The Shapella Upgrade: A Deep Dive into Withdrawals

What’s this article about?

The Shapella upgrade brings significant changes to the Ethereum network, introducing new withdrawal options for validators in the form of full withdrawals and partial withdrawals. This article delves into the details of withdrawal eligibility, the step-by-step process for withdrawals, and what to expect in the immediate, mid-term, and long-term future. We also explore the potential impact on the activation queue, withdrawal queue, and APR dynamics, as well as the various factors that may influence these aspects of the Ethereum ecosystem.

Table of contents

• Uncovering Withdrawals: Key Information You Should Know
• The Withdrawal Process Step-by-Step
• Is Your Validator Ready for Withdrawals?
• Navigating the Post-Shapella Market: A Comprehensive Overview
• Anticipating the Withdrawal Queue: What to Expect
• Forecasting the Activation Queue: Preparing for the Future
• Post-Shapella APR: Factors That Will Influence Your Return

Uncovering Withdrawals: Key Information You Should Know

The Shapella upgrade introduces two types of withdrawals: full withdrawals (also known as exits) and partial withdrawals (staking reward collection).

Core withdrawal concepts

1. Withdrawal eligibility. Not every validator can withdraw immediately after the Shapella upgrade, as only validators with 0x01 format withdrawal addresses are eligible. Validators with old 0x00 format addresses (58% of the total) need to switch to the new format, a process that will take approximately three days. So if you have 0x01 format, you have an advantage over other validators to exit with a minimal queue.
2. Full withdrawals involve validators withdrawing their entire stake after passing through an exit queue (dependent on the number of validators wishing to exit) and a withdrawal period (1-5 days). This process prevents sudden changes in validator numbers, ensuring network security.
3. Partial withdrawals automatically withdraw accumulated staking rewards (balances over 32 ETH) if validators possess the required withdrawal credentials. Right after the Shapella update, this process will take around 2 days since some validators are not eligible for withdrawals. But this is temporary, and in the near future partial withdrawals should be expected every 5 days.
4. You will continue to earn staking rewards while you wait in the exit queue.

The Withdrawal Process Step-by-Step

1. Active validators can earn rewards and perform partial withdrawals.
2. To perform a full withdrawal, validators initiate a voluntary exit and enter the exit queue. The exit queue works on a first-in, first-out (FIFO) basis and limits the number of validators that can withdraw every epoch to a dynamic churn limit. The minimum churn limit is set to four. Currently, for 560k validators, it’s 8 validators per epoch (or 1800 validators / 57.6k ETH daily)
3. Validators enter a waiting period to ensure no malicious activity. This is approximately 27 hours if not slashed, and 36 days if slashed. After the waiting period, the stake becomes withdrawable.
4. All withdrawals, both full and partial, are processed sequentially at a rate of 16 validator addresses per block, amounting to 115k validators daily. Each validator has a designated position in this withdrawal queue. The queue operates in a loop, starting from the beginning after each cycle. It takes 5 days to complete one rotation. Consequently, the maximum waiting time for this withdrawal step is 5 days, while the minimum waiting time can be just a few minutes if the validator completes step 3 (waiting 27 hours) right before their turn for withdrawal.

More about the withdrawal eligibility

Validators must use withdrawal credentials with the 0x01 format, introduced in March 2021, to be eligible for withdrawals. Validators with the older 0x00 format will be able to switch to the 0x01 format after the Shanghai upgrade, limited to 16 switches per block. It may take two days for every validator to switch their credentials and another two to three days for most staking rewards to be withdrawn.

Navigating the Post-Shapella Market

• Immediately (first days) after the Shapella upgrade, we expect only a limited number of validators to exit, as 58% of the total will lack the necessary withdrawal credentials. Substantial partial withdrawals should occur in the following days. We assume that half of the partial withdrawals (550k ETH) will be restaked in order to get more rewards, remaining 550k ETH will likely be sold to pay taxes, which may temporarily cause price pressure.
• Mid-term (around 3 months), there will be large stake movements with the maximum possible full withdrawal limit reached and new validators (with long queues). The main factors will be a regulatory crackdown on CEX staking, switching staking providers, complete withdrawals, and staking of accumulated rewards. While waiting in the long activation queue (up to 20 days), validators don't receive any rewards. This is likely to lead to higher demand for liquid staking. It generates yield immediately after staking, distributing rewards among all staking derivatives holders. However, the downside of this feature is a reduced average APR for all liquid stakers (even for those who staked before the Shapella update). As a result, direct staking will generate a higher yield in the upcoming months.
• Long-term (several years), we expect that the reduced risk associated with the enabling of withdrawals will bring more adoption but a corresponding drop in APR, which will conversely slow the adoption rate. The two factors balance each other out. Nevertheless, we estimate that 30% of ETH will be staked by the end of 2024 and 50% within 5 years (more on this below)

Anticipating the Withdrawal Queue: What to Expect

Various factors affect the demand for staking withdrawals. We have selected the most important ones, in our opinion, and tried to evaluate their effect on the market:

Below we have analyzed our assumptions in detail:

1. Regulatory crackdown on CEX staking: Kraken's recent fine by the SEC has led to the exchange winding down its US staking operations. We already know that Kraken will withdraw US investors' staked ETH shortly after Shapella, which represents approximately 400k ETH (2% of total staked ETH). Other CEXs may be more likely to withdraw a significant part of their staked ETH as well. However, this stake will likely be quickly restaked.
2. Withdrawals to switch staking providers. There are numerous reasons to change staking providers, and we assume that at least 20% of validators will do it shortly (first three month)
   
   2.1. Disliking validator performance: For example, around 8% of validators have effectiveness significantly lower than the network average. Some providers don't have MEV-boost at all (10%) or use a limited number of MEV relays (10%). Additionally, 8% don’t have client diversity. All of the above is not necessarily a bad thing. The validator may have a super secure setup that reduces performance or a principled position to censor/not censor transactions. Our point is that more than half of the validators have been staking for over a year (before the merge and the appearance of MEV, at least). Therefore, disagreement with the provider's approaches is quite possible.
   
   2.2. CEXs risks: The recent FTX collapse and Kraken unstake of all U.S. client assets cases have reminded us of custody risks. Currently, 27.3% of ETH is staked by CEXs, and some part of that will be restaked.
   
   2.3. Solo stakers may exit and stake their ETH with Liquid-staking derivatives (LSDs), as it is a better deal for them. It's hard to estimate the number of solo stakers, but according to our research of ETH deposits, approximately 350k ETH came from separate different addresses in the last three months alone (32 ETH per address). So, solo stakers likely account for 5-10% of validators in total, at least.
   
   2.4. Switching LSDs to direct staking in favour of diversification: Currently, Liquid staking accounts for 33% of the total stake and seems to be increasing its market share. Despite good diversification in the validator pool, Liquid staking carries additional smart contract risk. Since it will be possible to unstake ETH, a good strategy would be to diversify and restake some amount of ETH in non-custodial direct staking services.
3. One-time withdrawal of ETH, reflecting the need that has accumulated over two years: Staked ETH has been locked for more than 2 years, a considerable period in the blockchain world, during which many circumstances could have changed. Bankruptcy, alterations in portfolio strategy, and other situations may necessitate the sale of ETH. Based on Polkadot and Solana's largest unstakes (10-15% of the total stake within a month), we believe it's fair to assume that at least 10% of the stake will be withdrawn as soon as such an opportunity becomes available.
4. Regular organic withdrawals. According to the Polkadot benchmark, there is evidence of organic stake/unstake movements. Polkadot's historical median value of unstaking is 0.04% daily, which amounts to 15% yearly. We cannot directly apply this benchmark to Ethereum, as it differs in terms of its popular liquid staking option (those who do not want to hold a stake for an extended period can use liquid staking). However, we believe it's reasonable to assume an organic unstaking rate of around 10% per year for Ethereum.

Considering the assumptions above and the fact that the maximum unstake bandwidth is 57.6k ETH daily, we’ve calculated the potential exit queue for the upcoming month.

Forecasting the Activation Queue: Preparing for the Future

The current percentage of staked ETH is low (15%) compared to other chains like Solana (68%) and Polygon (43%). The Shanghai upgrade should unlock pent-up demand from investors who have been reluctant to lock their ETH. A larger proportion of staked ETH will provide greater network security over time.

Yields from staking are higher than those from the largest and safest DeFi protocols. After the Shanghai upgrade, the risk of locking funds through staking will decrease, making it more attractive to investors.

In addition, partial withdrawals allow validators to withdraw rewards regularly and restake them, utilizing compounding. Validators can restake these rewards promptly to maximize their returns.

Until now, staked ETH has increased fairly linearly over time: +6 pp. to the staking ratio yearly (or around 220k new validators per year). But we believe that the Shapella update is a game-changer, and we will see accelerated organic growth (up to 440k new validators or 14M ETH per year).

Other factors affect the activation queue

1. Staking of accumulated rewards: after partial withdrawals, validators may choose to restake their rewards in new 32 ETH units to generate additional yield. Now there are approximately 1.1M ETH rewards locked, and these will be withdrawn within the first week following Shapella. Most likely half of them will go to taxes, half will be staked.
2. ETH restaked from Kraken unstake. 400k ETH within 3 months.
3. ETH restake from switching staking providers. 3.5M within 3 months.

Applying these assumptions to activation queue bandwidth (57.6k ETH daily), we are getting the following activation queue projections:

Post-Shapella APR: Factors That Will Influence Your Return

Since the activation and exit queues have similar bandwidth, and based on the assumptions mentioned above, during the first 3 months after Shapella, we can expect to see a stable number of active validators (57.6k ETH activations / 57.6k ETH exits daily). This leads to a consistent APR, as the number of active validators is one of the main factors influencing rewards. The more validators there are, the fewer rewards each of them receives.

Below is the APR baseline forecast that takes into account a limited number of factors. It may not be entirely accurate, as many other factors can significantly impact rewards. Nevertheless, it is interesting to consider the trends as a baseline scenario.

Regarding the other factors not accounted for in the baseline scenario:

Factors that may increase rewards:

• Increased DeFi activity after the update, potentially contributing to a period of higher execution rewards and APR immediately following Shapella.
• Eigenlayer mainnet release. Restaking will enable staked ETH to be used as cryptoeconomic security for protocols other than Ethereum, in exchange for protocol fees and rewards.

Factors that may decrease rewards:

• A large influx of new validators may temporarily reduce the effectiveness of current validators due to increased attestation propagation time, affecting consensus rewards.
• The average liquid staking APR for the first three months is likely to be lower than for those staked directly before Shapella (due to reward distribution among all pool members, even if their validators are not yet active).
• The lengthy activation queue will implicitly impact those staked directly after Shapella, as validators do not receive any rewards while waiting for activation.
• A shift of transactions from Ethereum to L2, leading to decreased priority fees & MEV rewards.

Conclusion: Navigating the Shapella Upgrade

The Shapella upgrade presents both challenges and opportunities for validators. To maximize benefits, validators should ensure they possess the necessary 0x01 withdrawal credentials, plan their withdrawal strategies, and be prepared for potential market fluctuations. By understanding the withdrawal process and adapting to the changing landscape, validators can ensure a successful experience with the Shapella upgrade.

More about Ethereum

1. Choosing the Best: Using Metrics and Data to Choose the Right Ethereum Validator.
2. P2P.org APR simulator that calculates the average expected APR and possible deviations.
3. Institutional Ethereum Staking with P2P.org