The world of DeFi is continually developing and evolving. New technologies and innovative approaches challenge the traditional financial model and its products. Liquid Staking is one of their numbers.
Even though liquid staking has existed since 2020, it gained special interest and popularity after the Shanghai update on the Ethereum network.
Let's have a look at what liquid staking derivatives is and how the Shanghai update influenced the rapid development of this narrative.
Initially, Ethereum ran on the Proof-of-Work (PoW) consensus algorithm. At the same time, the transition to Proof-of-Stake (PoS) was planned for a long time. But given that this process was very difficult to implement, it was carried out in several stages:
In December 2020, Ethereum started working on two parallel blockchains: the old one - Ethereum Mainnet, running on PoW, and the new one - Beacon Chain, running on PoS;
On September 15, 2022, an update called “The Merge” took place, which combined the Ethereum Mainnet and Beacon Chain into one single blockchain running on the PoS consensus algorithm;
On April 13, 2023, the Shanghai update took place, which allowed validators to withdraw previously locked ETH for staking.
To become a validator on the Ethereum network, you need to lock 32 ETH into the smart contract of the network to activate the validator software. 32 ETH (at the current rate of $60,000) — creates a fairly significant financial entry threshold for staking. Against this background, staking pools began to appear, which are collective staking. Separate third-party services, both custodial and non-custodial, began to offer users to join and jointly deposit the 32 ETH required to activate the validator. The logic is as follows: the user deposits part of the ETH, in return receives a tokenized version of the staked ETH in a ratio of 1:1.
Liquid staking has some obvious benefits, such as a user may get staking rewards without a liquidity freeze. An individual can use the received derivatives for participation in the DeFi ecosystem by trading, lending, providing liquidity for DEX pools, etc. Besides, liquid staking significantly lowers the 32 ETH entry threshold for ETH staking and is therefore accessible to most retail investors.
Let’s have a look at ETH locked through liquid staking providers’ dynamics:
To date, 9.5 million ETH or 7.9% of the total ETH circulating supply has been locked up through liquid staking providers. And the share of liquid staking in the volume of all staked ETH is 43.4%.
The liquid staking market is currently represented by the following players:
Each of these services has its level of centralization - ranging from fully centralized solutions (Coinbase, Binance, etc.) to fully decentralized ones (Rocket Pool).
Here is the table with a comparative analysis of the main liquid staking providers:
LSD-tokens could be dividied into the following types:
With this type of LSD - staking rewards are credited in the form of tokens to holders' wallets. stETH (by Lido Finance) and sETH2 (by Stakewise) are examples of Rebase LSDs.
Here’s an example with Lido to look at how it functions in practice. So, a user connects his wallet to the Lido Finance protocol and stakes ETH, in return he receives an equivalent amount of stETH. Staked ETH is credited with rewards, which are credited in the form of stETH to the user's wallet. Thus, the balance of stETH will constantly increase (today 1 stETH, in half a year - 1.03 stETH).
Unlike Rebase tokens, this type of LSD does not add any extra tokens to the user’s balance. Instead, the LSD token increases in its value as staking rewards are added.
The majority of liquid staking providers run upon a reward-bearing model.
Let’s take Rocket Pool as an example of how it works in a real case: after ETH has been exchanged for rETH, the user automatically starts receiving staking rewards. For example, a user staked 10 ETH and received 10 rETH in return.
Let's deduce that in a few years, the balances of the validators in the Beacon Chain grew due to the validators’ rewards. For example, 128 ETH was staked through the Rocket Pool, and after the reward, the total balance of all validators was 160 ETH. Then, 1 ETH will cost (128/160) = 0.8 rETH, and vice versa, 1 rETH = 1.25 ETH (160/128). When exchanging 10 rETH, the user will receive 12.5 ETH in return.
Base tokens & reward tokens
Projects using the following model have 2 tokens: one of them is pegged 1 to 1 with ETH, and the second one is for rewards. Here’s an example:
- Frax: base (frxETH) and reward (sfrxETH);
- Stakewise: base (sETH2) and reward (rETH2).
Let's take a closer look at two key liquid staking projects to date:
Lido Finance Case
Lido Finance offers liquid staking solutions within Ethereum, Polygon, Kusama, Solana, Polkadot, and Terra networks. The project has launched in 2020.
When stake ETH through Lido, users are given stETH, a 1:1 representation of staked ETH. stETH tokens are minted when a user deposits and burns once they’re paid off. stETH - combines the locked ETH amount, as well as the staking rewards. The balance of stETH tokens updates daily, and the mechanism that updates the balances is called “rebase”. Thus, every day the balance of stETH within the wallet will increase due to the latest APR.
With stETH, staking bonuses are awarded regardless of where the token was purchased. It does not matter if the user bought stETH directly from the Lido Finance platform, through Curve, or simply received a transfer from a friend — in all these situations, the reward for staking will be daily awarded.
It’s worth noting, that stETH is a rebase token. A distinctive feature of rebase tokens is that not all DeFi protocols allow you to receive rewards for this type of token.
For instance, if you stake stETH on Curve or Yearn Finance, you will also continue to receive staking rewards. However, such protocols as Uniswap, 1inch, and SushiSwap are not suitable for rebase tokens, and that leads to staking rewards loss when you provide stETH as liquidity within the above-mentioned platforms.
The solution to this problem is the wrapped version of stETH - wstETH, Wrapped stETH. By wrapping stETH into wstETH, you can easily deposit staked ETH to any DeFi protocol without losing staking rewards.
Lido Finance works on DAO principles and that’s why has its governance token — $LDO. The DAO makes decisions such as choosing node operators and setting protocol parameters.
Rocket Pool Case
Rocket Pool is the second most popular liquid staking protocol on Ethereum. Rocket Pool is designed to meet two main groups of users’ demands:
1. those who want to participate in tokenized liquid staking using rETH;
2. those who want to run a node on their own to become a validator on Ethereum:
1. Tokenized Liquid Staking
Just like in the Lido case above — when depositing ETH to Rocket Pool, users receive a tokenized representation of the staked ETH - rETH. However, unlike stETH from Lido, rETH is not a rebase token, i.e. it is fully integrated into the existing DeFi ecosystem from the outset, with no loss in staking rewards.
Once ETH has been exchanged for rETH, the user automatically receives staking rewards. For example, a user staked 10 ETH and received 10 rETH in return. Let's assume that in a few years, the balances of the validators in the Beacon Chain grew because of the rewards of the validators. Let's say 128 ETH was staked through the Rocket Pool, and after the reward was received, the sum of the balances of all validators was 160 ETH. Then, 1 ETH will cost (128/160) = 0.8 rETH, and vice versa, 1 rETH = 1.25 ETH (160/128). When exchanging 10 rETH, the user will receive 12.5 ETH in return.
2. Running Rocket Pool Nodes
Rocket Pool allows users to run full-fledged nodes without charging protocol maintenance fees. It takes only 16 ETH to run a node, and then the remaining 16 ETH protocol will add from funds contributed by users.
Rocket Pool has a flat rate of 15%, allowing the node operator to receive a percentage of the rewards earned on those 16 ETH assigned by the protocol. This means that node operators are rewarded for their deposit of 16 ETH and a fee from the network for staking their ETH.
When depositing ETH, node operators must also deposit a minimum amount of $RPL, the platform’s native token, as collateral in case they are fined by the protocol. Currently, the minimum collateral is 10% of the ETH’s value and the maximum is 150%.
Rocket Pool is a completely non-custodial, trustless Ethereum staking protocol.
Liquid Staking Risks
It is important to take into account the risks connected to liquid staking. Below are some of the potential drawbacks of platforms offering liquid staking opportunities:
Slashing risk: Validators are penalized for failing to reach certain staking parameters (e.g. going offline). LSD holders are at risk of being slashed by validators;
LSD price risks: the prices of LSD tokens may change in price and differ from the price of the underlying asset under the influence of market conditions. This can lead to price volatility and potential liquidation risks when they are used as collateral;
Smart contracts risks: each smart contract that the user interacts with creates additional risks;
Third-party risks: some projects may use other dApps (e.g. yield strategies). In such cases, users are exposed to additional counterparty risks.
The Shanghai update, which allowed the withdrawal of locked-up ETH, served as the basis for the development of a fundamentally new liquid staking primitive.
Liquid Staking opens up and broadens the possibility of using LSD tokens within the DeFi ecosystem and has several advantages, such as becoming eligible for staking rewards without freezing liquidity.
You, as an investor, can use the received derivatives for trading, lending, providing liquidity for DEX pools, etc. On top of that, liquid staking lowers the 32 ETH entry threshold for ETH staking and is therefore accessible to most retail investors.
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.Liquid Staking (LSD): Decoded by Notum Research