What is liquid staking?

Liquid staking protocols provide additional yield generating opportunities for traders looking to stake their assets on proof-of-stake blockchains.

By issuing receipt tokens pegged 1:1 to the value of staked assets, liquid staking protocols helped solve a major pain point for Ethereum stakers.

But, there are some risks when using these decentralized finance services.

When the Beacon Chain launched in December 2020, ETH holders could become proof-of-stake validators on Ethereum for the very first time. However, this new feature came with some hefty strings attached to it.

First, Ethereum's development team set the barrier to entry for becoming a network validator extremely high. To become a Beacon Chain validator, investors were required to deposit a minimum of 32 ETH. This amount was worth around $18,600 on the day of the Beacon Chain launch, and is now considerably higher.

Second, before the Shanghai upgrade date was announced, ETH validators did not know when they could withdraw their staked ether.

This situation meant ETH deposited into the specified staking smart contract became illiquid. Holders who opted in had to accept significant risks and opportunity costs.

To combat this illiquidity issue and improve capital efficiency, a new type of DeFi protocol emerged known as liquid staking.

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Liquid staking lets traders stake their assets on proof-of-stake blockchains like Ethereum, and participate in other DeFi activities like yield farming.

It achieves this via three steps:

• A trade deposits their liquid staking tokens with a liquid staking protocol.

• The protocol stakes those assets on the investor's behalf.

• The investor receives a receipt token from the protocol at a ratio of 1:1 to the value of their deposited assets. Investors can deploy these receipt tokens on other DeFi protocols to generate additional yields, or fulfill other purposes.

To withdraw ETH, liquid stakers have two options:

• Wait until Ethereum Improvement Proposal (EIP) 4895 is implemented in the Shanghai hardfork. Eth Beacon Chain stakers would be required to burn their receipt token(s) to receive ETH.

• Locate a DeFi liquidity pool that supports the staked asset and the receipt staking token, and perform a swap.

There are two major staking protocols in the market right now, though others are quickly gaining prominence as this niche sector grows.

Lido

Lido Finance established itself as the first liquid staking solution, arriving less than a month after the Beacon Chain went live.

Lido's native receipt token Lido Staked ETH (stETH) commands a a majority market share of all liquid staking. Daily trading volumes for this asset have peaked at as high as $800 million.

The Lido platform offers services for other types of blockchain besides Ethereum, such as:

• Solana (SOL)

• Polkadot (DOT)

• Kusama (KSM)

• Polygon (MATIC)

Rocket Pool

Rocket Pool is a key competitor of Lido and debuted around a year after them.

Rocket Pool boasts a considerable share of the liquid staking market and exclusively supports Ethereum.

The daily trading volume of its native liquid token, Rocket Pool ETH (rETH), has peaked at around $20 million as of 2023.

To understand the differences between liquid staking and staking, it's important to first know the different ways investors can choose to stake their crypto assets. Excluding liquid staking, there are three main avenues that are available:

1. Solo staking: This can be a popular option for token holders who have the technical expertise to run their own validator node. Solo stakers must also be comfortable shouldering the responsibilities that come with it, including maintaining a consistent uptime. Solo stakers keep 100% of their rewards and self-custody their assets, but must maintain their equipment and uptime or face potential slashing penalties.
    
2. Staking as a Service (SaaS): This involves entrusting a third party to run your validator node equipment on your behalf. You can think of it as a form of delegated staking, but in this instance the investor maintains custody over their crypto wallet. A fixed fee or percentage of the rewards is usually paid to the delegate for their services.
    
3. Centralized exchanges: Many centralized exchanges operate their own staking services and aggregate customer deposits to form staking pools. This option is beneficial because more people can stake with low minimums, but you have to trust a third party with your assets and often follow set staking periods.

Liquid staking represents the fourth avenue available to prospective stakers and differs from the above-mentioned options in three key areas; liquidity, rewards, and risk.

Liquidity

Liquid staking services issue a receipt token pegged 1:1 to the value of assets deposited. When this happens, the depositor no longer has custody of the digital assets they deposited — only custody over the new receipt token(s) they receive.

For example, if Bob deposits 4 ETH into the Lido liquid staking protocol, he'll receive an equivalent amount of stETH tokens in return. The stETH tokens are not directly pegged to the price of ETH. Instead, the price relies on crypto arbitrage trading to maintain parity.

As such, Bob maintains liquidity while his staked assets are locked in the protocol. Bob can choose to swap his stETH token for ETH at any time using an stETH/ETH DeFi liquidity pool. This type of swap is possible before or after the Shanghai upgrade.

Rewards

Bob can also stake his stETH tokens to earn additional yield. Bob earns this yield on top of his ETH staking rewards (denominated in stETH and paid via Lido).

This additional option opens up the potential for compounded yields; something that isn't available with the other three types of staking.

Risks

Liquid staking protocols carry many of the same risks associated with other DeFi lending protocols. These include rug pulls, smart contract risks, and impermanent loss from yield farming activities. There is also an additional risk of the receipt token "de-pegging" from the base asset. De-pegging can happen on secondary markets if arbitrage trading fails to keep the prices aligned.

De-pegging is where the value of the receipt token plummets in comparison to the market price of the deposited token.

The Terra/Luna collapse and a run of the Celsius Network in 2022 caused problems for liquid staking protocols like Lido. A loss of confidence in algorithmically pegged assets and concerns over systemic risks sent receipt tokens like stETH tumbling. This inherent issue highlighted a potential fatal flaw in the architecture of these platforms.

Finally, liquid staking also entails risks associated with staking, such as slashing penalties and fraud. These can be difficult counterparty risks to mitigate and so it's advisable to exercise caution when investing in liquid staking protocols.

In summary, liquid staking protocols represent a powerful DeFi tool for improving capital efficiency, particularly when staking with blockchains that mandate lock-up periods. However, this is still a growing area of the industry and, as such, there are many risks associated with the technology.

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