Liquid staking refers to a process that enables staked assets like cryptocurrency to become more liquid and tradable. In proof-of-stake (PoS) blockchains, users can stake their coins to help validate transactions and secure the network in exchange for rewards. However, these staked assets are typically locked up and illiquid during the staking period. Liquid staking aims to unlock the liquidity of staked assets without compromising the security of the blockchain network.
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How Does Liquid Staking Work?
There are a few different technical approaches to enabling liquid staking, but the general mechanism involves depositing staked assets into a smart contract system that mints derivative tokens to represent the staked assets. These derivative tokens can then be freely traded and transferred while the original assets remain staked.
Some key players in liquid staking include:
- Stakers: Individuals and entities that stake their crypto assets in order to help validate proofs and secure the blockchain network. Stakers can deposit their staked assets into liquid staking protocols to receive liquid derivative tokens in return.
- Validators: Nodes that are responsible for validating transactions and producing new blocks. Validators need to have enough staked assets delegated to them to fulfill their duties. With liquid staking, validators can accept derivative token deposits instead of the actual staked asset.
- Liquid Staking Providers: These are platforms and protocols that custody staked assets and facilitate the minting and trading of liquid staking derivative tokens. Some providers include Lido, Stafi, Ankr, and others.
- Liquid Staking Derivative Tokens: These tokens represent claims on the underlying staked assets. They can be freely transacted while the staked assets remain locked. Examples include Lido’s stETH, Ankr’s aETH, etc.
There are two primary approaches to enabling liquid staking derivatives:
1. Tokenized IOUs
This method involves issuing tokenize IOU notes that represent claims on the underlying staked assets. For example, a user can deposit 1000 ETH into a liquid staking protocol and receive 1000 iouETH in return. The iouETH tokens are ERC20 tokens that can be traded and transferred just like any other cryptocurrency. At any point, the user can redeem their iouETH for the underlying ETH.
Validator nodes accept deposits in iouETH rather than ETH, but they still maintain control of the actual staked ETH assets. This model is used by protocols like Lido, Ankr, and StaFi.
2. Synthetic Assets
Synthetic asset models use on-chain collateral and smart contracts to mint derivative tokens that synthetically track the value of staked assets. There is no actual ETH being deposited or held in custody. Instead, ETH is used as collateral in a smart contract that mints “ETH synths” – ERC20 tokens that mirror the price of ETH.
Synthetic models allow for trading and transferring liquidity without having to custody the underlying assets. However, they require complex smart contract systems and on-chain collateral. Synthetix and Kava are examples of protocols using a synthetic asset approach.
Benefits of Liquid Staking
Liquid staking solutions offer several advantages, including:
- Liquidity – The main benefit is that stakers can regain the liquidity of their assets without unstaking. This allows them to sell, send, or use their staked tokens in DeFi without interrupting the staking process.
- Capital efficiency – Stakers can put their capital to work earning staking rewards and interest in DeFi simultaneously rather than locking assets in one or the other. Liquid staking derivatives enable capital stacking.
- Yield opportunities – By utilizing liquid staking derivatives, users can take advantage of yield farming opportunities to earn additional rewards. Liquid staking tokens can be further deposited into yield generating protocols.
- Staking participation – Liquid staking lowers barriers to participation in staking. Users don’t have to lock up assets or meet minimum staking amounts. They can buy liquid staking derivative tokens of any amount.
- Validators benefit – Validators need large amounts of staked assets delegated to them to operate correctly. Liquid staking means they can accept derivative token deposits, making it easier to attract delegations.
- Decentralization – By opening staking participation, liquid staking helps decentralize validation across more validator nodes compared to concentration among whales.
- DeFi composability – Allowing staked assets into DeFi expands composability and unlocks new potential applications merging staking and DeFi.
Risks and Drawbacks
However, liquid staking also comes with some downsides and risks to consider:
- Impermanent loss – The value of liquid staking derivatives may deviate from the underlying staked asset value due to volatility. Users are exposed to impermanent loss.
- Trust assumptions – Users must trust the protocols issuing and honoring the derivative token representations of staked assets. Protocols must hold and manage staked assets properly.
- Validator centralization – While lowering barriers to staking participation, liquid staking providers become somewhat centralized intermediaries. They may accumulate control over pooled assets.
- Regulatory uncertainty – The regulatory status of staking derivatives is still undefined in many jurisdictions. Changing regulations could impact liquid staking protocols.
- Smart contract risks – Bugs or exploits in liquid staking smart contracts pose risk of loss of funds. Complex synthetic derivative models compound this risk.
- Dilution concerns – Some liquid staking derivatives are not redeemable 1:1 for the underlying asset. This can lead to dilution as more derivatives get issued.
Criticisms of Liquid Staking
Liquid staking has been met with some skepticism and criticism from purists:
- Goes against ethos of staking – The volatility and speculative nature of liquid staking derivatives contradicts the purpose of staking as a long-term commitment to securing a network.
- Increases centralization – Critics argue concentration of staked assets into large liquid staking providers defeats the purpose of decentralizing validation.
- Obfuscates risks – Allowing lay users to freely trade staking derivatives hides the risks and lock up period of actual staking from them.
- Unproven security – Long term security tradeoffs are theoretical until liquid staking mechanisms withstand the test of time and real world attacks.
- Regulatory arbitrage – Detaching and freely trading liquidity from staked assets skirts regulations that would otherwise apply to securities like staking derivatives.
Despite criticisms, liquid staking continues gaining adoption among users who prioritize accessibility and liquidity over purist ideology. The technology and mechanisms are rapidly evolving to mitigate risks and improve decentralization. Regulatory direction remains a key uncertainty in how liquid staking will ultimately fit into the broader blockchain ecosystem.
Also Read: What are Blockchain Rollups
Liquid Staking in Action: Case Studies
Liquid staking is in varying stages of development across different blockchains. Here are some examples of how it is being implemented:
Ethereum
Several protocols are working to launch forms of liquid staking for Ethereum in anticipation of its transition to proof-of-stake consensus:
- Lido – The largest liquid staking provider on Ethereum, Lido allows stETH token holders to stake ETH while retaining liquidity. stETH trades on major exchanges like Coinbase and Binance.
- Ankr – Ankr’s liquid staking protocol mints aETH tokens that users can redeem 1:1 for ETH or use across DeFi apps to earn yield.
- Stafi – Stafi issues liquid derivative tokens called rETH that represent a claim on staked ETH. rETH can be used across various DeFi platforms.
- Rocket Pool – Rocket Pool takes a decentralized approach to liquid staking using smart nodes and rETH tokens that can be redeemed for ETH by node operators.
Terra
The Terra blockchain has native support for liquid staking of its LUNA token via the Bond and Unbonding periods:
- LUNA can be bonded to validators instantly, making the bonded assets liquid.
- There is an unbonding period when undelegating bonded LUNA during which undelegated tokens vest over time.
- Terra proposals are exploring ways to further enhance liquidity and flexibility for stakers like allowing instant unbonding.
Solana
Solana uniquely uses a Proof of History consensus that does not require users to lock up stake. All SOL tokens remain liquid by default. Validators only stake lamports rather than full SOL tokens. Users can delegate lamports to validators without reducing their SOL liquidity.
Polkadot
As an early adopter of staking and liquidity, Polkadot facilitates liquid DOT tokens in multiple ways:
- Ledger and custody staking – DOT holders can stake from ledgers and custodial wallets without giving up liquidity.
- Unbonding – Unbonding DOT takes just 28 days on Polkadot compared to up to 90 days on other chains.
Cardano
Cardano takes a native approach to liquid staking through its Ouroboros proof-of-stake consensus protocol and delegation mechanism:
- No lock-up period – ADA can be delegated to stake pools at any time without locking assets for an extended period.
- Instant rewards – Staking rewards are distributed instantly and remain liquid rather than subject to unbonding delays.
- Decentralized staking – Cardano allows direct staking delegation between users and validators without intermediaries, enhancing decentralization.
- Native liquidity – Ouroboros and minimal slashing penalties incentivize keeping assets liquid rather than locked for security unlike other chains.
Algorand
Algorand utilizes a unique “participation node” model that separates block proposal from validation and enables liquid staking:
- Off-chain voting – Consensus voting takes place off-chain so staked ALGO never have to be locked on-chain.
- No unbonding – ALGO can be unstaked instantly with no delays. Rewards are delivered immediately when unstaking.
- Permissionless participation – Anyone can run a participation node without minimum staking requirements and earn rewards.
- Weighted voting – Consensus voting is weighted based on participation node account balances so stakes remain liquid.
The Future of Liquid Staking
Liquid staking is still an emerging concept that will likely evolve as blockchain technology matures. Some potential developments include:
- Widespread adoption across all major PoS chains like ETH, Solana, Polkadot, etc.
- Liquid governance through tradable tokenized votes enabling on-chain governance processes while retaining user liquidity.
- Interoperability between liquid staking derivatives across diverse blockchains and ecosystems.
- Secondary markets and financial products built on liquid staking assets such as options, derivatives, leveraged tokens.
- Stricter regulations by agencies like the SEC to define boundaries for staking derivatives and custodianship.
- Decentralization enhancements like trustless protocols and pooled validation models to mitigate centralized intermediary risks.
- Fee optimizations like meta-transaction support and zkRollups to improve cost efficiency of transacting liquid staking derivatives on layer 1 chains.
- Enhanced liquidity and convertibility between staking derivatives and underlying staked assets to minimize basis risk and deviation.
As liquid staking continues evolving, it has the potential to fundamentally reshape incentives and participation in blockchain consensus while retaining the core benefits of staking for security. Widespread adoption could lead to fairer and more decentralized network validation compared to the risks of centralized staking services or exchange custodianship dominating the landscape. However, regulatory uncertainty and technology risks remain challenges to overcome. Overall, liquid staking represents an important infrastructure layer that broadens access and composability between staking and DeFi.
Liquid Staking Terminology
| Term | Definition |
|---|---|
| Liquid staking | The process of enabling staked assets like cryptocurrency to become more liquid and tradable through derivative tokens |
| Proof of stake (PoS) | A blockchain consensus mechanism that requires users to stake assets in order to validate transactions and produce blocks |
| Staking derivatives | Tokens that represent claims on staked assets without giving up ownership of the assets e.g. Lido’s stETH |
| Staking rewards | Cryptocurrency rewards distributed to stakers that help validate proofs and secure the network |
| Slashing | Punishments like burning or confiscating staked assets for malicious staker behavior |
| Unbonding period | The required lockup period when assets are staked before they can be withdrawn again |
| Impermanent loss | When the value of a liquid staking derivative deviates from the underlying staked asset due to volatility |
| Basis risk | The risk that the value of a derivative staking token detaches from the underlying staked asset value |
| Delegation | The process where stakers assign their assets to validator nodes to participate in securing a PoS network |
Conclusion
Liquid staking opens up staked cryptocurrencies to freely trade while still securing the network. Despite criticisms, it promises to enhance capital efficiency, decentralization, and DeFi composability. Technical and regulatory challenges remain as liquid staking mechanisms evolve. Widespread adoption could fundamentally expand access and participation in blockchain validation, although centralized provider risks persist. Overall, liquid staking helps unlock the vast liquidity in staked assets to boost staking yields, DeFi usability, and user adoption.
Raksha, a seasoned journalist, specializes in crafting insightful narratives on blockchain and AI developments. With a keen eye for innovation, she distills complex topics into accessible stories, providing readers with a clear understanding of the dynamic intersection between these transformative technologies.
