Liquid Staking Explained

paul faecks
Liquid Staking Explained

What is Liquid Staking and why does it Matter?

At a Glance
  • With liquid staking protocols, stakers receive liquid staking derivatives in exchange for staking their assets, representing their claim on the underlying stake pool and its yield
  • Liquid staking is gaining traction with 11 billion $+ deployed through liquid staking protocols
  • Liquid staking improves capital efficiency: it allows investors to use staked assets in the ecosystem for lending, trading, and as collateral, thereby lowering the opportunity cost of locking assets up for staking
  • Similar to how large investors and nation states hold a majority of their USD holdings in US treasuries, treating them as defacto cash, we consider it likely that staking derivatives such as stETH increasingly replace ETH as collateral in DeFi

This year, liquid staking protocols have skyrocketed in popularity as they added unprecedented capital efficiency to native assets of popular blockchains such as Ethereum, Solana, Polkadot, Cosmos, Kasuma, and Polygon (formerly MATIC). The long-awaited trifecta between healthy yields, sustainability, and security liquid staking offers to investors will in all likelihood shape the future of DeFi.

We should consider how a shift in perspective to view native assets on top blockchains as stable forms of collateral and the ever-growing composability (lego building blocks/interoperability) of DeFi impacts protocol security and institutional adoption. With the ESG-friendly proof-of-stake consensus mechanisms used by the aforementioned blockchains, this renaissance in DeFi is made possible because investors can gain exposure to the rewards emitted to stakers via liquid staking protocols, unlike in proof-of-work (Bitcoin), where “work” in the form of computational resources is required.

Liquid Staking Explained

With liquid staking protocols, stakers receive liquid staking derivatives in exchange for staking their assets, representing their claim on the underlying stake pool and its yield.

There are two main reasons why liquid staking is so popular in DeFi: it allows investors to use staked assets in the ecosystem for lending, trading, and as collateral, thereby lowering the opportunity cost of locking assets up for staking. Secondly, it increases flexibility.

In the case of Ethereum, where unstaking is not yet enabled natively, by staking through Lido/Rocketpool, investors can sell their stETH/rETH anytime, effectively circumventing the unstaking process entirely.

Liquid staking differs from direct staking in that assets are functionally not completely locked up. Instead, a smart contract mints a liquid asset pegged to the staked asset in a 1:1 ratio. The original token is staked and generates yield, and the new liquid pegged asset is made available for use in DeFi — giving users two avenues for generating income.

There is a high technical barrier to entry for staking assets natively, also referred to as solo staking. It requires upfront investment in hardware, server bandwidth, and ongoing maintenance. A lockup period of some kind is also generally associated with solo staking for most blockchains, preventing assets from being unstaked. Another factor to consider is the operational risk of running validator infrastructure, validators need to be mindful of slashing risks.

illustration by @Leo_Glisic (Messari)

Investors of digital assets have embraced liquid staking because it allows them to stake assets with less operational risk, routing assets to a staking pool utilizing existing validator infrastructure with only a few clicks.

Each participant in a liquid staking pool receives a staking reward proportional to how much they contribute to the pool. Liquid staking offers investors the freedom to stake as much as they want, unlike solo staking, which has minimum thresholds.

Liquid Staking is Leading the growth of DeFi

Lending, liquidity provisioning, yield farming, and staking are among the many categories of DeFi. Staking digital assets is the newest and fastest-growing sector today. The adoption of liquid staking protocols grew exponentially in Q2 of 2022, with Ethereum (ETH) being the most popular staking asset by far. Among the liquid staking protocols on the Ethereum network, Lido, a non-custodial Liquid staking platform, holds 69% of the market share. Coinbase, which offers custodial liquid staking services, takes second place. An Ethereum community favorite, Rocket Pool (non-custodial) takes third place. A total of 41.9% of all staked Ethereum is dedicated to liquid staking, which represents more than $11 billion in unlocked DeFi liquidity.

In a post-merge proof-of-stake (PoS) world, investors are more confident than ever in Ethereum’s robustness and growing adoption. At the time of writing, Lido is the second most popular DeFi platform in the entire Industry across all categories, with more than 7b$ in value locked.

Source: Defilama

Lido’s Winning Formula

Lido offers a 1:1 exchange rate on deposits of ETH by issuing “stETH” also known as Staked ETH. Lido, like Rocket Pool, handles the actual back-end setup process of committing users’ ETH to the beacon chain where it works to secure and validate transactions on the blockchain, earning ETH as rewards. All rewards on Lido are subject to a 10% fee. The fees are split between the node operators, Lido DAO, and a coverage (insurance) fund in case of slashing.

A large part of Lido’s success and dominance in the “staking-as-a-service” sector of DeFi is its multichain approach, offering liquid staking services for the native tokens of Solana, Kasuma, Polkadot, and Polygon (formerly MATIC) blockchains. Rocket Pool, on the other hand, focuses solely on the Ethereum network and offers only ETH-based staking services. Lido and Rocket Pool users can expect to earn the standard ~8.0%* APR for ETH staking minus fees on their deposits. Advanced users typically deposit their liquid pegged assets to other DeFi platforms to compound their net yield.

Adding Liquidity and Security to the Blockchain

For the advanced DeFi user, depositing digital assets to a liquid staking service is only the first step in a layered strategy for generating yield. For example, after exchanging ETH for stETH on Lido, users can use stETh in other DeFi protocols such as Aave, Curve, or Yearn to put their stETH to work. These aforementioned DeFi platforms are home to newly created markets such as USDC/stETH, DAI/stETH, which offer liquidity mining opportunities for users to compound their total gross yield.

Each step of the process where a transaction must be signed and a deposit committed introduces additional smart contract risk(s) and requires a reverse chronological order of operations to withdraw their original ETH from the liquid staking platform of their original choosing. In the event that a user is unable to recover the derivative asset from one of these auxiliary DeFi platforms, then they will not be able to withdraw their original deposit or any yield generated from staking. It is therefore imperative that DeFi users manage their private keys with extreme caution and choose liquidity pools with enough liquidity to sustain volatile market conditions.

Overall, liquid staking solutions increase the capital efficiency of digital assets and help facilitate emerging DeFi markets by increasing overall market liquidity. Furthermore, liquid staking enhances blockchain security by increasing the cost of a hostile network takeover and promoting institutional adoption of digital assets, creating a positive flywheel effect for the entire industry.

A comparison of Lido versus Rocket Pool

Generally speaking, Rocket Pool is perceived by the Ethereum community to be more invested in the decentralization of the blockchain. This is a clear mission statement made by the developers of Rocket Pool who deliberately diversify the consensus clients utilized by the validator nodes funded by user deposits.

Staking with Exchanges

Centralized exchanges (CEXs) such as Kraken, Coinbase, Binance, Gemini, etc. continue to be the most popular on-ramp for new users entering the digital asset markets. Privately owned exchanges offer fiat on-ramps for buying crypto assets and non-fungible tokens (NFTs) using their fiat on-ramps. Users must be processed through KYC/AML procedures in order to purchase and withdraw funds. Nevertheless, CEXs offer a full suite of utilities that mimic the options available in DeFi in a limited manner, including but not limited to staking. Generally speaking, exchanges offer reward payouts in like-kind currency (eg. users who stake ETH will earn yield in ETH). However, relative to non-custodial staking services, APRs on CEXs tend to be lower and options limited. Not all staking services on exchanges are liquid staking services. Some exchanges enforce a lockup period in exchange for staking rewards and do not issue a pegged asset for user deposits.

The Future of DeFi May Revolve Around Staking

Liquid staking services as measured by TVL will likely continue to grow due to the ease of use and benefits of blockchain security. It is estimated that 80% of the ETH supply will be locked up in staking in the future, according to Justin Drake, an Ethereum Foundation researcher, and core developer. As an added benefit, all of this growth is environmentally/ESG friendly given that proof-of-stake is a very energy-efficient consensus mechanism relative to proof-of-work.

An outcome such as this would cement ETH’s status as a store of value for billions of dollars in collateral for DeFi. Liquid staking solutions are likely to become (and to an extent, already are) the foundation of a new era in DeFi as they increase the capital efficiency of assets which leads to increased yield-generating opportunities.

Similar to how large investors and nation states hold a majority of their USD holdings in US treasuries, treating them as defacto cash, we consider it likely that staking derivatives such as stETH increasingly replace ETH as collateral in DeFi.

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