Liquid staking is a method of turning illiquid-staked assets into liquid assets. This means that liquid staking gives these assets value while providing the same benefits as staking.
The main benefit of liquid staking is that it frees up assets that would have otherwise been locked. However, this benefit comes with some risks. These risks include token de-pegging, which describes a situation where the locked token and its derivatives have unequal value.
Thankfully, this risk can be mitigated by taking careful steps during the staking process. There’s so much more to learn about liquid staking, and this is the ultimate guide to that.
What is Liquid Staking?
It’s impossible to decouple the popularity of liquid staking from the rise of Proof-of-Stake consensus mechanisms. A blockchain that uses Proof-of-Stake consensus mechanisms requires validators to stake a certain amount of tokens. These tokens are what decide the hierarchy of validators on the blockchain.
The tokens also serve as insurance for validators who behave fraudulently or irresponsibly. The tokens of these validators will be slashed, which serves as a deterrence against dishonest behavior. However, this system has a significant drawback.
Proof-of-Stake requires validators to lock vast amounts of tokens to get a chance to validate on the chain. This is like keeping money in a savings account and locking it in hopes of interest.
The problem with this is that there are usually more opportunities for the owners of these tokens to earn with their assets. Proof-of-Stake stops them from using these opportunities, and many investors find this suboptimal.
Asides from Proof-of-Stake, other DeFi ventures, like lending, require users to lock their tokens. These ventures have the same problem with Proof-of-Stake; they require users to lock their tokens. Again, this is a suboptimal arrangement for many investors.
Liquid staking is the crypto ecosystem’s solution to this problem. The way liquid staking works is simple. A liquid staking provider takes the tokens to be staked and stakes them on behalf of the owner. Then the provider provides a receipt, usually in the form of derivatives. These derivatives are equal to the staked tokens and can be traded or used as collateral elsewhere.
Why People Liquid Stake
The primary reason people liquid stake is because it allows them to spend or use their tokens while staking it. The biggest advantage of liquid staking is its immediate liquidity and how it allows investors to react to sudden market movements. The crypto market is notoriously unstable, so this is an important advantage for investors to have.
Aside from providing immediate liquidity, liquid staking also protects users from certain risks associated with staking. Investors who stake through the normal process often delegate their tokens to a validator. This validator doesn’t take control of the staked tokens — it’s only delegated to them. The person the tokens are delegated to ideally keeps a share of the regards for staking as a pay.
However, the staked tokens are slashed when the validator suffers significant downtime and cannot validate correctly. This can cause significant losses to users.
But this risk can be avoided when the tokens are delegated to liquidity providers. Liquidity pools often distribute staked tokens across different nodes, which means the potential losses from slashed tokens are spread across the pool.
Another benefit of derivatives is that they make it easier for you to get your staked tokens back. Many blockchains have a mandatory waiting period for investors to unstake their tokens. Investors on Polkadot, for example, have to wait for a mandatory 28-day unbonding period to unstake their tokens.
People who want to obtain their tokens immediately can simply swap them for original tokens on the regular market at a slight discount.
Risks of Liquid Staking
Liquid staking isn’t without its risks. The primary risk of liquid staking is that the value of the derivatives may depeg from the value of the original tokens.
The problem with derivatives is that they aren’t automatically pegged to original tokens through algorithmic means. The derivatives trade freely on the market, and their prices are determined purely by market forces. This means that these derivatives may start selling for much lower than their original tokens during a bear market or a liquidity crunch.
This isn’t just a doomsday scenario, either. Derivatives in the Terra ecosystem depegged almost simultaneously when the chain crashed. This led to millions of dollars in losses to investors. In June 2022, the stEth token, a derivative of Eth, also depegged about 7% from regular ETH because of market pressures.
When a massive depeg happens, one almost immediately loses access to their original tokens. Even if they can trade in their derivatives for their staked assets, the value of the original assets received will be slashed horribly. This is a huge risk that doesn’t exist with regular staking.
Another risk of liquid staking is that it provides a gateway to centralization. Liquidity pools that have access to many staked tokens can delegate these tokens to a number of stakers. If the pool gets big enough, it could centralize the governance of the blockchain and even take control of it.
One more risk of liquid staking is usually a lack of excessive liquidity with derivatives. ETH, for example, has a daily trading volume that runs into billions of dollars. However, stETH, the largest liquid staking derivatives, barely has a trading volume above $20 million per day. Therefore, investors must know the sort of market that they are entering and whether the derivatives they get will cause a crunch in liquidity.
Finally, liquidity staking is primarily executed on smart contracts. This means that investors risk getting swindled by signing defective smart contracts. That’s why it’s important to use liquidity providers with a strong market reputation or cross-check the smart contract if possible.
Liquid Staking Protocols
Source: Ankr Staking
Investors who want to try their hands out at liquid staking should first stake with popular and large protocols. While these protocols aren’t infallible, they still carry relatively smaller risks.
Some blockchains, like Cardano, enable liquid staking by default. However, others like Polkadot and Solana rely on third-party projects to facilitate their liquidity staking.
Ethereum has the highest value in both staked and liquid staking tokens. Ethereum also has several liquid staking providers. These providers include Lido finance, Rocketpool, Frax Finance, Cream, Stakehound, Ankr staking, and Stakewise.
Lido Finance is the biggest of the lot, and the firm issues the biggest liquid staking derivative, staked ETH or stETH for short.
Lido was the first liquid staking provider, and its first-mover status in the ecosystem has ballooned its market share. They charge about 10% of the staking rewards on the staked assets and share them with the DAO treasury and the mode operators.
Currently, Lido is the largest protocol on Ethereum in terms of Total Value Locked (TVL), with over $7 billion in Ethereum locked. Its next competitor, Rocketpool, barely has up to a billion dollars in Ethereum locked.
Rocketpool is the world’s second-largest staked liquidity provider, and the protocol has about 5.5% of all ETH staking deposits. Stakers receive rETH, which is the Rocketpool derivative for ETH.
Rocketpool gets around 5-20% of the rewards of the staked tokens and gives them to node operators directly. People who want to become node operators with Rocketpool need to purchase RPL, the protocol’s governance token. The payment of this RPL keeps the administration system of Rocketpool running smoothly.
Frax finance is a rising star in the liquidity-staking provider market. That’s because staking with Frax returns around 6-7% in ETH, while others only offer around 5% in ETH. The Frax derivative is frxETH, and users have to stake that frxETH to receive sfrxETH, which grows in value by about 6.63% per year.
Liquid Staking on Ethereum
Liquidity staking is quite popular on the Ethereum blockchain for a few reasons. The first is that ETH can only be staked in 32 ETH increments and cannot be unstaked until the Shanghai upgrade. This means that people who want to unstake their Eth would need to get Eth derivatives through liquid staking and then exchange them on the regular market.
Another reason liquid staking has become so popular on Ethereum is that ETH stakers cannot delegate their tokens to a validator. The validator must have custody of the tokens before they can be staked. This means that liquid staking pools have to play a bigger role in lowering the barrier for new investors to enter the staking business.
Is Liquid Staking Safe?
Like every investing strategy in the crypto ecosystem, liquid staking has its benefits and disadvantages. If done properly, investors can earn a lot of money using their staked tokens and their derivatives.
However, the reverse can also be the case. Unfavorable market conditions can cause massive losses for investors who liquid stake. It’s important to understand that liquid staking still carries some elements of risk and is certainly riskier than regular staking. But DeFi is a financial market, and additional risks come with additional benefits.
Investors without a risk appetite should steer clear. At the same time, those who do should reap the benefits — or the consequences.
On the Flipside
- While it’s theoretically possible for people to gain control of a blockchain through staking, it’s still an improbable doomsday scenario.
Why You Should Care
Liquid staking is one of the biggest markets in crypto today. It’s extremely lucrative and may get even bigger in the coming years. That’s why it’s essential to understand everything about it today, as that may give one an advantage in the future.