What is Liquid Staking?
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Introduction to Liquid Staking
Liquid staking protocols provide a flexible solution for traders looking to stake their assets on proof-of-stake (PoS) blockchains while also participating in other decentralized finance (DeFi) activities. By issuing receipt tokens pegged 1:1 to the value of staked assets, liquid staking protocols offer a way to mitigate the illiquidity of staked assets. However, using these services does come with certain risks.
The Challenges of Traditional Staking
When the Beacon Chain launched in December 2020, it allowed ETH holders to become proof-of-stake validators on Ethereum for the first time. However, the entry barrier was high: investors needed to deposit a minimum of 32 ETH, which was worth around $18,600 at the launch and has since increased. Moreover, before the Shanghai upgrade was announced, ETH validators did not know when they could withdraw their staked ether. This uncertainty created significant risks and opportunity costs for stakers, as their ETH became illiquid.
What is Liquid Staking?
Liquid staking addresses these issues by allowing traders to stake their assets on PoS blockchains and still participate in other DeFi activities like yield farming. Here’s how it works:
- Deposit Tokens: Traders deposit their assets with a liquid staking protocol.
- Staking: The protocol stakes those assets on the investor’s behalf.
- Receipt Tokens: Investors receive a receipt token from the protocol, pegged 1:1 to the value of their deposited assets. These receipt tokens can be used on other DeFi platforms to generate additional yields or fulfill other purposes.
To withdraw staked ETH, liquid stakers can either wait until the Shanghai upgrade (Ethereum Improvement Proposal (EIP) 4895) or locate a DeFi liquidity pool that supports the staked asset and perform a swap.
Examples of Liquid Staking Protocols
Lido
Lido Finance was the first liquid staking solution, launching less than a month after the Beacon Chain went live. Lido’s native receipt token, Lido Staked ETH (stETH), holds a majority market share in liquid staking, with daily trading volumes peaking at $800 million. Lido also supports other blockchains like Solana (SOL), Polkadot (DOT), Kusama (KSM), and Polygon (MATIC).
Rocket Pool
Rocket Pool is a significant competitor to Lido, debuting about a year later. Rocket Pool supports Ethereum exclusively and has seen daily trading volumes for its native token, Rocket Pool ETH (rETH), peak at $20 million.
Differences Between Liquid Staking and Traditional Staking
Understanding the differences between liquid staking and traditional staking is crucial. Here are the three main avenues for staking crypto assets, excluding liquid staking:
Solo Staking
Solo staking is for those with the technical expertise to run their own validator node. Solo stakers keep 100% of their rewards and self-custody their assets but must maintain their equipment and uptime to avoid slashing penalties.
Staking as a Service (SaaS)
This involves a third party running the validator node equipment on behalf of the investor, who maintains custody over their crypto wallet. A fixed fee or percentage of rewards is paid for these services.
Centralized Exchanges
Many centralized exchanges operate staking services, aggregating customer deposits to form staking pools. This option allows more people to stake with low minimums but requires trusting a third party with your assets and adhering to set staking periods.
Key Differences in Liquid Staking
- Liquidity: Liquid staking protocols issue receipt tokens pegged to the value of deposited assets. For example, depositing 4 ETH into Lido gives you an equivalent amount of stETH tokens. These tokens maintain liquidity, allowing swaps for ETH at any time using a DeFi liquidity pool.
- Rewards: Investors can stake receipt tokens to earn additional yield on top of their ETH staking rewards, offering compounded yields.
- Risks: Liquid staking protocols carry risks similar to other DeFi lending protocols, including rug pulls, smart contract risks, impermanent loss from yield farming, and the potential de-pegging of receipt tokens from their base assets.
Risks of Liquid Staking
Liquid staking entails risks associated with both staking and DeFi protocols:
- Slashing Penalties: Validators failing to maintain uptime can face penalties.
- Smart Contract Risks: Vulnerabilities in smart contracts can be exploited.
- De-Pegging: Receipt tokens may lose parity with their base assets, especially during market instability, as seen during the Terra/Luna collapse.
Conclusion
Liquid staking protocols offer a powerful tool for improving capital efficiency, especially for blockchains with mandatory lock-up periods. However, the technology is still evolving, and users must be aware of the associated risks. By understanding how liquid staking works and the potential pitfalls, investors can make informed decisions to optimize their staking strategies.