFi infrastructure: liquid staking.

How it works is instead of locking up 32 ETH to run a validator (the minimum required to stake on Ethereum), liquid staking protocols let users stake any amount of ETH and receive a tradable token in return.

Lido Finance is the largest of these protocols, by a significant margin.

This guide covers how Lido works, the mechanics of its stETH token, the governance structure, how it compares to alternatives, and the risks that come with being the dominant liquid staking provider on Ethereum.

What Is Lido Finance?

Lido is a liquid staking protocol that lets users stake ETH (and assets on some other chains) without running their own validator infrastructure and without meeting the 32 ETH minimum.

In return for depositing ETH, users receive stETH which is a liquid token that represents their staked position plus any accrued staking rewards.

Lido has grown to become the single largest protocol in DeFi by total value locked (TVL), with tens of billions of dollars in staked ETH.

It accounts for a substantial share of all staked ETH on the beacon chain, which has raised both enthusiasm (it made staking accessible) and concern (it concentrates staking power).

How Lido Staking Works

The Staking Flow

The process is straightforward from a user perspective:

• A user deposits ETH into Lido's smart contracts.
• Lido pools this ETH and distributes it across a curated set of professional node operators.
• These operators run Ethereum validators on behalf of the pool.
• The user receives stETH in a 1:1 ratio with their deposited ETH.
• Staking rewards accrue to the stETH balance automatically.

The Node Operator Model

Lido doesn't run validators itself. It maintains a curated set of node operators, which is a professional infrastructure providers vetted and approved by the Lido DAO.

These operators handle the technical work of running validators, maintaining uptime, signing attestations, proposing blocks, and managing keys. The operator set has grown over time and includes well-known infrastructure companies.

However, the selection process is governed by the DAO, which means it's not permissionless, you can't simply become a Lido operator without approval.

This decision is a deliberate design choice favouring reliability and professionalism, but it also means Lido's operator set is more centralized than, say, Rocket Pool's permissionless model.

Withdrawal Credentials and Key Custody

An important part of Lido's architecture is that validator keys are held by the node operators, not by individual stakers.

Lido has been working on integrating Distributed Validator Technology (DVT) through partnerships with protocols like SSV Network and Obol.

These protocols would distribute key management across multiple operators per validator, reducing the trust placed in any single operator. This is an ongoing development, not yet fully deployed.

stETH: How the Liquid Staking Token Works

Rebasing Mechanism

stETH is a rebasing token. This means the token balance in your wallet changes daily to reflect staking rewards.

If you hold 10 stETH today and staking yield is approximately 3.5% APR, your balance will gradually increase, 10.001 stETH, 10.002 stETH, etc., as rewards are distributed.

This rebasing mechanism is intuitive (your balance grows), but it can cause issues with certain DeFi protocols and smart contracts that expect static token balances.

wstETH: The Wrapped Version

To solve DeFi composability issues, Lido offers wstETH (wrapped stETH).

Instead of the balance changing, wstETH's value increases relative to stETH over time. One wstETH is always worth more than one stETH, and the exchange rate grows as rewards accumulate.

wstETH is generally the preferred version for DeFi integrations, lending protocols (Aave, Spark), L2 bridging, and other smart contract interactions.

Most DeFi references to "Lido staked ETH" in protocols actually mean wstETH.

stETH Pricing and the Secondary Market

stETH can be redeemed for ETH through Lido's withdrawal mechanism (introduced after Ethereum's Shapella upgrade in April 2023).

Before withdrawals were enabled, the only way to exit was selling stETH on secondary markets. This sometimes led to stETH trading at a discount to ETH during periods of market stress, most notably during the 2022 bear market when stETH traded as low as 0.93 ETH.

With withdrawals now live, the peg has been much more stable. Users can request a withdrawal, wait for the processing period (typically a few days depending on the exit queue), and receive ETH directly.

Lido's Fee Structure

Lido charges a 10% fee on staking rewards (not on the principal). This fee is split:

• 5% goes to node operators (for running the validator infrastructure).
• 5% goes to the Lido DAO treasury (for protocol development, insurance, and governance-directed spending).

The remaining 90% of staking rewards goes to stETH holders.

This fee structure is competitive with other liquid staking protocols and is lower than the opportunity cost of running a solo validator (which requires 32 ETH, hardware, and technical expertise).

The LDO Token and Governance

Lido's LDO Governance Token

LDO is Lido's governance token. Holders vote on protocol decisions including:

• Node operator onboarding and removal.
• Fee parameter changes.
• Treasury spending and grants.
• Protocol upgrades and integration decisions.
• Risk management frameworks.

The Dual Governance Discussion

One of the more significant governance developments at Lido is the "dual governance" proposal. This mechanism give stETH holders (not just LDO holders) a veto power over governance decisions that could negatively affect stakers.

It addresses a potential conflict of interest: LDO holders govern the protocol, but stETH holders provide the capital. Dual governance would ensure stakers can protect their interests even if they don't hold LDO.

What LDO Is Not

LDO doesn't accrue protocol revenue directly by default. It's a governance token, its value is tied to the protocol's strategic importance and governance influence, not to a direct claim on Lido's fee income.

There have been ongoing discussions in governance about potential value accrual mechanisms, but as of now, LDO is primarily a governance instrument.

Lido's Dominance and the Centralisation Debate

Lido's success has created one of the most debated dynamics in Ethereum: concentration of stake.

At various points, Lido has controlled over 30% of all staked ETH. This raises legitimate concerns:

• Validator centralisation: If a significant share of Ethereum's validators are controlled by one protocol's operator set, it creates a potential single point of failure or influence.
• Governance attack surface: LDO holders effectively control which operators run a large fraction of Ethereum's validators. A governance attack on Lido could have systemic implications.
• Social consensus pressure: Some Ethereum community members have argued that no single entity should control more than 33% of stake (a critical consensus threshold). Lido has acknowledged this concern and has taken steps to expand its operator set.

Lido's counterargument is that its existence actually improves decentralization compared to the alternative. Without liquid staking, more ETH would likely be staked through centralized exchanges (Coinbase, Binance), which are even more centralized.

By spreading stake across dozens of professional operators, Lido may be a "less bad" form of concentration than the realistic alternatives.

How Lido Compares to Other Liquid Staking Protocols

vs. EtherFi

EtherFi's key differentiator is non-custodial validator key management where stakers retain control of their keys through a distributed key generation process. Lido's operators hold the keys.

EtherFi also integrates natively with EigenLayer for restaking. Lido is exploring restaking but has been more cautious about the additional risk it introduces.

vs. Rocket Pool (rETH)

Rocket Pool is permissionless on the operator side, which means anyone can become a node operator by posting a bond (minimum 8 ETH).

This makes it more decentralized at the operator level than Lido's curated model. The tradeoff is that Rocket Pool has lower TVL and less DeFi integration depth than stETH.

vs. Coinbase (cbETH)

Coinbase's liquid staking is fully centralized, meaning one company, one custodian. It's the simplest option but involves the most trust in a single entity.

stETH offers a middle ground between Coinbase's simplicity and the more decentralized approaches of Rocket Pool and EtherFi.

Key Risks to Understand

• Smart contract risk: Lido's contracts manage billions in staked ETH. While extensively audited and battle-tested, the scale makes them a high-value target.
• Operator risk: Slashing events (where a validator is penalised for misbehaviour or downtime) would reduce stETH holders' principal. Lido's operator vetting and slashing insurance fund mitigate this, but the risk exists.
• Centralization and systemic risk: Lido's large share of total staked ETH creates systemic dependency. A major issue with Lido could affect Ethereum's security model.
• Governance risk: LDO governance controls operator selection and protocol parameters. A governance attack or poor decisions could affect all stETH holders.
• stETH depeg risk: While withdrawals have stabilised the peg, extreme market conditions could still create temporary discounts if exit queues grow long or secondary market liquidity dries up.
• Regulatory risk: Liquid staking tokens may face regulatory scrutiny regarding their classification as securities in some jurisdictions.

The Bottom Line

Lido Finance democratised Ethereum staking, making it accessible to anyone with any amount of ETH, without requiring technical infrastructure or a 32 ETH minimum.

stETH has become one of the most widely integrated tokens in DeFi, used as collateral across lending protocols, L2s, and yield strategies.

The protocol's dominance raises real questions about concentration of staking power, and the Ethereum community continues to debate where the acceptable limits lie.

Lido's efforts to expand its operator set, integrate DVT, and implement dual governance are attempts to address these concerns while maintaining the accessibility and DeFi composability that made it the largest protocol in the space.

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