LSDs as the Dominant Collateral in Future Money Markets

LSDs are superior collateral because they generate native yield. Assets like Lido's stETH or Rocket Pool's rETH accrue staking rewards while being used as loan collateral, creating a positive carry loop absent with static assets like ETH or stablecoins.

The composability of LSDs creates a flywheel for money markets. Protocols like Aave and Compound integrate yield-bearing collateral, which attracts deposits, increases TVL, and lowers borrowing costs for users seeking leveraged staking positions.

This dominance introduces new systemic risks. The rehypothecation of staked ETH across protocols like EigenLayer and money markets creates complex, interlinked dependencies, making the system vulnerable to correlated liquidations during validator slashing events or network instability.

Yield-bearing collateral wins. In a competitive market, rational actors migrate capital to the highest utility asset. An LSD like Lido's stETH or Rocket Pool's rETH provides staking yield and functions as collateral. Idle ETH in a vault is a wasted opportunity cost.

Negative-rate borrowing emerges. Protocols like Aave and Compound will see users borrow stablecoins against stETH to farm additional yield, accepting rates below the staking APR. This creates a perpetual borrowing demand that non-yielding collateral cannot match.

The flywheel is self-reinforcing. More LSD collateral increases protocol TVL and liquidity depth, which lowers borrowing rates and attracts more users. This dynamic starves traditional collateral types, cementing LSDs as the primary reserve asset for DeFi credit.

Evidence: Aave's Ethereum market already holds over 3M stETH as collateral, representing the largest single asset pool and demonstrating clear user preference for yield-bearing positions.

LSDs are capital-efficient collateral because they accrue staking yield while simultaneously being lent out. This creates a dual-yield flywheel where the underlying asset (e.g., stETH) earns PoS rewards and the lent derivative earns borrowing interest. Native staked assets are idle and cannot be rehypothecated.

Composability drives network effects across protocols like Aave, Compound, and Euler. An LSD deposited in Aave can be borrowed to mint a stablecoin like MakerDAO's DAI, which is then deployed elsewhere. This creates a self-reinforcing liquidity loop anchored by the LSD.

The data confirms the shift. On Aave V3 Ethereum, wstETH comprises over 40% of the supply-side. This concentration creates a systemic dependency where the stability of major money markets is now directly tied to the security of Lido and Rocket Pool.

Concentrated failure vector is the primary risk. A critical bug or slashing event in a dominant Liquid Staking Token (LST) like Lido's stETH or Rocket Pool's rETH would cascade through every major money market simultaneously, creating a systemic liquidity crisis.

Recursive leverage loops are inevitable. Protocols like Aave and Compound will accept stETH as collateral to borrow more ETH to stake, creating a reflexive dependency on the underlying validator set's security and the LST's peg stability.

Oracle risk is paramount. The entire system relies on price feeds from Chainlink and proof-of-solvency mechanisms to value staked assets. A manipulation or delay here would trigger mass, inaccurate liquidations.

Evidence: The 2022 stETH depeg event demonstrated this fragility. Aave's risk parameters and oracle configuration were the only barrier preventing a complete cascade; a more integrated system lacks these circuit breakers.

LSDs are superior collateral. They provide native yield, which offsets borrowing costs, and are more capital efficient than idle ETH or stablecoins. This creates a self-reinforcing flywheel for protocols like Aave and Compound.

Programmability enables new primitives. LSDs like stETH and rETH are composable assets. This allows for recursive lending strategies and novel products like yield-backed stablecoins, moving beyond simple overcollateralization.

The network effect is decisive. Protocols that integrate LSDs first, like EigenLayer for restaking or MakerDAO for DAI backing, will capture the deepest liquidity. This establishes a winner-take-most market for collateral.

Evidence: Over 40% of all staked ETH is now in liquid form. Aave's wstETH market consistently maintains >90% utilization, demonstrating insatiable demand for yield-bearing collateral.