Liquid Staking

Generate yield by validating blockchains

Sep 07, 2022
Proof-of-Stake blockchains enable coin holders to participate in producing blocks for such blockchains. A set of factors determined by the protocol elects a node, whose job is then to verify the validity of the transactions in the block, sign it and propose it for validation in the network. Validating these blockchains is not without rewards. “Staking” is a financial term specific to the cryptocurrency industry. It is the process of locking up crypto assets in a protocol to earn rewards in return for validating transactions and blocks. As such, staking cryptocurrencies can be a great way to earn a passive income by putting idle assets to work.

Different forms of staking

Staking is a popular, yet conservative way, where users leverage their crypto investments into Layer-1 blockchains such as Ethereum, Cardano, BNB, Avalanche and the like to earn yield on their idle digital assets. Since its inception, it attracted interest from retail and institutional investors for the relative high yield you can generate with small additional downside. Smart-contract and blockchain risks are always present, but other than those factors, little other elements of risk exist.

Delegated staking

Staking, while being easier than mining in a Proof-of-Work protocol, still requires expertise. It is important to have no down time, run the right version, have good hardware, and other complications. These hurdles have spawned delegated staking, where the user gives away control of their coins to a centralized party that stakes it for them and takes a service fee. Major centralized exchanges such as Kraken, Binance, Coinbase, Gemini, and more, have added this service to their offering with many participants signing up. Currently, Coinbase, Kraken, Binance and Bitcoin Suisse produce 14%, 8%, 6.5%, 2% of Ethereum Proof-of-Stake blocks.

Liquid staking

Attracting huge amounts of capital in different Proof-of-Stake networks bolsters the security of these chains in their pursuit to earn the validator rewards. However, it also silos away staked assets from Decentralized Finance and gives a limited utility to staked assets. This is in stark contrast with the high amount of composability in the crypto ecosystem where building blocks are used to build more and more interesting protocols and applications with the financial opportunities that follow.
Liquid staking, sometimes known as “soft staking,” is the process of locking up funds to earn rewards while still having access to the funds. Unlike proof-of-stake (PoS) staking that “locks” funds up in a protocol, liquid staking funds remain accessible in an escrow. Users will deposit their funds in a DeFi application built on top of a Layer-1 blockchain, and receive a tokenized version of their funds. As such, the delegator can validate the blockchains and the user has a liquid token that represents their share of the validation. Since their inception, liquid staking variants on many blockchains have been hugely popular, with Lido being the clear market leader, now validating 31% of the Ethereum blocks.

Benefits of liquid staking

Liquid staking has several benefits over normal staking or delegated staking. Increased composability by unsiloing staked assets means more liquidity in the DeFi ecosystem and more avenues to potentially earn yield. This essentially means that you can achieve higher capital efficiency with the same amount of capital when opting for liquid staking over normal staking.
The accessibility of staking to the masses increases further as well. Anybody with a cryptocurrency wallet for a certain Layer-1 blockchain can access staking from their own blockchain wallet instead of via a middleman custodian while simultaneously giving quicker access to your funds if you need to. Many Proof-of-Stake blockchains take 7 days to unbond your assets and dissolve your validator. This is unnecessary with liquid staking protocols because users on secondary markets can trade their vanilla token for the staked version, giving the users that want to use a staking protocol what they want, while also making the unbonding instant for the staked users that wants to unstake.

Downsides of liquid staking

Both Delegated staking and liquid staking have downsides as well. The biggest one is on a macro level and has to do with the blockchain trilemma. Liquid and delegated staking offers more security since it becomes more accessible to stake. However, this is traded in by a lower amount of decentralization since the pooling of stakes means that the Nakamoto Coefficient goes down. Currently, just three staking protocols need to collude to take control of the Ethereum Network by having more than 50% of the block producing. This is a clear risk that Liquid Staking brings to the forefront and will need to be dealt with adequately.
Finally, while a higher capital efficiency is desired, using a receipt of your staked asset as an underlying token in other DeFi protocols stack risks. A clear example of this is the LUNA situation, where certain protocols used the staked LUNA asset in their DeFI protocol, resulting in alot of unexpected problems when the LUNA blockchain halted. Another example of this problem is that secondary markets only ‘soft peg’ the staked asset next to the unstaked asset, meaning that in the long term your staked asset can be redeemed for the unstaked one, but it is not guaranteed. This can lead to differences in the price between the Staked Asset and the Unstaked Asset, reportedly one of the biggest oversights of Celsius, that led to liquidity issues.
While there are many benefits to liquid staking, it does come with some risks. However, through risk assessments, strategy, and self-awareness, the risk of loss can be minimized. Your risk framework should not allow using staked assets as collateral to eliminate the risk of loan-to-collateralization ratios. Furthermore, usage of both Delegated Staking and Liquid Staking can mitigate risks further by spreading the risks.. One thing is sure, if you invest in Layer-1 crypto-assets that power Proof-of-Stake blockchains, staking in some form is a prudent way of earning yield on your crypto-assets.