The Proof of Stake (PoS) consensus mechanism secures the vast majority of modern blockchains. In Proof of Stake, a token holder can lock up their tokens and use them to verify the authenticity of transactions. In return, the token owner receives a yield roughly similar to that of a bond. However, unlike a bond, as long as the tokens are staked, they cannot be traded, exchanged, or used as collateral—they are illiquid.
Understanding Staking Basics
In the traditional financial sector, banks offer returns to customers for storing their hard-earned money. They lend out their clients' funds to make a profit through a process called fractional reserve lending. The banks then pay their customers a small percentage in return while keeping the majority for themselves.
A similar process occurs in the cryptocurrency industry. However, unlike the opaque operations of the current financial system, cryptocurrency transactions are transparent and public on the blockchain. Moreover, without profit-driven third-party intermediary companies, DeFi protocols are known for their attractive yields and competitive interest rates.
Staking is a financial term specific to the cryptocurrency industry. It describes the process of locking up crypto assets in a protocol to earn rewards in return. As such, crypto staking can be an excellent way to earn passive income by putting otherwise idle assets to work. Additionally, staking allows users to participate in securing the network by locking their tokens.
There are hundreds of different staking protocols implementing various parameters, including support for different assets, the duration tokens are staked, and the rewards offered. Staking is ideal for investors who are certain they will not need to access their funds for a while, as the funds are locked once they are staked.
Therefore, one of the major problems with traditional staking is not being able to access the funds for a certain period. After locking funds in a staking protocol, you cannot trade, sell, or transfer those assets.
Consequently, Liquid Staking protocols have emerged to counter some of these obstacles.
What is Liquid Staking?
Liquid staking, sometimes called soft staking, is a variation of classic PoS staking. Instead of just locking a token and not being able to use it, you receive a synthetic version of the token you deposited (a liquid staking token or derivative token). Essentially, your funds will do the same thing as before—they will provide you with a yield—but you will also be able to use them elsewhere.
Furthermore, with liquid staking, you can add and remove funds at will (usually with a reduced APR). Liquid staking offers the best of both worlds: passive income and access to your staked funds.
Thanks to liquid staking, investors can earn income on idle assets while simultaneously earning additional rewards on the tokenized value of the staked funds in other DeFi protocols. According to Blockdaemon, $7.5 billion worth of ETH, representing 20% of the total share of ETH staked in ETH 2.0 contracts, is held in liquid staking protocols.
Key Advantages of Liquid Staking
The most obvious advantage of liquid staking is immediate liquidity. The exact scale of this advantage depends on the blockchain and the token you are using.
Note, however, that the immediate liquidity of a liquid staking token comes at the cost of overall reduced liquidity.
Take the native token of the Ethereum blockchain, ETH, as an example. At the time of writing, it has been traded for approximately $8 billion in volume over the last 24 hours. In contrast, the largest ETH liquid staking token, stETH, was traded for $280,000 in volume over the same period. The liquidity is clearly not the same, and you must account for this depending on the size of your positions.
An additional advantage of liquid staking is the composability of the yield strategies it enables. Liquid staking tokens can be used as collateral on centralized exchanges (CEX), decentralized exchanges (DEX), or in lending pools. For example, a staker can lend their liquid staking token and receive interest from the loan in addition to the base staking yield. Users don't have to choose between staking or providing liquidity in an AMM (Automated Market Maker), a lending protocol, etc. They can do both!
Since derivative tokens can be immediately swapped for their underlying staked assets, users do not have to wait for the end of an "unbonding period" to withdraw their tokens.
Furthermore, diversifying across multiple validators minimizes exposure and acts as insurance against the poor performance of individual validator nodes. With liquid staking, you can delegate your tokens to a multitude of validators rather than just one.
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Popular Liquid Staking Platforms and Supported Tokens
According to DefiLlama.com, there is currently roughly $7 billion in liquid staking protocols across numerous blockchains. Here is a non-exhaustive list of some of the most popular liquid staking tokens:
- Ethereum: ETH → stETH
- Polygon: MATIC → stMATIC
- Solana: SOL → stSOL
- Binance Smart Chain: BNB → aBNBc
- Avalanche: AVAX → aAVAXc
- Kusama: KSM → stKSM
- Polkadot: DOT → stDOT
With approximately $5 billion in total value locked (TVL), Lido Finance currently represents over 70% of the liquid staking market, a large majority of which comes from their Ethereum pool.
Final Thoughts on Liquid Staking
The cryptocurrency industry is known for creatively producing ways to generate passive income with unused assets. The concept of staking is essential to the security and operations of Proof of Stake (PoS) consensus models in many crypto projects. As such, it is very common for savvy crypto investors to put their assets to work by locking funds and earning rewards in return.
Liquid staking takes this a step further. Investors can earn passive income on idle assets while maintaining liquid access to the value of their initial funds. Moreover, liquid staking solves most of the challenges posed by traditional staking.
In conclusion, these liquid staking protocols are at the forefront of the next evolution of the staking economy.
Frequently Asked Questions
What is the main difference between traditional staking and liquid staking?
The core difference is liquidity. Traditional staking locks your assets, making them illiquid and unusable for the staking period. Liquid staking issues you a derivative token representing your staked assets, which you can freely trade, sell, or use in other DeFi applications while still earning staking rewards.
Are liquid staking tokens as valuable as the original assets?
Liquid staking tokens are designed to be pegged 1:1 to the value of the underlying staked asset. They can typically be redeemed for the original asset. However, their market liquidity on exchanges might be lower, which could lead to slight price deviations, especially for large trades.
What are the risks associated with liquid staking?
Key risks include smart contract vulnerabilities in the staking protocol, potential de-pegging of the derivative token from its underlying asset, and lower liquidity for the derivative tokens compared to the native assets. It's also crucial to assess the security and reputation of the validators used by the protocol.
Can I use my liquid staking tokens in other DeFi protocols?
Yes, that is a primary advantage. You can use liquid staking tokens as collateral for loans on lending platforms, provide liquidity in Automated Market Maker (AMM) pools, or utilize them in various other yield-generating strategies within the DeFi ecosystem.
Is liquid staking available on all blockchains?
No, liquid staking is primarily available on blockchains that use a Proof of Stake (PoS) or similar consensus mechanism. Its availability and maturity vary significantly from one blockchain network to another.
How do I choose a liquid staking provider?
Consider factors like the provider's total value locked (TVL), its security audit history, the reputation of its chosen validators, the fees it charges, the liquidity of the derivative token it issues, and the overall user experience of the platform.