What is Liquid Staking & How Does It Work?

Liquid staking is a new concept in the world of decentralized finance (DeFi) that allows users to stake their cryptocurrency assets while still maintaining their liquidity. Staking is the process of locking up a portion of your cryptocurrency assets in order to secure a blockchain network and earn rewards for doing so. However, once you have staked your cryptocurrency, it becomes illiquid and you cannot use it for other purposes. This is where liquid staking comes in. It allows you to stake your cryptocurrency while still being able to trade or use it for other purposes. 

Lido.fi is a platform that offers liquid staking services for Ethereum and other cryptocurrencies. In this article, we will explain how liquid staking works and how to use the Lido.fi platform to stake your assets. 

How Does Liquid Staking Work? 

Liquid staking works by creating a tokenized representation of your staked cryptocurrency assets. This token is called a staking derivative, and it represents your staked assets on the blockchain. You can trade or use this token just like any other cryptocurrency, while still earning staking rewards. 

When you stake your cryptocurrency assets on a blockchain network, you are essentially helping to secure that network by participating in the consensus mechanism. In return for your contribution, you receive a share of the network’s block rewards. These rewards are usually paid out in the form of the same cryptocurrency that you staked. 

However, with liquid staking, your staked assets are converted into a staking derivative that can be traded or used like any other cryptocurrency. The staking derivative is pegged to the value of your staked assets, so you still earn staking rewards even though your assets are liquid. 

Liquid staking is useful for a number of reasons. First, it allows you to earn staking rewards while still maintaining the liquidity of your cryptocurrency assets. This means you can use your assets for other purposes, such as trading or investing in other projects. Second, it can help to reduce the risks associated with staking. When you stake your cryptocurrency assets, you are locking them up and exposing them to risks such as slashing (penalties for breaking network rules) or network downtime. With liquid staking, you can still earn rewards without exposing your assets to these risks. 

Liquid Staking on Ethereum 

Recently, Ethereum, the second-largest cryptocurrency by market capitalization, made the switch from Proof-of-Work (PoW) to PoS. This represents a major milestone in the blockchain’s roadmap, from the launch of Beacon Chain on December 1, 2020, to the “Merge” — the merging of the original Ethereum mainnet with a separate PoS blockchain called Beacon Chain on September 15, 2022. Proof of Stake disincentivizes an attack on the network by requiring control of the majority of tokens to control the blockchain. New blockchain transactions are verified by putting tokens “at stake”, which can be taken away (“slashed”) in the event of fraudulent behavior. With Proof of Stake, a token holder can lock up tokens and use their weight to verify the authenticity of transactions. Up to four percent interest can be earned in this way. 

However, currently, only around 17 percent of all ETH coins in circulation are staked. Unlike other investment tools, however, while the tokens are staked they cannot be transacted, traded, or used as collateral — they are illiquid. This poses too great of a risk for many investors. 

The next planned step on the Ethereum roadmap as part of the “Shanghai Fork” expected in March 2023 is to provide the technical capability to un-stake Ether (ETH) and thus move staked assets back out of staking. 

Even after all planned blockchain upgrades will be completed, there is still a lockup period for staked ETH during which the tokens are locked to the user. This lockup period is due to the fact that the staked assets are used to give the network enough time to detect potentially negative behavior and take appropriate action. Thus, a user can stake his ETH and receive rewards meanwhile. However, the tokens remain locked for some time and cannot be used for other activities such as trading or lending. 

Advantages of Liquid Staking 

The goal of the liquid staking concept is to solve the barriers to entry associated with initial ETH staking — illiquidity, immobility, and inaccessibility — by converting the locked capital into liquid capital. With this concept, the staked position can be “made liquid,” meaning a Receipt Token is issued to the user when ETH is deposited into the staking. By being able to un-stake a staked position immediately by selling the Receipt Token, the user gains access to additional liquidity and a (secondary) market is created. 

Liquid staking provides the added benefit of allowing for the “composability” of yield strategies. By using liquid staking tokens as collateral on centralized or decentralized exchanges or lending pools, stakers can earn interest on top of the staking yield. This applies to all yield strategies in decentralized finance (DeFi). Additionally, on centralized platforms, staked tokens can be used as collateral for loans, margin trading, and derivative trading depending on the platform. 

There are also advantages to liquid staking on a technical level: when staking the usual way, a token holder would delegate their stake to a single validator, who keeps a share of the reward in return for running the required infrastructure. 

Liquid Staking Provider 

Liquid-staking providers are likely to profit the most from the Shanghai Upgrade. They act as a pool to which investors transfer their coins. These are staked together. To become active as a validator, you need at least 32 ETH. With a liquid-staking provider, you can get started with smaller amounts. According to DefiLlama, there are about $8.5b in liquid staking protocols across many blockchains including. The most well-known liquid staking provider is Lido.fi. 

Users should decide whether they want to use liquid staking on a centralized or decentralized provider. A centralized provider (e.g. exchange) holds custody of the assets, while a decentralized provider does not require custody but instead requires that tokens are deposited into a smart contract. 

The risk here is that the smart contract is hacked or exploited and the “backing” of the liquid staking token is stolen. However, decentralized protocols like Lido are some of the most heavily audited in the space and have successfully supported billions of dollars. 

What is Lido.fi? 

Lido.fi is a platform that offers liquid staking services for Ethereum and other cryptocurrencies. This liquid staking solution allows users to stake their ETH without locking their assets while participating in on-chain activities such as DeFi lending. The resulting stETH token represents the staked ETH in Lido and allows users to receive ETH staking rewards while benefiting from other rewards, as stETH tokens are accepted in various DeFi protocols and are tradable with significant liquidity. 

Conclusion 

Liquid staking is a new and innovative concept that provides stakers with several advantages, including immediate liquidity, composability of staked assets, and the ability to distribute stakes across multiple validators. However, the market for liquid staking tokens has limited liquidity, and stakers face custody or smart contract risk depending on whether they choose a centralized or decentralized provider. 

In the case of Ethereum, the benefits of liquid staking have encouraged more supply to be staked, which could potentially come at the expense of decentralization. Nevertheless, the benefits of liquid staking apply to many blockchains, and the growth of liquid staking pools is an ongoing trend. 

Lido.fi is a user-friendly platform that makes it easy to stake your cryptocurrency assets and earn rewards, without having to deal with the technical complexities of staking yourself. Lido is also the largest liquid staking provider with over 75 percent of the market share. This concentration has caused controversy in the past. Some see the decentralized nature of the network in danger. While Lido still holds dominance, it faces an increasing challenge from smaller protocols such as Rocket Pool, StakeWise, and Swell, which offer product enhancements.