Liquid staking has become a popular development in decentralized finance because it allows cryptocurrency holders to earn staking rewards while maintaining greater flexibility over their assets. Traditional staking can require users to lock or delegate their cryptocurrency for a period of time, making it unavailable for other uses. Liquid staking attempts to solve this limitation by providing a separate token that represents the user’s staked assets.
The concept can be useful for long-term crypto holders, but it also introduces additional risks. Understanding how liquid staking works is important before depositing any cryptocurrency.
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Liquid staking allows users to stake cryptocurrency while receiving a liquid token representing their staked position.
For example, a user can deposit an eligible cryptocurrency into a liquid-staking protocol. The protocol stakes the underlying assets on the blockchain and provides the user with a liquid staking token.
That token can potentially be held, transferred, traded, or used in other decentralized finance applications, depending on the protocol.
This creates more flexibility than traditional staking because the user doesn’t necessarily have to leave the original staking position completely inactive.
How Does Liquid Staking Work?
The process generally involves four steps.
First, the user deposits an eligible cryptocurrency into a liquid-staking protocol.
Second, the protocol stakes the underlying assets through validators or other network participants.
Third, the user receives a liquid token representing their staked position.
Finally, staking rewards accumulate according to the protocol’s system, while the value or exchange rate of the liquid token can reflect those rewards.
The exact mechanism differs between protocols and blockchains.
Why Is Liquid Staking Popular?
Traditional staking can create a liquidity problem.
If your cryptocurrency is locked in a staking arrangement, you may not be able to immediately use it for another investment, trade, or DeFi opportunity.
Liquid staking provides an alternative by creating a token that can potentially be used elsewhere.
For example, someone staking ETH might receive a liquid staking token that can potentially be used in supported DeFi applications.
This allows users to pursue staking rewards while retaining some flexibility.
Liquid Staking vs Traditional Staking
Traditional staking generally involves directly participating in a blockchain’s staking system or delegating tokens to a validator.
Liquid staking adds another layer between the user and the underlying staking process.
With traditional staking, users may have fewer options for using their staked assets during the staking period.
With liquid staking, users receive a representation of their staked position that may remain usable.
However, liquid staking also introduces additional risks that may not exist with direct staking.
How Do You Earn Rewards?
Staking rewards are generated by the underlying blockchain.
Validators receive rewards for helping secure and operate the network, and liquid-staking protocols distribute the economic benefit to users according to their rules.
The liquid staking token may increase in value relative to the underlying asset, or rewards may be reflected through another mechanism.
The actual return depends on the blockchain, validator performance, protocol fees, network activity, and other factors.
Staking rewards should therefore not be treated as guaranteed interest.
What Can You Do With a Liquid Staking Token?
One major advantage of liquid staking is that the resulting token may have additional uses.
Depending on the ecosystem, users may be able to:
- Hold the token
- Trade it
- Use it as collateral
- Provide liquidity
- Participate in DeFi applications
- Earn additional rewards
However, using a liquid staking token in another DeFi protocol increases the overall complexity and risk of the strategy.
The more protocols involved, the more potential points of failure exist.
Major Risks of Liquid Staking
Liquid staking isn’t risk-free.
Smart-Contract Risk
Liquid-staking protocols rely on smart contracts. A vulnerability could potentially result in the loss of deposited assets.
Depegging Risk
A liquid staking token may not always trade at exactly the same value as the underlying cryptocurrency. During periods of market stress, its price can move significantly.
Validator Risk
Validators responsible for staking the underlying assets may experience technical problems or penalties.
Liquidity Risk
If many users attempt to sell a liquid staking token at the same time, there may not be enough market liquidity to support withdrawals at the expected price.
Protocol Risk
The liquid-staking protocol itself could experience technical, governance, or operational problems.
Is Liquid Staking Truly Passive?
Liquid staking can be relatively passive because users don’t need to operate their own validator infrastructure.
After depositing their cryptocurrency, users can potentially receive staking rewards through the protocol.
However, users should still monitor their positions.
Reward rates can change, liquid staking tokens can fluctuate in value, and DeFi conditions can change quickly.
Simply receiving staking rewards doesn’t eliminate the need to understand the risks.
How to Choose a Liquid Staking Protocol
Don’t select a protocol based solely on the advertised reward rate.
Consider its security history, validator selection process, liquidity, fees, withdrawal mechanisms, and overall adoption.
Understand exactly what token you will receive and how it represents your underlying cryptocurrency.
It’s also important to determine what happens if the protocol experiences technical problems or if the liquid token trades below the value of the underlying asset.
Final Thoughts
Liquid staking provides a way to potentially earn blockchain staking rewards while maintaining more flexibility than traditional staking.
Instead of leaving cryptocurrency completely locked, users receive a liquid representation of their staked assets that may be usable across supported applications.
However, this flexibility comes with additional risks, including smart-contract vulnerabilities, depegging, validator problems, liquidity issues, and protocol risk.
Liquid staking can be useful for experienced cryptocurrency holders who understand these risks. Before participating, research the protocol carefully, understand the withdrawal process, and avoid using complex DeFi strategies simply because they advertise higher returns.
The goal should be to earn staking rewards without taking risks you don’t fully understand.