How The Shanghai Upgrade Will Impact MEV

Executive Summary

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The Shanghai upgrade, set to take place in early spring, will permit validators to withdraw their staked ETH, opening the door to new opportunities in the Maximal Extractable Value (MEV) market. In addition, liquid staking tokens, such as stETH, will be redeemable for ETH without the need for a decentralized exchange, enabling a new trading primitive that will allow arbitrage opportunities between liquid staking coins and base ETH. Currently, the potential for MEV profit in liquid staking is limited, and atomic transaction earnings will be low due to decreased market volatility.

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Despite this, the adoption of liquid staking tokens is expected to increase in the long term, as they offer superior functionality in various DeFi applications, such as liquidity pools and lending markets. Furthermore, this upgrade will likely drive innovation in the liquid staking market, providing a significant source of MEV and arbitrage opportunities in the future.

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Current MEV From Liquid Staking

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Liquid staking on Ethereum accounts for a small percentage of total MEV profits. According to data from Flashbots and EigenPhi, liquid staking generated $595k in earnings from the Merge up until January 10th, 2023. In comparison, the total MEV market on Ethereum generated $2.5m in profits during the 30 days leading up to January 18th.

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Low DEX Integration: A Headwind For MEV

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Atomic (single-transaction) arbitrages account for most of all MEV (upwards of 80%), and roughly 80% of all arbitrages are extracted from either Uniswap V2 or V3. While stETH is the largest liquid staking coin by market capitalization, it is primarily traded on only three DEXes: Curve, Balancer, and Euler Finance. This lack of integration and liquidity leads to fewer arbitrage-based MEV opportunities compared to established Uniswap pairs.

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Instead, stETH is primarily used as collateral in lending markets to borrow WETH, and as of January 20th, 2023, 73% of Aave’s stETH supply (673k stETH) was used as collateral to borrow WETH. As a result, the stETH and ETH prices are effectively pegged, making liquid staking tokens behave similarly to stablecoins. This factor, in conjunction with the stability of ETH, makes liquidations of these positions unlikely, further reducing the MEV opportunities compared to pairs like USDC/WETH.

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Arbitrage Trades Dominate MEV

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Most MEV profits linked to liquid staking came from arbitrage between prices on different platforms, accounting for 80.2% of total profits. Sandwich attacks accounted for 19.1% of MEV profits. Liquidations have generated little MEV since the Merge.

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RocketPool’s rETH token appears to be the most arbitraged, but it’s important to note that these rates are highly skewed by one trade executed on November 8th, 2022, during the FTX collapse. This single trade comprised almost half of all extracted MEV from liquid staking tokens at the time of execution. MEV profits are generally not distributed, and a tiny fraction of trades generate outsized profits. In this case, one trade was responsible for $277k out of the $595k total MEV profits from liquid staking. You can find more information about this trade on the EigenPhi Website.

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The results are more predictable when looking at the count of MEV transactions between different liquid staking tokens. For example, around 47% of transactions are on stETH, 30% on rETH, and 8% on Coinbase ETH (cbETH). These percentages indicate that while large, outlier trades may skew the overall MEV profits for a specific token, the distribution of transactions across different tokens is more stable.

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Short Term Impact

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Less MEV Opportunities Due to Lower Price Volatility

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When withdrawals are enabled, the discount between liquid staking tokens and ETH will likely narrow significantly, similar to what happened following the Merge. Unlike stablecoins such as USDC and USDT, an exit queue will be in place to manage redemptions. Once a validator has exited the queue, it will have to wait at least 27 hours to withdraw its stake. (More information )
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New Types of MEV

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Currently, there is no way for a searcher to capitalize directly on a trading discount between ETH and a liquid staking token. Any arbitrage that occurs utilizes discounts between different liquid staking tokens. After the Shanghai upgrade, by operating their validators, MEV searchers will be able to implement new strategies, including but not limited to the following:

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• If withdrawal demands are too high, validators will want to be at the front of the exit queue to avoid delays. Therefore, it makes sense to pay bribes to ensure that one’s exit request or partial withdrawal is processed.
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• Pay validators to back-run users selling a significant quantity of liquid staking tokens.

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Arbitrage Opportunities Will Increase

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As we have seen previously, withdrawals will take a minimum of 27 hours. As a result, atomic transactions will not be possible; thus, arbitrage opportunities will require capital to be executed. These are not strictly MEV because the transactions are not atomic, and the trade will last as long as the withdrawal duration, creating two classes of liquid staking arbitrage:

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1. Buying liquid staking coins when the discount reaches certain levels. When the discount drops below a certain threshold, it’s profitable to arbitrage trades until the withdrawal completes. Even small discounts on liquid staking tokens will be worth arbitraging. For example, if you purchased stETH at a 20 bps discount and redeemed it three days later, you would generate an annualized profit of 23%.
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2. Arbitrage between liquid staking tokens. As the liquid staking token market share increases, the additional volatility will create other opportunities. On top of that, staking tokens utilize different rebasing strategies and redemption mechanisms, creating an additional factor when pricing these staking tokens. This market will become similar to stablecoins, where each asset fulfills the same fundamental purpose, but each token has a slightly different implementation.
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To make things comparable, we have looked at the historical discount vs. fair value of rETH, cbETH, and stETH. As one can see, the prices of the three tokens are uncorrelated, creating attractive arbitrage opportunities.

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Long Term: DeFi Adoption Will Drive MEV Opportunities

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The current staking ratio of ETH is low (14%) compared to other chains like Solana (68%) and Polygon (43%). Only when the Shanghai upgrade is implemented are withdrawals possible. Staking entails locking one’s ETH for an undetermined period; this prevents many users from staking their tokens as they may need to access them in the future. Liquid staking tokens provide an alternative, but their discount may widen during volatile periods.

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After the upgrade, the liquid staking market will likely expand, and their associated coins will become more critical in the DeFi ecosystem. Liquid staking protocols will have to focus on their decentralization and composability aspects. More DeFi integration combined with higher volumes will increase MEV and arbitrage opportunities from liquid staking coins.

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Liquid staking tokens enable composability and better capital efficiency. Liquidity providers will prefer to provide capital to a Uniswap V3 pool USDC/stETH vs. USDC/WETH as they can accrue rewards on their ETH. As liquid staking coins increase ETH staked, they will generate more trading volume. Moreover, protocols will have more incentives to include these coins as collateral in liquidity or even lending pools. For example, cbETH, with a market cap above $1bn as of January 19th, 2023, is an attractive integration candidate.

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We also expect to see more L2 adoption in liquid staking, unlocking more cross-chain MEV opportunities. The number of stETH tokens on Ethereum bridges has been increasing steadily since the Merge but remains a small part of the circulating supply (less than 1%).

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