Liquid staking

Liquid staking, also known as "soft staking," is an approach to staking cryptocurrency or tokens in a proof-of-stake (PoS) network while offering greater liquidity for the staking party. This process works through an individual delegating tokens to a service that stakes the token in the network while receiving a derivative token, considered an IOU, which can be further invested or used. Whereas in a traditional staking scenario, the token is locked into the network, often for fixed periods, and is inaccessible.

In this way, liquid staking allows the individual to take the derivative token and either use it to stake in other networks and increase a token's ability to generate revenue for a holder. Or it allows the derivative token holder to sell the token, in a case when the network price is crashing, rather than watching a locked-in token lose value or incur a penalty for un-staking early.

The emergence and growing popularity of PoS networks have increased the potential for token holders to stake in a network. Staking allows users and investors to take a native token of a particular blockchain and lock up the token in the chain to help support the security and functionality of the respective network. An individual staking in a network can also be used as a network validator. These are often randomly selected and incentivized to maintain the network by confirming transactions, checking other transactions, and staying online.

This is known as a validator "node," and if a node goes offline and does not validate blocks or otherwise misbehaves in the network, they will incur a penalty known as slashing. Slashing is the process of a validator losing their staked token for failing to meet the expected requirements. There are also two types of slashing: partial slashing, in which the validator loses some of their staked tokens, and full slashing, when all staked tokens are taken from the validator.

As noted above, other risks of illiquid staking include the lock-up period, in which a staked token, especially in a validator node, will be locked up for a specified period of time. And in the case of a token holder wishing to un-stake their tokens, they will often incur a penalty, and the process can take up to a few weeks. As well, the fees in an illiquid network can be variable, the fees for validators may be variable, and these can reduce the potential yield of the staked token.

Exchange staking, as the name suggests, is the process of staking tokens through a centralized exchange service. This is a more liquid way of staking tokens, as the exchange will allow the token holder to stake and un-stake at any time and withdraw any rewards from the staking. Although, the exchange will apply a percentage fee on the rewards from staking. In the case of longer lock-up periods, an exchange can only safely stake a portion of deposits to allow users to withdraw the staked token, and this decreases the potential reward rate from the stake. This lower reward potential is estimated to be lower than self-staking or liquid staking.

In liquid staking, the locked-up funds staked to earn rewards are placed in a protocol, or pool, which places the funds in escrow and offers the user a tokenized version of their funds. This tokenized version of their funds, similar to a derivative token, can further be used to earn more passive income, including being staked in other networks or used in other DeFi projects. This allows the user to earn rewards on their original staked token and again earn further rewards on their derivative token. This is while offering the user the chance to pull their original token out of the staked network at any time, so the token holder can retain as much of their original value as possible in the case of a network downturn.

With liquid staking, users can potentially stake their tokens into riskier networks to increase their yields with reduced risk. For example, they can stake their tokens through a liquid staking protocol into a liquidity pool, such as a decentralized exchange. While providing liquidity protocols can be risky, going through a liquid staking protocol can reduce that risk while offering increased yields on the stake. Another potentially risky deposit is into a lending protocol, allowing token holders to stake their tokens as collateral for others to borrow crypto while remaining liquid and, therefore, somewhat more protected against the risk of default on the staked loan.

In a liquid staking protocol, a user can stake their tokens into a protocol and receive a synthetic token in return, which represents the underlying staked asset. This creates liquidity for the original asset, as it can be used elsewhere in the cryptocurrency ecosystem while continuing to earn rewards on the underlying staked asset. As well, some liquid staking protocols allow users to stake partial amounts. For example, on Ethereum 2.0, a user is required to have 32 Ether (ETH) to stake on the network, in the case when the requirements may be otherwise out of reach. This allows a user to earn on a partial stake when they otherwise would be unable to.

Graphic exploring the underlying framework of a liquid staking protocol.

To do this, a user has to purchase an initial token from a proof-of-stake network (such as ETH). They can take this asset to a liquid staking protocol provider, where they connect their cryptocurrency wallet to stake the token on the protocol (so long as it is a supported asset). In return, the individual receives a synthetic token, sometimes called a derivative token, which represents the underlying staked asset. This synthetic token is the liquidity promised in liquid staking protocols, which can be used elsewhere, including participating in other DeFi strategies. All while the underlying staked asset continues to earn staking rewards. At any point, the synthetic token can be redeemed with the liquid staking protocol to unlock access to the underlying staked assets, further increasing the overall liquidity of the asset.

The platforms offering liquid staking differ in their type, with some offering a single liquidity or staking pool, some offering two paired staking pools, and others providing multiple pools in which investors can stake various tokens. As well, the platforms can differ based on the algorithms on which their liquidity pool operates. This can be important to reduce the sensitivity of a platform or staking pool to individual transactions and allow pools to make the asset rate more stable, even when staking large amounts.

The synthetic tokens can be used elsewhere to augment a DeFi strategy, allowing users or investors to boost their yields by earning staking rewards and leveraging those synthetic assets elsewhere. There are some strategies based on the level of risk an investor may take, including the following:

Liquid staking tokens can be placed into liquidity pools with correlated assets to provide a reliable return with a low risk of loss. When an investor is ready to pull out of their stakes, the synthetic tokens can be redeemed to their original tokens, which can, in turn, be sold.

In a moderate strategy, the synthetic tokens can be used as collateral on lending protocols to borrow other assets or stablecoins. These are riskier investments but can provide more returns than stable liquidity pools or staking only the token.

An aggressive strategy could include using the synthetic token as collateral to borrow further assets against and repeating this process to increase leverage with multiple borrowing layers, using the final assets in liquidity pools offering high yields but often high volatility.

In traditional finance, a derivative is a contract between two parties with a price determined by the fluctuations in the underlying asset, with common derivatives including futures, options, forwards, and swaps. These were originally developed to protect one position over an underlying asset. In cryptocurrency, the underlying asset of a derivative would be any cryptocurrency token. The derivative, in this case, would be a financial contract to speculate the cryptocurrency's price on a future date, allowing investors to profit from changes in the underlying asset's price.

A derivative staked token would be the tokenized representation of a staked asset through a liquid staking protocol. It represents the underlying, illiquid staking position and is subject to protocol limits. But the derivatives are liquid and can be employed in a variety of financial products, which, as a result, means the derivative may be able to earn higher returns or allow an individual to manage their risk exposure in a variety of ways (such as reducing validator associated risk).

Liquid staking protocols are seen as revolutionizing liquidity across the decentralized finance (DeFi) industry, allowing users to interact and use funds while earning rewards. Liquid staking protocols, as a result of this potential and interest, have provided the foundations for lending protocols and yield farming activities. Some of the benefits of liquid staking include the following:

One of the benefits of liquid staking is that it allows for yield stacking, also known as yield farming, because while earning yields for staking, a user can use the derivative token to stake or earn yields in another DeFi project or protocol. Since the original token is staked in a layer 1 network, the chance of a liquid staking protocol failing or collapsing is rare, as the probability of a layer 1 network failing is very low, and that is the base of the liquid staking protocol project. This is partly considered to increase the security of the layer 1 network as there is a larger pool of staking tokens that are unlikely to leave or fail, as some projects built on the network may.

As noted above, liquid staking protocols are considered to increase the security and stability of the underlying network, especially as PoS networks require capital on the blockchain to validate transactions, and the amount of available capital in the validator's wallet and duration of time in which the capital is held is part of the ability to validate. This means the strength of the network is proportional to the amount of validators and the amount of capital staked in the network. And with liquid staking protocols removing some of the limitations around staking, the amount of staked capital can increase and strengthen a network.

Another benefit of liquid staking protocols is the ability to gain access to funds much faster than in self-staking. A liquid staking protocol, as noted above, offers the user a chance to remove their funds from the PoS network at any point, without concern about a lengthy un-staking process or un-staking penalties. This can benefit users in times of market turbulence or in the instance of unexpected payments or costs.

Similar to the above access to funds, if a user is hesitant to sell their cryptocurrency or network assets in a case when they need extra cryptocurrency or fiat currency, a liquid staking protocol allows the user to maintain their stake in a network and use the tokenized liquid version of the asset to convert into fiat currency or use as collateral for a loan for access to funds. But as their initial asset remains locked up, they can continue to earn yields and retain their position.

Unless an individual is going through an exchange, the process of staking can be a hassle and confusing. As explored above, in the case of an exchange stake, the exchange retains a considerable amount of stake on the network, leading to concerns around stake centralization, which creates added risk to the individual staking their token in the case of an exchange facing an attack risking their entire capital. Liquid staking solves the problem of many of the frustrations for the average user of self-staking and offers a potentially more secure alternative to exchange staking, intended to allow users with minimum to no technical knowledge to stake, without concern about staking with a validator with the highest uptime and no slashing history, which a user is required to research, let alone understand.

While liquid staking has various parameters to select its validators, its business model is based on retaining the liquidity of protocol users, and it is incumbent on the protocol to have reliable validators and not incur any slashing events. In this way, a liquid staking protocol allows an individual to approach staking in a simple and easy way.

There are several risks or concerns around liquid staking. Some are considered to be able to undermine the integrity of a network, according to some researchers, and could lead to vulnerabilities to censorship demands or other abuses of power the technology was intended to circumvent.

A researcher at Ethereum Foundation, Danny Ryan, believes that liquid staking has the chance to lead to what he called "cartelization" through a tendency toward centralization. He described a slow process, in which the most popular liquid staking protocols become larger and begin to hold controlling stakes of the staked capital in a network and the validator nodes in a network. They begin to centralize the power around the network, increasing the liquidity further and utility as collateral, which derives further adoption of its solution compared to its competitors.

This, in Danny Ryan's opinion, will lead to a reduction in competition as only certain protocols will have the amount of staking capital to be able to exist in a meaningful way. And the increase in staking through a protocol can lead to the monopolization of staking, which will increase a network's security but come with the risk of what Danny Ryan called "cartelization." He defines cartelization as the ability for the token holders to force activities such as censorship, validator removal, and censorship attacks in which governance token holders can be pressured to make the moves the larger holder wishes.

Another problem or risk of the liquid staking synthetic derivative token is that often the derivative token will be depegged from the underlying asset or the original token. In the case of Ethereum, for example, if staking the Ethereum token, the derivative token can trade at 5 to 10 percent below the original token price, especially as it is, even as a representation of the original token, a separate token with its own value depending on the staking of the asset. And with the original token locked up in a stake, it could be argued that the derivative token is of less value. And in the case in which another DeFi project uses liquid protocols to maintain their liquidity and decides to flood exchanges with a derivative token, it can further undervalue the derivative token as a separate asset class. This occurred when Celsius began sending millions of cryptocurrency assets to the FTX exchange, which depegged the Ethereum token price from the derivative token price.

Even with time delays in liquid staking governance, such as pooled capital exiting the system before a change occurs, the protocol can suffer from frog-boil governance attacks—small, slow changes unlikely to get staked capital to exit the system and change the system drastically with one change at a time, over a longer period of time. As well, liquid staking protocol users often have different incentives and concerns than the original network users. In some cases, they may not care about the underlying network's success insofar as it continues to provide the liquid staking user with the yields they expect. This could mean liquid staking holders could be fine with censorship-requisite governance, which could be seen as an attack on the underlying network. Although, some have pointed out, there are potential means at the developers' disposal to mitigate some of these risks. But many of these potential solutions could make the maintenance of liquid staking protocols more difficult, if not eliminate them in favor of illiquid staking alone.

While a lot of the concerns around liquid staking mentioned above are focused on the risk posed by the pool of the liquid staking on the underlying network, there is also a risk to those holding capital in the pooled system. Similar to the "tragedy of the common," where individuals make a rational decision to stake with a liquid staking protocol is a good decision for the individual but can be an increasingly bad decision for the protocol. However, the risk to the underlying network and the risk to the liquid staking protocol, especially when the liquidity pool exceeds consensus thresholds, are tied together. And in the case of some of the above concerns, such as cartelization, censorship, or otherwise abusive behavior, and related threats to the underlying network can create a response from the network to respond to the concern by leaking or burning through the nodes associated with the attacks or the pooled capital.

This then puts both the underlying network and pooled capital at risk. The protocols and the underlying staked networks are tied together; some have suggested, based on the symbiosis between the two, it is imperative for the liquid staking protocols to maintain and nourish the underlying network to continue to exist. Allowing the pooled capital to succumb to these kinds of existential threats to the network becomes an existential threat to the pooled capital and to the concept of liquid staking.