Liquid Staking Tokens: Everything to Know
By Beluga Research July 30, 2023
- Liquid staking tokens are cryptocurrencies that allow users to stake their assets and simultaneously use them in decentralized finance (DeFi) applications
- These tokens are created through tokenization, where staked assets are wrapped or minted into separate tokens that can be traded and used within the DeFi ecosystem
- Users of liquid staking tokens can continue to earn staking rewards while having the flexibility to trade, borrow against, or utilize their assets in various DeFi activities
- However, they also come with potential risks, including counterparty risk, slashing risk, complexity and learning curve, potential for centralization and regulatory considerations
Liquid staking tokens are cryptocurrencies that allow users to stake assets and simultaneously use them in decentralized finance (DeFi) applications. Staking has become a popular way for cryptocurrency holders to participate in network consensus and earn rewards. By locking up tokens in a staking contract, users contribute to network security and validate transactions, all while receiving additional tokens as an incentive. However, traditional staking models suffer from a lack of liquidity. Once tokens are staked, they are typically locked for a predetermined period, restricting holders from utilizing them for other purposes.
Liquid staking tokens aim to address this liquidity issue by introducing a new layer of financial innovation. These tokens are created by "wrapping" or tokenizing the staked assets, allowing users to hold and trade them on compatible platforms. By doing so, stakers can retain the benefits of staking, such as earning rewards and participating in network consensus while also gaining the flexibility to use their assets in other ways within the broader cryptocurrency ecosystem.
A Brief History
The concept of liquid staking tokens can be traced back to the advent of decentralized finance (DeFi) and the emergence of Ethereum-based protocols. In 2020, projects like Lido Finance and Rocket Pool gained attention for efforts to bring liquidity to staked assets. Lido Finance, for instance, introduced a liquid staking solution for Ethereum, allowing users to stake ETH and receive liquid stETH tokens in return. These liquid stETH tokens represented a user's staked ETH and could be freely traded or used as collateral in DeFi applications.
Since then, the popularity of liquid staking tokens has grown significantly, with various blockchain networks and projects exploring similar solutions. Polkadot, for example, introduced the concept of "staking derivatives" through projects like Polkastarter and Moonbeam. These platforms allow users to trade wrapped staked assets while still receiving staking rewards. Other networks, such as Cosmos and Tezos, have also witnessed the development of liquid staking solutions to enhance the usability and liquidity of staked tokens.
What are Liquid Staking Tokens?
To understand liquid staking tokens comprehensively, it's important to explore the key aspects that define them.
- Tokenization. Liquid staking tokens are typically created through a process called tokenization. This involves wrapping or minting a separate token that represents the staked assets. For example, when staking ether, a tokenized version like stETH or wETH can be freely traded or used in other applications.
- Staking rewards. One of the primary benefits of liquid staking tokens is the ability to earn staking rewards while maintaining liquidity. When staking tokens and receiving liquid staking tokens in return, investors continue to earn staking rewards on the underlying assets. This allows benefits from network participation while having the flexibility to utilize tokens elsewhere.
- Trading and liquidity. Liquid staking tokens can be traded on compatible platforms, providing users with the ability to buy, sell or exchange them as desired. This introduces liquidity to staked assets that were previously illiquid, enabling users to react to market conditions or capitalize on investment opportunities without waiting for staking periods to end.
- Collateralization. Another compelling aspect of liquid staking tokens is the potential use as collateral in decentralized finance (DeFi) applications. By leveraging liquid staking tokens as collateral, users can access loans, borrow assets or participate in various yield farming strategies. This expands the utility and value of staked assets beyond their traditional staking role.
- Risks and considerations. While liquid staking tokens offer enhanced liquidity and flexibility, it's important to understand the associated risks. As with any investment or financial instrument, there are potential risks involved, such as smart contract vulnerabilities, market volatility and slashing risks. It's crucial to conduct thorough research, evaluate the credibility of the projects offering liquid staking tokens and assess the potential risks before engaging in such activities.
To start using cryptocurrency liquid staking tokens, users need to possess the underlying staking asset. This typically involves obtaining a native token of a proof-of-stake (PoS) blockchain network, such as Ethereum's ETH or Polkadot's DOT. Once a user has acquired these tokens, they can proceed to a platform that supports liquid staking, such as a specialized protocol or a decentralized exchange (DEX). Users can deposit staking tokens, which will then be locked and used to generate staking rewards.
Once the staking tokens are locked, users receive a representation of their staked value in the form of a liquid token. These liquid tokens are often referred to as staked or wrapped tokens and are tradable on various decentralized exchanges and platforms. Users can freely transfer, trade or utilize these tokens within the DeFi ecosystem without affecting a staked position. It's important to note that staked tokens remain locked and cannot be directly accessed or transferred until the user decides to unstake them.
One of the key advantages of cryptocurrency liquid staking tokens is the ability to provide liquidity while maintaining exposure to staking rewards. By converting staked tokens into liquid tokens, users can simultaneously participate in staking and access the benefits of liquidity provision. This flexibility allows users to engage in various DeFi activities, such as yield farming, lending or trading. All without sacrificing the rewards earned from staking.
Additionally, liquid staking tokens introduce a new level of composability within the DeFi ecosystem. These tokens can be utilized as collateral for borrowing or lending protocols, used in decentralized exchanges for trading, or even integrated into other DeFi applications. This composability expands the potential use cases for staked assets and enhances the overall efficiency and utility of the crypto ecosystem.
Moreover, liquid staking tokens can also mitigate the trade-off between staking and liquidity. In traditional staking models, participants need to choose between locking tokens for a specific period to earn rewards or maintaining liquidity and flexibility by keeping tokens readily available for transactions. Liquid staking tokens provide a solution to this dilemma by allowing users to stake tokens and still have access to the value for other purposes. This flexibility makes staking more accessible to a wider range of participants who may have different liquidity needs or investment strategies.
- Enhanced liquidity. Liquid staking tokens enable users to access liquidity without the need to unstake assets. This allows individuals to utilize staked assets for various purposes, such as trading, borrowing or providing liquidity in decentralized finance (DeFi) protocols.
- Flexibility. With liquid staking tokens, stakeholders have the freedom to use assets as collateral for borrowing or lending activities. This flexibility opens up new avenues for financial opportunities and strategies, empowering users to optimize holdings to meet their specific needs.
- Yield generation. By minting liquid staking tokens, users can earn additional yield on staked assets. These tokens often represent a claim on underlying staked assets and generate rewards through the consensus mechanism of the blockchain network. This enables stakeholders to compound returns and potentially increase their overall earnings.
- Participation in governance. In many cases, liquid staking tokens allow users to retain their voting rights and participate in the governance of the underlying blockchain protocol. This ensures that stakeholders can actively contribute to decision-making processes and have a say in the future development and direction of the network.
- Diversification. Liquid staking tokens provide an opportunity for asset diversification by allowing users to hold both staked and liquid assets simultaneously. This diversification can help mitigate risk and optimize investment strategies, as users are not solely dependent on the performance of staked assets.
- Counterparty risk. When engaging with liquid staking tokens, users often rely on third-party platforms or service providers to mint and manage these tokens. This introduces a level of counterparty risk, as the security and reliability of these platforms can impact the safety of user assets. It is crucial for individuals to carefully evaluate the reputation and security measures of platforms they choose to interact with.
- Potential for slashing. Liquid staking tokens represent a claim on staked assets, and any penalties or slashing events incurred on the staked assets may also affect the value of the corresponding liquid tokens. In the event of a network disruption or a validator's malicious behavior, stakeholders may face potential losses or reduced token value.
- Complexity and learning curve. Engaging with liquid staking tokens may require users to familiarize themselves with new protocols, interfaces and processes. This complexity can pose a barrier to entry for individuals who are not well-versed in blockchain technology or decentralized finance concepts. It is essential for users to invest time in understanding the underlying mechanisms and risks associated with liquid staking tokens.
- Potential for centralization. In some cases, liquid staking tokens may introduce a degree of centralization, as users rely on specific platforms or custodians to manage their tokens. This concentration of control can undermine the decentralized nature of blockchain networks and introduce vulnerabilities. It is important for users to consider the trade-offs between convenience and decentralization when engaging with liquid staking tokens.
- Regulatory considerations. As the cryptocurrency landscape evolves, regulatory frameworks surrounding liquid staking tokens may vary across jurisdictions. Users must stay informed about the legal and regulatory implications of minting, trading or holding these tokens to ensure compliance and mitigate potential risks associated with changing regulations.