What is liquid staking?

13.06.2022

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#Cryptocurrency Staking #Lido #Proof Of Stake

Key points

Liquid staking is the issuance of a “derivative” token backed by cryptocurrency locked for staking. The token can be used for yield-generating strategies in DeFi applications.
It lets users earn staking rewards without forfeiting the ability to manage their capital.
Lido is the largest DeFi project for liquid staking. Other players include Acala Network, Tempus Finance, Meta Pool and more.
Liquid staking carries a higher level of risk than traditional staking.

What are the advantages of liquid staking?

Staking is widespread in crypto: holders of assets on Proof-of-Stake networks earn passive income by running a validator or delegating their coins to node operators. To receive staking rewards, assets must be locked in a special smart contract.

Liquid staking, by contrast, allows continued use of assets after they are locked—by issuing a tokenised version of the underlying asset.

Thus, investors can earn a steady staking yield while using the derivative asset in DeFi applications.

How does liquid staking work?

Liquid staking is a relatively new practice found in a small number of DeFi projects.

The best-known example is Lido Finance. The protocol lets users stake various cryptocurrencies and receive an equivalent amount of a liquid derivative token in return. In this way, users earn staking rewards while retaining flexibility over those funds. Lido takes 10% of staking rewards.

The most popular asset to liquid-stake via Lido is ETH. Through the protocol, coins can be sent to the Ethereum 2.0 contract and stETH received in return.

stETH can then be used for yield farming or borrowing in popular protocols such as Aave, Maker, Compound, yearn.finance, Harvest, Badger and others. All use cases for stETH are listed in Lido’s blog.

Each stETH token is backed by ETH locked in staking. In addition, the amount of stETH in a user’s wallet changes in line with accrued ETH rewards. After the full launch of Ethereum 2.0, each stETH can be burned to redeem real ETH. For now, the token can be exchanged on the secondary market.

Beyond Ethereum, Lido supports liquid staking for Solana (SOL), Polkadot (DOT), Kusama (KSM) and Polygon (MATIC).

What other liquid-staking services are there?

Besides Lido, there are at least a few applications that provide liquid-staking services:

Acala Network. A Polkadot-based protocol that supports only assets issued on that network. Acala offers higher yield for staking DOT than classic staking. The minimum amount is 5 DOT. As with Lido, the protocol issues an LDOT token for the user. It can be posted as collateral to borrow a certain amount of aUSD (a basket-backed stablecoin created by Acala), after which one can become a liquidity provider in the LDOT/aUSD pool. LDOT can be swapped directly for aUSD or other assets in the Acala ecosystem at market prices.

Rocket Pool. A Lido competitor in the Ethereum ecosystem. It works on a similar principle, issuing rETH in exchange for locking ETH for staking. The minimum entry threshold is 0.1 ETH. The rETH token can be swapped for the more popular wrapped ether (WETH) on the Uniswap exchange, opening broad possibilities for DeFi operations.

Tempus Finance. Operates on the Ethereum blockchain with various liquidity tokens: stETH, cDAI, aDai, xSushi. Tempus users are invited to lock these tokens for a set period in exchange for another derivative asset whose value is determined by the price of stETH, cDAI, aDai or xSushi plus the yield accrued from staking by a specified future date.

Marinade. A liquid-staking service on the Solana blockchain. In exchange for locking SOL in the protocol, Marinade issues an mSOL token, which can be swapped for SOL plus accrued staking income. mSOL can be used in lending protocols, liquidity pools and yield farming to earn Marinade’s governance token (MNDE).

Meta Pool. A service in the Near ecosystem. For locking Near tokens in the protocol, users receive stNEAR, allowing them to accrue staking income while maintaining liquidity for use in other markets. As in the previous examples, stNEAR can be used in liquidity pools or as collateral for a loan.

What risks does liquid staking involve?

Liquid staking is not entirely risk-free. At least a few risks stand out:

Smart-contract vulnerabilities are a classic DeFi risk. Poorly written code may contain flaws that attackers can exploit.
Blockchain risk—applies mainly to staking ETH via Lido. Users will be able to withdraw ETH from the staking contract only after the launch of the Ethereum 2.0 mainnet. The exact timing of this event is unknown. The upgrade could also lead to unexpected network disruptions.
Market risks. Liquid staking is a way to issue pseudo-derivatives backed by cryptocurrencies. The price of the underlying asset is highly volatile. If the derivative token backs an open position, a drop in the “primary” coin’s price can trigger a chain of liquidations and amplify losses.
Systemic risks. Because of the tight interconnectedness of DeFi protocols, including via liquid staking, collateral stress in one protocol can spill over into several projects at once.