Ether’s (ETH) decentralized finance (DeFi) activity has declined in the bear market, and the sector faces further competition from Ethereum’s annual staking reward of 4%, according to Glassnode analysts. However, a DeFi narrative is building around liquid staking derivative (LSD) tokens, which could revive Ethereum’s network activity.

The percentage of gas consumed by DeFi protocols has dropped from 34% in 2020 to between 8% and 16% presently, with nonfungible tokens (NFTs) commanding the maximum share of 25–30%, according to a recent report from Glassnode.

Glassnode’s supply-weighted price index for DeFi, priced in United States dollars and ETH, recorded a 90% loss since early 2021.

The so-called DeFi “blue chips,” which represent a basket of governance tokens from well-known DeFi protocols like Uniswap (UNI), MakerDAO (MKR), Aave (AAVE), Compound (COMP), Balancer (BAL) and SushiSwap (SUSHI), have lost 88% of their market capitalization from all-time highs of $45 billion in May 2021.

DeFi blue chip tokens have underperformed against ETH during bullish market rallies and experienced a more severe drop than ETH “on the downside during the bear.” The analysts predict that since the staking of ETH now yields 4%, it will act as a “new hurdle rate over which token returns must jump.” This yield represents the benchmark rate for Ether investors.

Leading lending protocols like Aave and Compound offer between 2–3% yields on lending stablecoins and Ether. Moreover, DeFi protocols also come with smart contract risk, which is eliminated with proof-of-stake validators.

Staking has become popular among Ethereum investors, especially after the Shapella upgrade in April 2023, which enabled redemptions from the staking contract.

By the end of May, Ethereum users staked 21.63 million ETH worth $40.021 billion, representing 18% of Ethereum’s total supply.

LSD platforms like Lido and Rocket Pool account for one-third of this massive market. These applications offer a tokenized representation of staked ETH, allowing investors access to the staking yields without compromising liquidity.

A growing trend among Ethereum investors is interacting with LSD financialization (LSDfi), which aims to put the liquidity offered by the LSD tokens to use in DeFi applications.

Related: LSD for DeFi: Tenet, LayerZero partner to drive cross-chain liquid staking adoption

Is LSDfi the solution?

LSDfi leverages the liquidity of LSD tokens into DeFi-like lending protocols and liquidity on exchanges for higher yields. Given that a considerable amount of ETH is staked with the LSD platforms, LSDfi has the potential to revive DeFi activity.

A Dune analytics dashboard by data analyst Defimochi shows the total value locked (TVL) in LSDfi protocols has touched $411 million, rising exponentially since mid-May. Some of the popular names in the sector are Pendle Finance, Lybra Finance, Curve Finance and Alchemix Protocol.

The liquidity of LSD tokens on Curve Finance — the largest stablecoin exchange in the market — has surpassed $1.5 billion. Curve also enabled the minting of its overcollateralized stablecoin crvUSD (CRVUSD) using Frax Protocol’s staked Frax Ether (SFRXETH) as collateral.

New protocols like Lybra Finance and Pendle Finance, which are looking to leverage the liquidity provided by LSD tokens, have also become popular.

As has happened before with DeFi, newer applications will likely tap the liquidity of LSD tokens by facilitating liquidity mining of their governance tokens for early depositors.

While these can bring decent gains for some users, these protocols could carry smart contract risks and the chance of getting rug pulled, introducing the risks that come with the higher gains that LSDfi provides.