Traditional staking and its main limitation
“Staking” is a financial term in the crypto field, which means locking assets in a protocol, to secure the network and earn rewards. It’s a great method to earn passive income and provide support on the security and operations side of a blockchain network.
The main limitation of staking is being unable to access funds for a certain period. After locking funds in a staking protocol, you cannot trade, sell, or transfer any of the assets. Also, many staking protocols, particularly PoS, include a penalty for withdrawing funds before completion of the staking period.
What is liquid staking?
Liquid staking, also known as “soft staking”, is a more advanced form of classical staking that is available on new-generation smart contract protocols. By going for liquid staking, users can capitalize their locked funds on other crypto-based activities, while still earning rewards from their original deposit.
Liquid staking protocols offer the same benefits as traditional staking protocols but reduce their potential disadvantages. Liquid staking aims to remove the obstacles regarding participation to financial operations, which regular staking implies, specifically illiquidity, immovability, and inaccessibility. Liquid staking turns the locked capital into liquid capital.
Overall, liquid staking is a product which promotes decentralization and accessibility, as well as earning extra staking rewards.
The liquid staking mechanism
Unlike proof-of-stake staking that locks funds up in a smart contract, liquid staking funds remain accessible in an escrow. Users deposit their funds in a DeFi application escrow account and get a tokenized version of their funds. This is where the issuance of a tokenized version of the staked funds, more precisely a derivative, comes into play, which can be transferred, stored, spent, or traded.
Liquid staking differs from regular staking in that assets are not completely locked up, more precisely a smart contract mints a liquid asset pegged to the staked asset in a 1:1 ratio. The original token is staked and generates rewards, and the new liquid pegged asset is available for use in DeFi, thus giving access to two avenues for generating income.
A receipt token is issued relative to the staking token, which gives the user access to liquidity and creates a secondary market. In liquid staking smart contracts, investors receive liquid staking derivatives in exchange for staking their assets, representing their claim on the underlying stake pool and its yield. This way, the economic position of staking can be invested in DeFi protocols, generating additional rewards.
By example, in $ETH liquid staking, one would deposit their token into a third-party application. This app would deposit for them this token into the token’s deposit contract, and in return would mint a receipt token for them (stETH). The stETH token will allow this user to maintain their $ETH liquidity, making them able to transfer their $ETH, all while still earning Ethereum staking rewards.
Advantages of liquid staking
+ Liquid staking brings stakers the benefits of immediate liquidity, composability of staked assets, and distribution of stake across multiple validators.
+ It offers the alternative to interact and use funds while simultaneously earning rewards. As a result, liquid staking protocols provide possibility for activities such as lending protocols and yield farming activities.
+ Users can interact with multiple DeFi platforms earning multiple rewards from one pool of funds.
+ Liquid staking maintains the benefits of PoS staking while removing most of the disadvantages. For example, you can easily and quickly remove funds from liquid protocols, a fact which is not possible in PoS protocols, and which occurs without unstaking penalties.
+ Liquid staking increases capital efficiency: it enables investors to use staked assets in the ecosystem for lending, trading, and as collateral.
+ It permits staking assets with minimum operational risk, routing assets to a staking pool which uses the existing validator infrastructure.
+ Liquid staking offers investors the freedom to stake as much as they want, unlike regular staking, which has minimum thresholds.
+ It facilitates emerging DeFi markets by increasing overall market liquidity.
+ Liquid staking improves blockchain security by increasing the cost of a hostile network takeover and promoting institutional adoption of digital assets.
Disadvantages and potential risks of liquid staking
– You can lose some of your staked assets through a process called slashing.
– Market fluctuations can make liquid staking risky.
– Liquid staking rewards are not standardized: different platforms offering liquid staking services have varying incentives, even for the same token.
– It also may happend that the new receipt token has a lower market price. For instance, the price of SOL may be $100 while the price of stSOL is $80.
– Risk of losing derivative tokens: if an investor loses their liquid token, they lose their staked token.
– Yield farming is risky, with each leverage in funds suffering a greater risk of liquidation. If a black swan event occurs, resulting in a very low turn in the markets, the asset value may drop below the necessary requirements for collateralization, and as a result, this may end in the liquidation of all assets.
– Without serious research and education, attempting to operate and interact with many liquid staking protocols simultaneously is very likely to be unprofitable.
– Every time a transaction must be signed, and a deposit committed, there are introduced additional smart contract risks.
– If a user is unable to recover the derivative asset from a DeFi platform, then they will not be able to withdraw their original deposit, or any yield generated from staking. It is therefore mandatory that DeFi users manage their private keys with extreme caution and choose liquidity pools with enough liquidity to sustain volatile market conditions.
– There are limited options for users who are looking to start liquid staking, because it is a novel market within the crypto economy and still being developed.