What is Liquid Staking: a Comprehensive Guide

With so many crypto terminologies, such as staking, dual staking, and multi-asset staking, it can be difficult to differentiate one from the other. So, what is liquid staking? Liquid staking branches out from the staking operation of staking consensus blockchains. Stakers deposit their cryptocurrency on a third-party platform. The deposited token is pooled and goes on to perform network validation.  Stakers receive liquid staking tokens (LST), equivalent to their staking capital. These LSTs are representations of the staked assets in a blockchain network. These liquid staking tokens may also be called liquid staking derivatives (LSD). The LST or LSD may be used on other protocols for trading or generating yield even further.  This available liquidity has made liquid staking a popular cryptocurrency investing method. As of writing, the market value of liquid staking tokens has grown to $23.7 billion. If this has gotten you interested, then let’s dive in!

How Does Liquid Staking Differ From Traditional Staking?

Liquid staking and traditional staking earn rewards and contribute to the overall security and operations of a blockchain. The difference occurs in the manner in which the staking process is conducted and how the staked crypto is treated after.

Third-party providers

Traditional staking refers to solo staking where a user sets up a computer that connects to the blockchain, adding to the overall network infrastructure.  The staker deposits cryptocurrency to support the operations of the said network. In return, the user receives staking rewards, determined by the amount and duration of the coins staked. Liquid staking takes place with third-party platforms called liquid staking platforms. Centralized exchanges such as Coinbase, Binance, and Gemini provide liquid staking services. Furthermore, decentralized finance (DeFi) applications such as Lido and Rocket Pool offer liquid staking through smart contract execution.

Delegated Validation

Under traditional staking, a user directly connects to a blockchain network and performs transaction validation. As liquid staking makes use of liquid staking providers, the staked tokens go on to form a pool along with other users. The platform operator makes use of these staked assets on their respective network and performs the validation process.

Centralization

Ideally, a blockchain runs in a decentralized fashion - by having numerous independent users provide the infrastructure. These users would be scattered around the world, mitigating single points of failure. Global users perform transaction validation and hold equal voting power. In reality, blockchain has become much more centralized. Institutions and wealthy individuals dominate the blockchain industry. Big players pool vast amounts of staked assets or invest in high-end mining equipment (staking's predecessor).

The top 10 validators on the Cosmos network

Take a look at the Cosmos network. Large centralized exchanges such as Coinbase and Binance control large amounts of staked tokens. Everstake and stake.fish, well-known staking-as-a-service companies, also own numerous digital assets.  

Pros of Liquid Staking

In traditional staking, cryptocurrency investors generate yield on their idle crypto assets.  Liquid staking takes this a step further by creating secondary markets for the staked assets. With billions of $ flowing through liquid staking platforms, liquid staking has spawned new business models.

Low Barriers to Entry

Solo staking is an expensive and technical process.  A solo staker must provide the hardware, software, and the full value of the required cryptocurrency. Hardware costs up to $1,000, while software installation requires coding and a computer background. The required staked tokens will also cost an arm and a leg. Ethereum staking (Proof of Stake) requires a deposit of 32ETH, equivalent to $64,000 in value. Lido Finance, a liquid staking protocol, does not require minimum staked tokens. Furthermore, a user can access the liquid staking service with just a smartphone or laptop. This ease of use has enabled Lido to grow to 14,000 monthly active users.

Market Opportunities

Users can deploy liquid staking derivatives to take advantage of market opportunities.   Here’s a simple example using the Binance liquid staking platform: 1.User stakes ETH and receives BETH, liquid-staked ETH on the Binance platform.

ETH Liquid Staking on Binance

The user may leave BETH in their Binance wallet and receive ETH staking rewards (also in the form of BETH). Or, a user can try to maximize their earnings by converting it to Wrapped BETH (wBETH).

  2.The user wraps BETH, turning it into wBETH.

BETH to wBETH wrapping platform on Binance

Blockchain networks such as Ethereum and BNB Smart Chain (Binance network) have varying protocols and functionalities. These different networks cannot operate with one another.

Wrapped crypto such as wBETH is pegged to the value of an original asset, in this case BETH. Note that the conversion rate is not 1:1 (more on this later). The wrapped currency can then be used on other blockchains   3.A user trades wBETH on the Binance spot markets  

WBETH/USDT spot trading on Binance

By trading wBETH, a staker would receive USDT (a stablecoin) which could be used to purchase another cryptocurrency such as Bitcoin, Solana, or Cardano. IF (note the big if), the traded cryptocurrencies outperform the wBETH/USDT pair, and then the user ends up with more USDT. 

More wBETH would then be purchased, earning staking rewards. In the end, this could be converted back to BETH, and finally ETH. 

 

Increased Yield

Stakers can transfer their wrapped tokens to an external crypto wallet, paving the way for decentralized finance uses. These DeFi protocols make use of smart contracts (self-executing code) and boost the yield of the deposited tokens.   Going back to wBETH as an example: 1.A staker transfers their wBETH from Binance to a decentralized crypto wallet such as MetaMask.

MetaMask browser plug-in login

2.The User goes to a decentralized finance protocol such as Pancake Swap and connects their wallet.

Pancake Swap wallet connect options

3.The staker deposits into a wBETH liquidity pool.A liquidity pool facilitates transactions on a decentralized exchange (DEX). Pancake Swap also operates a DEX. With the liquidity provided, users can trade on the DEX without relying on middlemen. Users who deposit into the pool earn rewards.

wBETH-ETH Liquidity Pool on Pancake Swap

Cons of Liquid Staking

Liquid staking sounds very enticing. A user can increase their rewards versus traditional staking.   Like any investment method, risk accompanies rewards. Make sure to study the cons of liquid staking before proceeding to commit capital.

Risk of Impermanent Loss

Impermanent loss takes place when the token price changes negatively, affecting the value of a user’s share in a liquidity pool.   Take for example a liquidity pool consisting of wBETH and Solana (SOL), where 1 wBETH = 100 SOL at the time of deposit: 1. The liquidity pool is programmed to keep the value of wBETH/SOL 1:1. If there is $10,000 of wBETH, then there should be $10,000 of SOL. 2 . A user deposits 10 wBETH and 10,000 SOL. The pool size totals 100 wBETH and 100,000 SOL, therefore the user owns 10% of the pool. 3. 60 days later, the price of SOL has quadrupled while wBETH has remained the same. Now 1wBETH = 25 SOL. 4. As the pool has yet to reflect the new value of the tokens, traders move in to buy wBETH at a discount. 5. The pool is finally balanced with 100 wBETH and 25,000 SOL. 6. The user withdraws the 10% share of the pool, receiving 10 wBETH and 2,500 SOL.  7. The realized loss comes out at 7,500 SOL (assuming no fees were earned).   The risk is called impermanent because the ratio of tokens in the pool can recover. However, token prices can be quite volatile. There’s no guarantee that the ratio will return to its previous state.   To mitigate the risk of impermanent loss, utilize less volatile token pairings such as stablecoin pairings. The prices of such tokens move proportionally to one another.

Security Risks

Unfortunately, many malicious actors have targeted DeFi applications and liquid staking services. These attackers swoop in to drain the liquidity and tokens from the platform. In a recent case, Raft Finance lost $3.3 Million in ETH after an attacker drained 1,577 ETH from the platform. Raft Finance offers yield on stETH, Lido’s liquid staking token. Users earn R stablecoin (Raft Finance’s stablecoin) in rewards.   In some attacks, users may not get their crypto refunded by the platform.

Technological Risks

While liquid staking protocols offer potentially higher returns, technological flaws could lead to financial losses. In June 2021, liquid staking platform StakeHound filed a case against crypto custody company Fireblocks. The lawsuit detailed how Fireblocks lost the keys to $70 million of StakeHound’s cryptocurrency. Fireblocks explained how StakeHound’s staking generated keys that were not supported by the former’s infrastructure. Other times, projects make a mistake in the code and lock out themselves and their customers from accessing their funds.  In addition, crypto stakers must be wary of projects with low liquidity.  Newer platforms have limitations on how quickly one can access the staked assets or convert them to other forms of cryptocurrency. Illiquid markets make it challenging to exit positions when needed.

Liquid Staking Statistics

Lido Finance emerged as the first liquid staking service in December 2020. Since then, numerous liquid staking providers have risen to serve users. Other large players include Rocket Pool, Binance, and Frax.    The industry now accounts for 37% of the total value locked in the decentralized finance space. Other statistics similarly attest to the strength of the industry.

Percentage of Total Crypto Assets Currently Staked in Liquid Form.

Liquid staking displays huge growth potential. An estimated $27 Billion is deposited in liquid staking protocols.    This accounts for just 2% of the entire crypto market capitalization!

Growth Rate of Liquid Staking Platforms in the Past Year.

Liquid staking has steadily grown over the past two years.

Lido Finance staked ETH, DefiLlama

Lido Finance has recovered users since the Terra Luna debacle last May 2022.    Staked ETH has doubled to 9.0 million from 4.3 million. Meanwhile, 2nd largest player Rocket Pool performed even better, doing a 5x in terms of staked ETH from 220 thousand to over 1.0 million.

What are the Current Trends and Developments in the Field of Liquid Staking?

In September 2023, famous investor Cathie Wood’s ARK Invest filed for the first spot ETH exchange-traded fund (ETF). Approval of such a fund would open the doors for institutional investors to invest in ETH.   Furthermore, this would open the floodgates for institutional investors to chase yield via liquid staking.   One can only imagine how decentralized finance and liquid staking would grow if big investment funds participated.  

Is it Worth it to Take the Risk at Liquid Staking?

Liquid staking allows investors to maximize the yield on their staked assets. However, the cryptocurrency industry remains nascent and has many risks.   Make sure to assess the risks of the liquid staking platforms, the underlying promise and volatility of the staked tokens, and the organizations behind the services.  

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