What Is Liquid Staking and How Does It Work? I Notum
May 26, 20238 min read
Staking in the world of cryptocurrencies is a fairly popular way to earn passive income and ensure the safety of the network. Crypto investors who do not use their assets can earn interest by providing their assets for a certain period. However, the disadvantage of this method is that for the duration of staking, the funds are locked and cannot be used.
Liquid staking not only solved this problem but also provided several innovative solutions related to liquidity and security. The opportunities of Decentralized Finance led to the widespread adoption of liquid staking back in 2022, and as of 2023, its popularity is only growing. Today we will talk in more detail about what liquid staking is, how it works, how it differs from traditional staking, and pay attention to its disadvantages and risks.
What Is Staking?
Staking is a term used in the world of cryptocurrencies, which can be described as the process of locking crypto in a protocol to receive a reward, as well as secure a network or a smart contract. Thus, if a person has free crypto assets, then staking protocols can be an excellent source of passive income. Staking is a great solution to secure the network with penalties and rewards. If you are interested in staking, then you should know that now there are a huge number of different Web 3 protocols with different parameters, crypto assets, rewards, and staking periods, so investors can choose the right asset for themselves.
However, despite the benefits of staking, it is also important to note that your funds will be locked in the protocol for a certain period, which means you will not be able to sell or trade your assets. Moreover, many protocols, such as the famous Proof-of-stake, have penalties for withdrawing funds before the end of the staking period. This is where liquid staking protocols come to the rescue, which we will talk about next.
An analog of staking can also be found in the traditional financial sector. For example, banks lend their clients' money to other clients at interest, and make money from it, which is called fractional-reserve lending. After that, banks pay part of the money earned to the client as a reward, while they take most of the money for themselves. There is a similar system in the crypto world, however, unlike the traditional banking system, crypto transactions are safe and transparent. Moreover, since DeFi protocols do not require third parties, they provide high returns and competitive interest rates.
What Is Liquid Staking (LSD)?
Liquid staking is an improved alternative to traditional staking and can be described as the process of locking funds to receive rewards with access to funds. So, while traditional PoS staking locks your assets, liquid staking keeps your funds in escrow. "Users will deposit their funds in a DeFi application escrow account and receive a tokenized version of their funds." - Academy Moralis. This type of staking continues to gain popularity as participants can stake directly on a Proof-of-stake network while still being able to transfer tokens. Liquid staking has a transferable token LST demonstrating ownership of the tokens and rewards.
An important role in liquid staking is occupied by providers, whose task is to accept user deposits. They then use these deposits for staking, after which they provide a receipt in the form of a new token. The advantage of this token is that it can not only be traded and used in DeFi protocols but also exchanged for the tokens they staked.
The emergence of liquid staking crypto is due to the existing problems that arise when staking ETH, namely unavailability and illiquidity. The new concept was aimed at making liquid assets instead of locked assets, which allows the user to withdraw their cryptocurrencies at any time without having to wait for the end of the locked period.
How Does Crypto Liquid Staking Work?
While liquid staking is similar to other staking options, it does have a few differences, such as the methods used for execution. Liquid staking protocols aim to make it easier for staking enthusiasts to earn passive income.
The protocols give users the ability to stake any amount of an asset with no minimum requirements. Moreover, they give users the ability to withdraw at any time, which is not possible with traditional staking. Liquid staking works like this: users transfer deposits to providers and receive a tokenized version of their assets as a receipt. For example, if you want to deposit, say, 10 ETH to a liquid staking service, you will receive a tokenized asset of 10 stETH. However, why do you need "st" in liquid staking?
The advantage of liquid staking and asset tokenization working is that users can transfer these tokens out of the protocol, as well as store them elsewhere or even spend them. While traditional staking blocks funds and requests a penalty for early withdrawal of staking assets, with liquid staking you have access to various operations with your activations that do not violate the initial deposit. Another unique feature of liquid staking is the ability to earn rewards on both the initial deposit and the tokens received.
If the user wants to withdraw his initial deposit, he must return the equivalent value of the deposit, after which he will be able to access his funds. It is also important to note that depending on the liquid staking protocol, fees may apply for using the platform.
Benefits of Liquid Staking
As you know, staking has taken passive income to the next level, and liquid staking is being considered an even more profitable alternative. In addition to its portability, the liquid staking model boasts other advantages:
- Unlocked liquidity
As already mentioned, in the case of traditional staking, staked tokens on a network such as Ethereum are blocked and cannot be sold. This is not the best investment decision as the cryptocurrency is volatile and can fluctuate in value, which can also lead to losses. Moreover, users also cannot use them as collateral. With liquid staking, you not only keep access to the funds but also get a tokenized version of them. Thus, liquid staking tokens open new opportunities for investors.
- DeFi capabilities
Receipts for staked assets are in the form of tokens, which means you can use them in DeFi spaces. For example, you can use your liquid staking tokens in DeFi protocols, namely prediction markets, credit pools, and so on. Using the tokenized version for a crypto-backed loan can also be a good solution, as investors can deposit the funds received into higher-income accounts, which is a big plus for investors.
With liquid staking, you get access to more rewards than with traditional staking. Not only will you be rewarded for verifying transactions, but you will also be able to profit from various DeFi protocols.
As you know, staking has a rather complex infrastructure. For example, to become a single validator on the Ethereum network, a user must hold at least 32 ETH. Liquid staking and its providers, in turn, allow any user to share block rewards.
Drawbacks and Risks of Liquid Staking
Of course, liquid staking is not without risks, which you need to be aware of before using this option. The main ones include:
You must remember that the price of liquid staking tokens is not tied to the underlying asset they are claiming. The risk is that although assets may have the same price most of the time, liquid staking tokens may lose value during a liquidity crunch or during unexpected market events.
As already mentioned, in liquid staking, providers accept user deposits, which means you give away your assets. It can also be associated with risks if a particular provider is unreliable or is an attacker. Without a doubt, the introduction of a third party is associated with additional risks, including those associated with smart contracts and the legitimacy of the protocol.
- Other points
Among other things, the user's funds may be at risk if the node operator's private keys are compromised. Also, imperfections in Smart Contracts staking can lead to reduced security and exploits.
Popular Liquid Staking Protocols
Before moving on to the most popular liquid staking protocols, it is worth knowing what LSPs and LSTs are. LSP refers to liquid staking protocols, that is, service providers that are used to deposit funds. LST, in turn, is liquid staking tokens. Below we will introduce you to the most famous and reliable liquid staking protocols:
Lido is currently considered the best platform for liquid staking, and its total staked tokens as of May 23, 2023 is almost $12.2 billion. This platform was launched in 2020 and allows users to stake their tokens and receive rewards without having to block them. Lido originally provided liquid Ethereum staking, but has now expanded to offer you a choice of the following supported staking networks - Ethereum, Polygon, Solana, Polkadot and Kusama. "Staking rewards on Lido range from 4.8% to 15.5%. For its liquid staking services, Lido charges a 10% fee." - OKX.
Another popular liquid staking protocol on Ethereum with a total locked value of over $1.4 billion is Rocket Pool. It was launched back in 2020 and allows users to stake ETH tokens. Even though Rocket Pool only serves Ether, it offers users two use cases. They can "either stake ETH and get a tokenized version of their asset pegged as rETH or directly run a node on the Rocket Pool ecosystem." - OKX. Rewards for them are paid separately - 5.17% and 6.95% + variable RPL reward, respectively.
Liquid staking is clearly a more profitable alternative than traditional staking, which not only gives you the opportunity to access your assets at any time, but also earn additionally on the received tokens using other platforms. However, before using liquid staking, do your own research and understand the risks, as despite the many benefits, it is important to use this strategy wisely.
Disclaimer: Notum does not provide any investment, tax, legal, or accounting advice. This article is written for informational purposes only. Cryptocurrency is subject to market risk. Please do your own research and trade with caution.