Preparations For The Merge (Part 1) - MEV Distribution Method

[kiriyha]

Preamble

Ahead of the monumental shift in Ethereum’s economic & consensus model, StakeWise DAO must assess the upcoming changes in specs and adapt its product accordingly. The changes in question mostly relate to the topic of Maximum Extractable Value, or MEV in short. The process of earning and distributing MEV require changes to the StakeWise product, which are only possible with the SWISE holders’ approval. Hence, in this and the upcoming forum posts, the StakeWise team will outline the different considerations for each required change and request DAO feedback, ultimately leading to a DAO vote.

We will start with the discussion on the method of distribution for MEV & priority fees because it requires more development resources and time. The discussion of the optimal infrastructure setup for maximizing MEV will follow in another forum post.

Summary

In light of the Merge, StakeWise DAO must decide on the distribution method for the rewards earned as priority fees & MEV. The two competing approaches - distributing ETH rewards via the Merkle Distributor vs staking ETH rewards and distributing them as rETH2 - have different implications for the tokenomics and user experience in StakeWise. In this post we will discuss the merits of each approach, voice the team’s opinion, and request feedback from the DAO members, which will inform the consequent Snapshot vote. Let’s get to it!

Motivation

Ethereum’s transition from Proof-of-Work to Proof-of-Stake, commonly referred to as the Merge, opens new revenue streams for the network’s validators, and by implication, the stakers in StakeWise. After the Merge, stakers will be the sole participants responsible for consensus on Ethereum, meaning that on top of the network emissions, they will receive the priority fees paid by Ethereum’s users to have their transactions processed. This potentially offers stakers a huge revenue boost because traders, bots and even the ordinary users compete for their transactions to be processed first, paying progressively more for the opportunity. The value generated by stakers from users competing for blockspace is what is referred to as Maximal Extractable Value, or MEV in short. Lots has been written about MEV over the past year, and now that it’s about to become a reality, StakeWise DAO must decide on the method of distribution for the extra ETH rewards generated this way.

Let’s start with the basics. Since the extra revenue is generated from Ethereum’s users paying for transactions, it will accrue in ETH to a special address called the ‘coinbase’ address (any name similarities with a famous exchange are random). This address exists on what is called the Execution Layer, or EL for short, meaning that ETH on its balance is immediately accessible for withdrawal. This is in contrast to the network emissions that accrue on the Consensus Layer, or CL for short, landing on the validator’s balance that is not immediately withdrawable.

There are, then, different ways to deal with the ETH that will accrue on StakeWise’s coinbase address. Below, I outline the two methods that the team would like the DAO to discuss.

Method 1 - Distribute via Merkle Distributor

Simply distribute accumulated ETH to stakers via the Merkle Distributor, proportionally to their sETH2 balances. Whenever stakers want to access the extra rewards, they will claim ETH from the Distributor, performing a manual step and paying gas each time they claim (but claiming all the tokens they have in the Distributor in one go). The staking commission will also be collected in ETH (10% of accumulated rewards as per usual).

This method is the simplest of all from the technical perspective, and offers rewards in a very liquid asset that stakers can use according to their discretion. The drawback is that claiming ETH from the Merkle Distributor costs gas, meaning there is de-facto a network tax on claiming MEV rewards. Another drawback is for folks with small sETH2 balances, the gas cost of claiming may exceed the value of the claim, pricing them out of accessing their rewards until sharding is enabled or until the Merkle Distributor migrates to a roll-up. Finally, it adds an extra step towards accessing the rewards, which is undesirable from the UX perspective. This is the least preferred method by the team, precisely for the reasons mentioned above.

Method 2 - Restake & distribute as rETH2

Stake the accumulated ETH directly into the Pool contract and mint rETH2 against it; then distribute both the staked ETH and the rewards it generates via the usual rETH2 accrual process to the sETH2 holders. The staking commission will still be collected in rETH2 (10% of accumulated rewards as per usual).

This method is the cleanest from the UX perspective and preserves the economic benefits offered by restaking, albeit at the cost of altering our tokenomics logic. Whereas currently sETH2 = ETH principal and rETH2 = ETH rewards, this change will mean sETH2 = ETH principal (non-MEV) and rETH2 = ETH rewards + ETH principal (MEV). Currently, only sETH2 provides the rights to earn staking rewards and this will remain the case after the change. Stakers will hold sETH2 in order to receive base staking rewards and their fair share of MEV rewards, also distributed in the form of rETH2. In the background (on the validator level), this rETH2 would be backed by ETH principal and actually earn interest, also distributed as rETH2. The net effect is an increased APR per sETH2, without changing the behaviour of both sETH2 and rETH2 tokens.

This change carries a compounding effect and allows StakeWise to demonstrate the highest possible APR, although with an implicit assumption that restaking MEV rewards is the best use of capital. It also comes without the gas and UX burdens associated with the previous two methods. Because of its clean UX and balanced economic benefit, this is the preferred method of MEV distribution by the StakeWise team.

Specification

Specification for the methods will follow once the forum discussion identifies its favourite. The chosen method will be introduced into the protocol via a Snapshot vote-based contract upgrade, subject to successfully passing a code audit.

Discussion

Due to the need to meet coding and auditing deadlines before the Merge, let’s aim to wrap up the discussion by next Monday and proceed to the formal DAO vote.

We welcome all the DAO members’ thoughts on the best method of distributing MEV given our tokenomics model and look forward to a fruitful discussion .

[brianchilders]

My initial reaction is Method 2. Will read more on this but I like the approach.

tl;dr understanding.

stake ETH, get sETH2
as sETH2 holder, be eligible for appropriate portion of MEV rewards based on amount of sETH2 staked
MEV rewards as ETH comes in; gets staked (swapped?) as rETH2 and rETH2 distributed to sETH2 holder (based on amount of sETH2 staked)

[cryptochrome]

I am torn. I love the simplicity and freedom that Merkle distribution would bring. Everybody could decide themselves what is the best course of action for their earned capital. On the other hand, I see the beauty and elegance method 2 would bring. It would really underline the power of Stakewise’s architecture.

I guess I would be fine with either approach, but would love to see more opinions from others first before rendering a final decision.

[porcupine]

I, too, like the second method at first glance. I’m sure smarter people than I will point out any nuances I have missed.

[Steel.Key]

Thanks for opening this up to the DAO and explaining the pro’s & con’s of each. I need to do some more research but I am partial to Method 2 as it stays true to the dual token model. While having the option of how to receive MEV is nice, I think most sETH2 stakers just want more ETH & if rETH2 compounding provides higher APR/gives them more ETH in a year, that’s what we should go with. (Plus if all goes to plan and liquidity across both sETH2/rETH2 continue to increase across DeFi, they’ll have the ability to sell if needed)

Few questions I have:

• have you done any institutional channel checks (via Blockdaemon maybe?) & what have their initial preferences been? (obviously want to give the people what they want)
• how much of an APR boost would Method 2 provide? (vs Method 1 & vs other single token liquid staking competitors) If Method 2 results in meaningfully higher APR vs competitors, I would view that as a competitive advantage that we definitely lean into.
• are there any tax implications between the two worth considering?

[brianchilders]

I think the fact that [1] we don’t pay gas fees and [2] we don’t lose 10% off the cuff makes it pretty compelling. I’d hate as whale to get 1mil back in ETH and then have to pay 10% of that back to StakeWise. I’d rather get 1mil back in rETH2 and then swap / play around as needed.
cheaper imho to go that route vs the loss of the 10% of MEV rewards.

[ottodv]

I am also in favor of method 2.

Saves everyone a lot of hassle with claiming and restaking. Assuming most people, like me, just want their investment to grow with the least maintenance effort (and least network fees).

[Fur1nator]

I am also supporting option 2. It seems hassle-free and more cost-effective for us small investors.

[ottodv]

@Steel.Key

are there any tax implications between the two worth considering?

That will depend on jurisdictions. In the Netherlands it makes no difference at all. In some countries receiving a payout might be seen as income.

[amphoria]

I am also in favour of method 2.

[rruoste]

I see method 2 as the most attractive out of them as it i) plays into StakeWise’s USP and ii) would mitigate problem of pricing out stakers.

[jayschoenherr]

I agree with Method 2, avoid gas fees, and maximize APY.

[Georg]

@kiriyha

Stake the accumulated ETH directly into the Pool contract and mint rETH2 against it; then distribute both the staked ETH and the rewards it generates via the usual rETH2 accrual process to the sETH2 holders. The staking commission will still be collected in rETH2 (10% of accumulated rewards as per usual).

Love the initiative on it. Thanks! Just a question for clarification:

Will sETH2 holders receive the staked ETH and the rETH2, or only the rewards generated by the staked ETH? I guess the payout to sETH2 holders will happen in a proportional way to ones sETH2 holdings?

[brianchilders]

IMHO it would be more complicated to do taxes on option 1 - as I’d have to figure out the fees taken out and write that off and determine the original amount.

option 2 - less math.

[brianchilders]

Would the team (@kiriyha / @tsudmi) be willing to share a high level pseudo-code implementation of what would be modified for Option 2? doesn’t have to be detailed, just highlight what would be modified and/or added?

Thank you for your consideration.

[Daniel_Finoa]

Thanks for bringing this topic up. I am also in favor of Method 2.
Did I understand this correct: rETH2 are then the ETH rewards + the staked MEV rewards ETH. This would mean the MEV Rewards are auto-compounded which is great. But how can this be displayed in the UI and is rETH2 then also getting a yield bearing asset? Is rETH then having its own APY, otherwise I could sell the rETH2 but still get the boosted APY, no?

[kiriyha]

@Steel.Key

• have you done any institutional channel checks (via Blockdaemon maybe?) & what have their initial preferences been? (obviously want to give the people what they want)
• how much of an APR boost would Method 2 provide? (vs Method 1 & vs other single token liquid staking competitors) If Method 2 results in meaningfully higher APR vs competitors, I would view that as a competitive advantage that we definitely lean into.
• are there any tax implications between the two worth considering?

Thanks for your questions! Answers below:

• We have discussed these options with the Blockdaemon team and they preferred Method 2 because of its simplicity & APR implications

• You can think of the APR boost as Amount of MEV rewards received * All-in staking APR (network emissions + MEV) on a continuous basis. A simple way of thinking of comparing the two methods is compounding 100 dollars (and the proceeds from re-staking) daily or weekly at a ±5% APR for 365 days and seeing the difference with Method 1. It works out to be as follows:

  Method 1: $36,500 ( = $100 * 365)
  Method 2: $37,417.60 with weekly compounding or $37,425.27 with daily compounding
  

• The benefit of Method 2 over Method 1 is $917.60 (weekly compounding) or $925.27 (daily compounding), which is a ±2.5% boost over 1 year, and a ±8% boost over 3 years. So if the all-in APR without compounding is 10% where MEV is half (5%), with compounding the all-in APR is 10.125% where MEV is 5.125%. By the end of year 3, it will have grown to 10.4% all-in APR, where MEV is 5.4%. The boost will be bigger if MEV rewards work out to a higher APR. Note that this calculation does not account for the manual reinvestment of rETH2 into sETH2, which can offer a considerable additional benefit.

• In terms of competitors, I believe Lido are planning to reinvest MEV rewards as well, while Rocket Pool are not. Reinvesting would mean that we stay par or beat Lido and remain ahead of Rocket Pool in terms of APR.

• Finally, not sure about the tax implications since for various jurisdictions taxes work differently.

If you want to cross-check the calculations for the compounding effect, see this simple calculator.

[kiriyha]

I think the fact that [1] we don’t pay gas fees and [2] we don’t lose 10% off the cuff makes it pretty compelling. I’d hate as whale to get 1mil back in ETH and then have to pay 10% of that back to StakeWise. I’d rather get 1mil back in rETH2 and then swap / play around as needed.
cheaper imho to go that route vs the loss of the 10% of MEV rewards.

Hmm not sure what you are referring to here StakeWise charges 10% on the rewards, so 10% of MEV is going to be collected by the protocol anyway, whether as ETH or rETH2.

Would the team (@kiriyha / @tsudmi) be willing to share a high level pseudo-code implementation of what would be modified for Option 2? doesn’t have to be detailed, just highlight what would be modified and/or added?

The technical implementation (roughly) is calculating total rETH2 supply as

Total rETH2 supply = Total Validators Balances - 32 * Number of Validators + Total MEV rewards historically accrued in the coinbase address

So whenever updateTotalRewards is called, rewardPerToken will calculate the amount of validator rewards and MEV that should belong to each sETH2 holder and update the balances of rETH2 accordingly. Hope I got this right @tsudmi !

[kiriyha]

Will sETH2 holders receive the staked ETH and the rETH2, or only the rewards generated by the staked ETH?

Glad to have you back sETH2 holders will receive rETH2, which will represent both the newly staked ETH and the rewards from it.

I guess the payout to sETH2 holders will happen in a proportional way to ones sETH2 holdings?

Since MEV is earned proportionally to sETH2 holdings, then reinvesting & distributing MEV will also happen proportionally to sETH2 holdings. So correct!

[kiriyha]

@Daniel_Finoa

Did I understand this correct: rETH2 are then the ETH rewards + the staked MEV rewards ETH. This would mean the MEV Rewards are auto-compounded which is great.

That’s correct sir.

But how can this be displayed in the UI and is rETH2 then also getting a yield bearing asset? Is rETH then having its own APY, otherwise I could sell the rETH2 but still get the boosted APY, no?

Not really - rETH2 does not become a yield-bearing asset since the rewards (rETH2) are still being distributed to sETH2 holders, despite a portion of them being minted against ETH principal. And as for selling rETH2 to get boosted APR - that’s true, you can go one step further and compound again. In short, sETH2 is still king.