What Is Liquid Staking & How Does It Work?.
Key Takeaways
- Liquid staking allows cryptocurrency holders to earn staking rewards while maintaining the liquidity of their assets.
- Staking derivatives, such as staked tokens or staking derivatives, represent a user’s stake in a network while providing liquidity.
- Liquid staking increases the utility of staked assets by enabling participation in various DeFi activities.
- Risks associated with liquid staking include potential centralization of control, counterparty risk, complexity, security concerns, and the challenge of navigating different platforms.
Staking is the process of locking up cryptocurrency to maintain the functioning of a blockchain network. In return, rewards are given to stakers. Traditional staking locks up the cryptocurrency, which reduces its liquidity. However, stakers can still preserve liquidity and get rewards through liquid staking.
Tokens that represent a stake in the network are issued as part of its liquid staking’s functioning mechanism. While still receiving staking incentives, these tokens can be exchanged or utilized in decentralized finance (DeFi) protocols. With liquid staking, users can take use of staking’s advantages without giving up liquidity.
Liquid Staking, Explained
Staking on a regular basis is similar to depositing cryptocurrency in a proof-of-stake (PoS) blockchain to validate transactions and earn interest. However, while staking, your money is locked up. This restriction is removed via liquid staking.
After depositing your cryptocurrency, you get a liquid token that represents your stake rather than it being locked. This token serves as a substitute. As your initial stake continues to accrue staking rewards, you have the option to swap it or utilize it in DeFi apps to increase your earnings.
Consider it as a loan secured by your deposit that enables you to make investments elsewhere. Through the liquid token, you maintain liquidity while reaping the perks of staking. For cryptocurrency holders, this creates new opportunities to optimize their profits.
For example, if you staked Ethereum, you would get a token, such as stETH, that represented your staked Ethereum. With the ability to trade this stETH token on exchanges and use it in other DeFi applications, you may take advantage of the rewards associated with your staked Ethereum while still having access to its liquidity. Thus, liquid staking offers a means to obtain staking rewards without giving up your cryptocurrency’s versatility.
How Liquid Staking Works
Liquid staking allows cryptocurrency holders to engage in staking networks while keeping the liquidity of their assets. This is how it operates:
Step1: Deposit Your Tokens
To support a blockchain network, a cryptocurrency holder first locks up their assets in a staking contract.
Step 2: Staking Token Issuance
The owners of the cryptocurrency receive staking tokens in exchange for staking it, which represent their stake in the network. A common term used to describe these tokens is “staking derivatives” or “staked assets.”
Step 3: Staking Rewards
The holder’s portion of the profits made by the staked cryptocurrency is represented by the staking tokens. More cryptocurrency is usually given out as compensation for these rewards.
Step 4: Liquidity
The staking tokens obtained through liquid staking are transferable and may be utilized in other DeFi protocols, in contrast to traditional staking, where the coin is locked up and illiquid.
Step 5: Trading And DeFi Applications
These staking tokens can be freely traded on exchanges by the holder or utilized for a variety of DeFi applications, including lending, borrowing, and liquidity provisioning in automated market maker (AMM) pools.
Step 6: Redeeming Staked Assets
The holder may exchange their staking tokens for the original cryptocurrency and any accrued rewards at any time to redeem their staked assets.
As a result, liquid staking increases liquidity and utility by giving cryptocurrency holders a means to get staking rewards while maintaining the freedom to spend their holdings for other DeFi ecosystem activities.
Types Of Liquid Staking
There are two types of liquid staking: centralized and decentralized.
Centralized Liquid Staking
Custodial companies or cryptocurrency exchanges provide centralized liquid staking services. They take care of everything for you, including rewarding users, maintaining validator nodes, and depositing your tokens.
Beginners will find this convenient, but there is a risk of counterparty. Therefore, users must select a service with a solid security record; after all, you are entrusting them with your money.
Decentralized Liquid Staking
Protocols for decentralized liquid staking are transparent and trustless. To maintain validator nodes and pool your tokens, they rely on smart contracts.
Although it needs greater technical knowledge, this removes the requirement for a central authority. You will have to deal directly with the protocol and be aware of the possible risks associated with smart contract exploitation.
What Are Liquid Staking Derivatives
The tokens you get as part of liquid staking are called liquid staking derivatives, or LSDs for short. These tokens provide various benefits by serving as a stand-in for your initial crypto that you staked:
Unlocking Liquidity
Regular staking prevents you from trading or using your tokens in DeFi applications by locking them for a set amount of time. Conversely, LSDs are easily traded on cryptocurrency platforms. While your initial investment continues to accrue rewards in the background, you have the option to purchase, sell, or utilize them for more investment opportunities.
Earning Additional Yield
LSDs earn benefits for staking in addition to representing your investment. You can even earn extra money by lending out your LSDs with certain DeFi protocols. This enables you to take advantage of the synergistic effects of DeFi opportunities and staking incentives.
Fractional Staking
To take part in validation, several blockchains, like Ethereum, have hefty minimum stake requirements. LSDs address this obstacle.
With a liquid staking provider, you can deposit any quantity of cryptocurrency and get the equivalent number of LSDs back. This makes staking available to everyone, irrespective of the magnitude of their original investment.
It’s critical to keep in mind that LSDs are derivatives, which means that the underlying staked asset determines their value. They have inherent risks, including platform-specific fees and potential weaknesses in smart contracts, even though they present intriguing possibilities.
Therefore, before you get involved, do your homework and pick a trustworthy liquid staking provider with a solid track record.
Pros Of Liquid Staking
Liquid staking offers numerous benefits. It offers a means of obtaining incentives for staking while preserving the liquidity of staked assets. This implies that users won’t have to wait for lock-up periods to end to exchange their staking derivatives freely on exchanges or utilize them in DeFi protocols.
Liquid staking also makes staked assets more useful by enabling users to take part in a variety of DeFi activities like lending, borrowing, and liquidity provisioning. Hence, liquid staking increases staking’s adaptability and accessibility, increasing its allure for cryptocurrency owners.
Cons Of Liquid Staking
Liquid staking has many disadvantages in addition to its many advantages. The possible centralization of control is one of the main worries. Counterparty risk is introduced via centralized liquid staking, which requires users to entrust a third party with the custody of their staked funds. Furthermore, non-technical users could find decentralized liquid staking systems too complicated.
Furthermore, the security and dependability of the smart contracts utilized in decentralized liquid staking can raise questions. Ultimately, customers can encounter difficulties comprehending and utilizing the many liquid staking platforms and protocols that are offered in the industry.
Conclusion
With liquid staking, cryptocurrency owners can take part in staking networks in a flexible manner without sacrificing the liquidity of their holdings.
Instead of having their cryptocurrency locked up, users receive liquid staking derivatives that let them to trade these tokens freely or utilize them in different DeFi protocols, all while collecting staking rewards.
Liquid staking boosts the accessibility and flexibility of staking, making it more attractive for cryptocurrency holders aiming to optimize their gains within the crypto ecosystem.
