Liquid Staking Vs. Direct Staking: A Deep-Dive Into The Dynamics, Pros, and Cons

Staking is one of the most popular ways to earn passive income without actively trading on exchanges. As digital assets continue to evolve, new innovations are redefining the DeFi landscape. Liquid staking is one of the latest trends in the industry. 

This article will dive deep into the world of staking, and explore the key differences between direct staking and liquid staking. We’ll also look at some of the existing liquid staking protocols on the Solana network and how you can use them. Let’s get started. 

Direct/Native Staking 

Direct staking involves locking up crypto assets in a protocol for a fixed period of time to earn rewards. Through staking, token holders can delegate their tokens to network validators. Direct staking is only supported on networks that use the proof-of-stake(PoS) consensus algorithm. PoS networks include post-merge Ethereum, Solana, Cardano, Cosmos, and Tezos. 

Different direct staking protocols implement different rules and parameters. Direct staking rewards, periods, and other terms vary for each protocol. One constant condition in direct staking is that once the funds are locked into a smart contract, token holders cannot transfer, sell, or trade their assets. In essence, staked tokens become “illiquid” until the staking period elapses. 

The rewards an investor receives from direct staking will depend on several factors, including the amount of liquidity they contributed to the pool, the overall size of the pool, and the current market conditions for the cryptocurrency being staked. 

Pros of Direct Staking 

Easy to set up and manage: Most direct staking protocols are user-friendly and do not require any technical expertise to set up and manage. 

Passive income: Investors can earn rewards without having to actively trade or manage their assets. 

Helps support the network: By participating in direct staking, investors contribute to its security and stability. 

Cons of Direct Staking 

Requires a minimum amount of assets: In order to participate in direct staking, investors need to have a minimum amount of the chosen cryptocurrency in their wallet. For example, investors need a minimum of 32 ETH to stake on Ethereum. 

Rewards can be unpredictable: The number of rewards earned through direct staking can vary depending on market conditions and other factors. 

Limited liquidity: Investors are unable to easily access or sell their staked assets if they need to. 

Enter Liquid Staking 

Traditionally, staking required users to lock up their cryptocurrency for a fixed period of time, often several months to years. This meant that users had to sacrifice the liquidity of their holdings in order to earn staking rewards. 

Liquid staking offers a way around this problem. It allows users to earn staking rewards without having to sacrifice their liquidity. 

How Does Liquid Staking Work? 

When a user deposits their assets into a liquid staking protocol, they receive a tokenized version of their funds, which they can use across the DeFi ecosystem. So, let’s say Bob wants to stake 1000 SOL into a liquid staking protocol. 

The protocol will mint 1000 stSOL equivalent to the 1000 SOL. Bob will earn rewards from the initial 1000 SOL staked, while still being able to use the stSOL tokens for other purposes. For Bob to get back his initial 1000 SOL, he’ll need to have 1000 stSOL. The terms and conditions vary depending on which protocol he’s using. 

The Pros of Liquid Staking 

Portfolio diversification: The most significant benefit of liquid staking is that it allows investors to maintain the liquidity of their crypto while still earning staking rewards. Investors can take advantage of market fluctuations using their assets to make more profit, while still enjoying their guaranteed APY. 

Crypto-backed loans: At times, investors may need to reshuffle their portfolio without selling their assets. Say a SOL holder needs fiat but doesn’t want to sell his SOL(no pun intended). The investor can stake the SOL, receive some stSOL, and sell this stSOL for fiat. In essence, the investors will still enjoy staking rewards while also benefiting from a SOL price increase. 

Enables quick access to funds: Unlike direct staking, liquid staking allows users to access their funds without lengthy “un-staking” processes or penalties for premature “un-staking.” Liquid stakers can unstake their assets immediately by swapping their staked tokens for normal tokens. 

Increase/Maintain the overall liquidity of the cryptocurrency market: By allowing users to earn rewards on their holdings without having to lock them up, it encourages more people to hold onto their cryptocurrencies for longer periods of time. This can help to increase the overall supply of cryptocurrencies in circulation, which in turn, helps to drive down volatility and improve market stability. 

The Cons of Liquid Staking 

Requires more technical expertise: Liquid staking requires a certain level of technical expertise to manage the staking process effectively. This can be a barrier for some investors, particularly those who are new to the world of crypto investing. 

Risk of deppeging: The price of the staked derivative may depeg from its original price. This may happed because the new 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. This can result from bad trades, rebalancing losses when farming in liquidity pools, and liquidations at lending protocols. 

Risk of network centralization: Token holders will likely choose to stake their tokens on liquid staking protocols. As a result, the balance of validator shares taking part in the network may be disrupted, giving room for undue control from more powerful validators. 

Liquid Staking On Solana: Which Platforms Are Available? 

There are a growing number of platforms and tools designed to make liquid staking easier and more accessible to investors. These platforms provide liquid staking opportunities and help investors manage staking rewards. Liquid staking platforms on Solana include Lido, Marinade Finance, Parrot, and Socean. 

Lido was launched in 2020. According to the crypto intelligence firm Messari, Lido’s current TVL stands at $5.79. Lido is unique in that it allows interoperability between multiple networks, including Solana and Ethereum. When you stake your tokens on Lido, you mint stSOL tokens at a 1:1 ratio to the initial tokens. These tokens can be used across the DeFi ecosystem for actions such as lending and borrowing. 

Parrot offers a suite of products built around its stablecoin called PAI. It offers liquid staking services, generating prtSOL when SOL is deposited for liquid staking. Socean and Marinade Finance, other platforms native to Solana, also offer similar liquid staking services. 

Closing Thoughts 

Overall, liquid staking is a new and innovative strategy with the potential to offer investors significant benefits in terms of portfolio diversification, flexibility, and higher returns. 

It’s likely to become more popular in the coming years as investors look for ways to take advantage of the opportunities presented by the crypto market.