Liquid staking, or LSD for short, has revolutionized the way cryptocurrency holders participate in proof-of-stake (PoS) networks. In fact, liquid staking has recently overtaken the TVL of decentralized exchanges (DEXs), making it the dominant DeFi use-case. This article explores the concept of liquid staking, its benefits, risks, and its impact on the decentralized finance (DeFi) ecosystem.
Liquid staking refers to a process that allows cryptocurrency holders to participate in proof-of-stake (PoS) networks while maintaining the liquidity of their staked assets. In a PoS blockchain, instead of miners solving complex mathematical puzzles to validate transactions and secure the network, participants lock up a certain amount of cryptocurrency as collateral, known as staking, to become validators.
Traditionally, when users stake their cryptocurrency, it becomes locked and illiquid for a specific period. During this time, they cannot use or transfer the staked tokens. However, liquid staking solutions aim to overcome this limitation by introducing tokens or derivatives that represent the value of the staked assets. These derivative tokens are often referred to as liquid or wrapped tokens.
This way liquid staking enables cryptocurrency holders to maintain liquid, while reaping the benefits of staking. It allows them to trade, transfer, or utilize their liquid staking derivatives that aim to represent the value of their underlying staked assets. In fixed periods, staking rewards are distributed to the holders of the respective liquid staking derivatives, minted by their liquid staking provider. Examples of liquid staking derivatives in the case of staked ETH are stETH of the market leading liquid staking protocol Lido, or Rocket Pool’s rETH.
Liquid staking offers several advantages for cryptocurrency holders and forms a somewhat symbiotic relationship with the DeFi ecosystem. By participating in liquid staking, users can enjoy the rewards generated by staking their assets while retaining the flexibility to engage in other opportunities within the crypto market. For example, some lending protocols are looking to accept liquid staking derivatives as collateral for borrowing funds, to build a leveraged position and generate additional yield from lending or liquidity provision. Due to limitations of some blockchains, the time from minting a staking derivative, to the funds actually being staked on chain, can take up to 48 hours. DeFi offers the ability to buy staking derivatives directly from the secondary market and immediately access the asset without waiting for it to start yielding staking rewards.
Even though the advantages are plentiful, liquid staking comes with several risks:
Liquid staking typically involves the use of smart contracts to lock and unlock tokens. Smart contracts are subject to vulnerabilities and bugs that can be exploited by malicious actors. Inadequate auditing or improper implementation of the smart contract code can lead to financial losses. Accredited liquid staking providers are audited on a regular basis and preferably by at least two to three professional smart contract auditors, such as Hacken, Chainsecurity or the likes.
Liquid staking platforms often rely on custodial services to manage the staked assets and issue the corresponding liquid tokens. This introduces a centralization risk, as users must trust the custodian to handle their assets securely. If the custodian encounters security breaches or operational issues, it can result in loss or theft of the staked assets. Liquid staking providers themselves can also be rather centralized as it may offer them performance and efficiency improvements.
When participating in liquid staking, users rely on the platform or protocol issuing the liquid tokens. There is a risk that the platform may face financial difficulties, regulatory issues, or other operational challenges, potentially resulting in the loss or devaluation of the liquid tokens. Even though LSD providers are supposedly decentralized, in reality a lot of them operate through traditional, centralized structures which are only utilizing DeFi technology to run their staking infrastructure.
In PoS networks, validators are subject to potential penalties, known as slashing, for misbehavior or protocol violations. When staking tokens are converted into liquid tokens, users may still be exposed to slashing risks. If a validator behaves maliciously or fails to meet network requirements, the staked assets could be affected, leading to potential losses for liquid stakers.
Liquid tokens derived from staked assets may still be subject to price volatility. Even though they represent the value of the staked tokens (being a stable coin to some degree), market fluctuations can impact the value of the liquid tokens, potentially leading to losses if the liquid tokens are sold or converted at an unfavorable price. An example may be the de-peg of a staking derivative from its underlying asset with technical or economical hurdles for arbitrage traders to come in.
While liquid staking aims to enhance the liquidity of staked assets, the liquidity of the liquid tokens themselves can vary. Depending on the platform and market conditions, there may be limitations on trading volume or liquidity, which could impact the ability to convert liquid tokens back into the original staked tokens when desired. This issue is enhanced with more and more LSD providers joining the market after the success of Lido. While liquidity should be solved, it actually becomes more and more fragmented by adding more staking derivatives and wrapped assets across chains.
Generally, as described in the Liquidity Risk section, adding additional liquid staking derivatives can fragment liquidity. It’s therefore vital for any liquid staking provider to make sure market makers and liquidity providers jump in to manage liquidity in the most efficient way.
Concentrated liquidity AMM protocols, such as Uniswap V3 can be specifically interesting, as both the staking derivative and the underlying token tend to be trading in a close range. Utilizing fully-automated software, liquidity positions on the DEX can be built for optimal capital efficiency and profitability, with both assets being exposed to nearly the same volatility. Impermanent loss becomes much less of a factor, and specifically low gas fee blockchains are primed for advanced liquidity provision strategies for liquid staking derivatives.
Having a market maker at hand to manage the liquidity also ensures that there is a low latency arbitrage player on the market who is able to support and maintain the peg of the liquid staking token to its underlying asset. Flash Loan attacks can potentially be counteracted to protect the funds that a liquid staking provider or any other market participant with a significant stake may deploy through a crypto market maker.
flovtec is your best bet when it comes to support of your liquid staking derivatives. If you would like to learn more, please contact the team.