What is Liquid Staking of your Crypto? Is It Safe and How Does It Work?

Overview

• Liquid staking is a way for investors to earn staking rewards on a crypto while still being able to use the underlying token for other purposes in DeFi
• Liquid staking derivatives are tokens that represent a staked asset in a cryptocurrency network. These derivative tokens are the key components of the liquid staking process.
• To participate in liquid staking, an individual purchases a liquid staking token, which represents a claim on a certain amount of staked tokens, and earns a portion of the staking rewards in proportion to their holdings
• Advantages of liquid staking include immediate liquidity, composability, and improved decentralization
• Liquid staking platforms include Lido, Anchor, and DeversiFi, which support various tokens such as ETH and DOT
• Risks of liquid staking include reduced overall liquidity, platform security, and the possibility of the liquid staking provider mismanaging the underlying assets
• It is essential to thoroughly research a liquid staking provider and their security measures before participating in their services

What is Liquid Staking?

Liquid staking is a type of staking in which tokens are staked on a blockchain in a way that allows them to be more easily bought and sold on the open market. This is achieved by creating a separate token that represents the staked tokens and can be traded more easily. For example, if a user wants to stake their Ethereum (ETH) tokens, they could do so directly by holding them and participating in the consensus process of the Ethereum blockchain.

Alternatively, they could purchase a liquid staking token such as stETH, which represents a claim on a certain amount of staked ETH and can be more easily bought and sold on exchanges. By holding a liquid staking token, the user can earn a portion of the staking rewards that the underlying staked tokens would have earned while also maintaining more flexibility in buying and selling the tokens.

What are Liquid Staking Derivatives?

Liquid staking derivatives (LSD) are tokens that represent a staked asset in a cryptocurrency network. These derivative tokens are the key components of the liquid staking process. To better understand this, consider a scenario where you decide to stake some Ether (ETH) on the Ethereum 2.0 network. In traditional staking, the ETH would be locked up for a specific period, unable to be transferred or sold, but would earn you staking rewards over time. In liquid staking, instead of your ETH being entirely locked up, you'd receive a derivative token - for example, stETH or rETH - representing your staked ETH. This derivative token could be used while your original ETH is still staked and earning rewards. These liquid staking derivatives can be traded on various decentralized exchanges, used as collateral in lending protocols, or further utilized in yield farming strategies, among other applications. Essentially, they allow the value of the staked asset to remain active in the DeFi ecosystem, increasing the overall capital efficiency. The value of the derivative tokens can fluctuate relative to the original staked asset due to market forces and the design of the specific liquid staking protocol.

How Does Liquid Staking Work?

To participate in liquid staking, an individual can purchase the liquid staking token directly from an exchange or the liquid staking provider. The provider then uses the assets associated with the token to stake on the PoS blockchain, earning rewards. These rewards are then distributed to the holders of the liquid staking token in proportion to their holdings.

For example, suppose an individual holds 1% of the total supply of a liquid staking token, and the provider earns 100 units of the staked asset as a reward. In that case, the individual will receive 1 unit of the staked asset.

One of the critical benefits of liquid staking is the ability to earn staking rewards while maintaining liquidity and flexibility with the underlying assets. This is in contrast to traditional staking, where the assets must be locked up to participate in staking and earn rewards.

In addition, liquid staking allows individuals who may not have the technical expertise or resources to set up their staking infrastructure to still participate in the process and earn rewards. It also provides for increased decentralization and distribution of rewards, as the liquid staking provider may distribute the rewards among a more significant number of token holders.

Advantages of Liquid Staking

There are several advantages to using liquid staking:

• Immediate liquidity: With liquid staking, you can earn a return on your tokens without sacrificing their liquidity. This can be particularly useful in situations where you need to sell your tokens quickly, such as in the case of a sudden market movement.
• Composability: Liquid staking tokens can be used as collateral in various decentralized finance (DeFi) platforms, allowing you to earn additional returns through lending or margin trading.
• Improved decentralization: By staking through a liquid staking provider, you can diversify your stake across multiple validators, which can help improve the blockchain's decentralization.

Liquid Staking Platforms and Supported Tokens

Several platforms offer liquid staking services, including Lido, Anchor, and DeversiFi. In addition, these platforms support various tokens, including ETH, DOT, and KSM.

Liquid staking platforms allow token holders to deposit their tokens into a pool staked on their behalf. The platform typically charges a fee for this service, which is taken from the staking rewards earned by the pool. The token holder is then issued a liquid staking token, representing their share of the staked tokens in the pool. This liquid staking token can be traded on exchanges or used in other DeFi protocols.

The supported tokens for each liquid staking platform vary, but generally, they support the most popular staking tokens, such as Ethereum (ETH) and Cosmos (ATOM). In addition, some platforms also support tokens from other blockchains, such as Binance Smart Chain (BSC) or Polkadot (DOT).

It's important to note that the yield earned from liquid staking may be lower than staking the tokens directly due to the fees charged by the platform and the reduced liquidity of the liquid staking token. Additionally, the risks associated with staking, such as the potential for slashed tokens, may differ when using a liquid staking platform. Therefore, token holders should carefully consider these factors when deciding whether to use a liquid staking platform.

Ethereum Liquid Staking

Ethereum is the most prominent blockchain platform that uses the Proof of Stake consensus mechanism and has several liquid staking options.

With the upcoming Shanghai upgrade scheduled for March or April, more ETH will likely be staked, leading to more revenue for LSD protocols. In addition, some investors unstake from top projects and restake with another protocol to achieve better decentralization.

There are several notable LSD protocols to consider, including Lido, Rocket Pool, Stakewise, and Frax Finance. Each has unique features and advantages, such as Lido's large market share and Rocket Pool's high staking rewards. Therefore, it's essential for investors to carefully consider the risks and opportunities of each protocol, as well as the potential for centralization, before choosing a liquid staking provider.

Stader Labs, also known as ETHx, is another promising option for LSDs. It is a decentralized, community-driven protocol that allows users to earn staking rewards without sacrificing liquidity. In addition, the ETHx token has a unique tokenomics design that includes a buyback and burn model and a distribution system that rewards early adopters and long-term holders.

In addition to its technical features, ETHx has formed partnerships with several DeFi projects, including Aave, 1inch, and Chainlink, which helps to increase its liquidity and yield. It also has strong community backing and is continuously audited to ensure security.

Stader Labs, with its strong partnerships, unique tokenomics design, and community support, is a good choice for those interested in liquid staking. However, it is also essential to consider whether the choice to stake with a dominant protocol or a sizeable centralized exchange could contribute to the overall centralization of the blockchain, potentially decreasing its value.

Centralized vs. decentralized liquid staking

When choosing a liquid staking provider, one crucial factor is whether to use a centralized or decentralized provider. A centralized provider, such as an exchange, holds custody of your assets and is responsible for securing them. In contrast, a decentralized provider, like Lido, does not retain custody of your assets but requires you to deposit your tokens into a smart contract. This means that you do not have to trust a centralized entity with your assets, but there is a risk that the smart contract could be hacked or exploited, resulting in the loss of the "backing" of your liquid staking tokens.

The level of centralization within the liquid staking ecosystem is also worth considering. A high level of centralization, where a small number of entities hold a large percentage of staked assets, can increase the risk of collusion and negatively impact the value of your assets. For example, data shows that over half of all staked Ethereum is held with Lido, Coinbase, and Kraken, which raises concerns about the potential for these parties to alter the blockchain's consensus. However, it is essential to note that dominant liquid staking providers, such as Lido, often offer the best liquidity for users.

Ultimately, it is up to the individual user to weigh the trade-offs and decide which type of provider and level of centralization is most appropriate for their needs.

Is Liquid Staking Safe? The Risks and Opportunities Weighed

Liquid staking is generally considered safe, but it is crucial to consider the risks associated with any investment or financial strategy.

Some of the risks to consider when it comes to liquid staking include the following:

1. Market risks: As with any investment, the value of liquid staking tokens can fluctuate due to market conditions. It is important to carefully consider the potential for market volatility and how it could impact the value of your investment.
2. Protocol risks: The success of liquid staking protocols is often tied to the success of the underlying blockchain. If the blockchain experiences issues or fails, it could negatively impact the value of liquid staking tokens.
3. Liquidity risks: As mentioned earlier, liquid staking tokens generally have lower liquidity than underlying tokens. This means that it may be more challenging to buy or sell the tokens, and the price could be more volatile.
4. Operational risks: Liquid staking protocols are run by teams of developers and other professionals. If the team experiences issues or makes mistakes, it could negatively impact the protocol's performance and the tokens' value.

It is also essential to diversify your investment portfolio and only invest what you can afford to lose.

Another risk is the security of the platform. As liquid staking providers handle large amounts of cryptocurrency, they can be attractive targets for hackers. This means it is essential for investors to thoroughly research the security measures in place at the liquid staking platform they are considering using.

Some things to look for in a secure liquid staking platform include the following:

• Strong passwords and two-factor authentication: These measures can help protect against unauthorized access to your account.
• Secure storage of tokens: Look for a platform that stores tokens in cold storage, meaning they are kept offline and are, therefore, less vulnerable to hacks.
• Regular security audits: A platform that undergoes regular security audits is more likely to be secure than one that does not.
• Comprehensive security policies: A clear and comprehensive platform is more likely to take security seriously.

Investors must do their due diligence and ensure that the liquid staking platform they choose has robust security measures to protect their tokens. While no system is entirely foolproof, taking the time to research and select a secure platform can help reduce the risk of loss due to a hack or other security breach.

Closing Thoughts

Liquid staking is a powerful tool for crypto investors seeking immediate liquidity and the ability to use their tokens in various yield-generating strategies.

While it does come with some risks, such as reduced overall liquidity and the need to trust a third party with the security of your tokens, the composability and technical advantages of liquid staking make it a compelling option for many investors.

It is vital to carefully research and compare different liquid staking platforms and tokens to make an informed decision that aligns with your investment goals and risk tolerance. Additionally, as the space continues to evolve, it will be interesting to see how liquid staking evolves and becomes integrated into the broader world of cryptocurrency and DeFi.