The emergence of liquid staking tokens has supercharged staking in the Ethereum ecosystem as one of the fundamental revenue streams serving the Decentralized Finance (DeFi) space since the protocol’s transition from Proof-of-Work (PoW) to Proof-of-Stake (PoS).
While staking reaps rewards for validators who offer their assets to the project for a given period, it also limits them by depriving them of access to their assets. This, in turn, reduces their liquidity and ability to use their assets for more returns.
For this reason, liquid staking emerged to give asset holders the chance to stake their assets and gain rewards while still using the staked assets in other ways that yield additional returns. A fundamental part of liquid staking is liquid staking tokens, also known as liquid staking derivatives.
These are IOU tokens created by “wrapping” or tokenizing the staked assets. Liquid staking tokens hold equivalent value to the staked assets and can be used on various decentralized platforms for trading and other use cases.
5 Key Aspects of Liquid Staking Tokens
To better understand them, it is necessary to understand the key aspects of liquid staking tokens.
Liquid staking derivatives are created from the staked assets through a process called tokenization. This is where the token is minted or wrapped as a representation of the staked asset.
Therefore, when one stakes Ether, the liquid staking protocol mints a tokenized version such as stETH or wETH, which can then be used for trading, lending, or borrowing on compatible platforms.
Once minted, liquid staking tokens function as a blockchain-based document of title attesting to the holder’s ownership of the staked token. They can, therefore, be presented as valid proof that the holder owns the staked assets as well as any rewards earned from participating in the network.
As such, liquid staking tokens can also be used to transfer ownership of staked assets without unstaking them, seeing as they represent ownership.
Just as warehouse receipts and bills of lading unlock the ability to transfer ownership of physical commodities in storage or transport, LSTs enable stakers to transfer ownership of digital commodities without unstaking them. /3
— Mike Selig (@MikeSeligEsq) February 21, 2023
By presenting liquid staking tokens, the holder can be permitted to withdraw their staked assets according to the network’s rules and requirements.
Another principle upon which liquid staking tokens are built is liquidity. By offering tokenized equivalents, holders are provided with liquidity that can be used to buy and sell other assets as the holder desires.
This gives previously illiquid staked assets a degree of liquidity, allowing users to respond to market conditions or take advantage of investment opportunities without having to wait for their staking periods to expire.
Seeing as they are pegged 1:1 to the staked asset, they hold value and are considered valid collateral. This expands their utility, allowing their holders to use them to acquire loans, borrow other assets, or participate in various yield farming strategies.
Unlike other staking-backed yield products, such as yield-generating tokens, which are only used on their native platform, some liquid staking tokens, such as Lido’s stETH, are cross-chain. This enables users to deposit their assets into a liquid staking protocol on one blockchain and utilize a representation of those staked assets on another blockchain.
By allowing the tokens to be used on multiple platforms, holders are given more use cases to apply their tokens. This expands their ability to earn more rewards, not only by how they are used but also where they are used.
5 Benefits of Liquid Staking Tokens
Given their function in the DeFi ecosystem, these tokens bring advantages that asset holders can explore.
1. Increased Rewards
Liquid staking tokens free up liquidity for the asset owners, allowing them to invest their assets in other return-yielding ventures. Therefore, while the staked assets earn their rewards for participating in validating transactions and securing the network, their tokenized representations can also be used to trade, borrow, and lend.
This generates more rewards for the owner, enabling them to maximize their capital.
Using liquid staking tokens, users can diversify their return-yielding strategy by staking the assets and using the tokens on another platform. This is especially possible when the liquid staking token is cross-chain.
By so doing, the user can leverage the benefits of several platforms by, for instance, choosing a more secure platform to stake their assets and trading their liquid staking tokens on another platform with higher return rates.
3. Participation in Governance
In most cases, liquid staking tokens allow users to retain their voting privileges and take part in the management of the underlying blockchain system. This guarantees that interested parties can actively participate in decision-making procedures and have a voice in the network’s future growth and direction.
4. Liquidity on other DeFi platforms
Aside from benefitting the holder and the platform on which the assets were staked, tokens also provide liquidity for lending and borrowing platforms on which they are used.
This enables more DeFi platforms, decentralized exchanges (DEX), and other platforms to have liquid funds with which they remain operational, keeping the ecosystem running.
2 Risks Associated with Liquid Staking Tokens
Despite the advantages, liquid staking tokens also present a set of risks to whoever chooses to stake their assets with liquidity protocols.
1. Possibility of Slashing
Given that the tokens are pegged 1:1 to the staked assets, the value of the liquid staking tokens may be impacted by fines or slashing events that occur on the staked assets.
As a result, token holders can experience possible losses or a decrease in the value of the token should there be a disruption in the network or malicious actions by a validator.
2. Additional Risk
While cross-chain liquid staking tokens allow users more flexibility in utilizing their assets, they also introduce an extra layer of complexity and exposure due to the smart contract and cross-chain infrastructure that facilitates them.
This adds another point of vulnerability that could be exploited, leading to losses to the user. As such, users ought to be aware of the increased exposure their assets suffer when they choose to stake their assets on liquid staking protocols for equivalent tokens.
The Future of Liquid Staking Tokens
A key issue that the crypto industry has been trying to solve, even with the release of more digital assets and projects, is utility. There remains an inherent need to increase the utility of assets within the ecosystem to encourage increased adoption.
Liquid staking tokens are a building block to unlocking increased possibilities of how holders can utilize the assets they hold. By growing to become cross-chain, these tokens are opening up the ecosystem and doing away with the limit of where holders can use their assets, enabling them to leverage every chain for its strength.
As developers and stakeholders continue innovating, liquid staking tokens will potentially be usable across all existing blockchains, resulting in unimaginable possibilities. Not only will this contribute to the essence of crypto, which is decentralization, but it will also be an incentive for more users to join the ecosystem.
The swift ascent of liquid staking derivatives serves as yet another illustration of DeFi’s impressive capacity to swiftly expand and transform to address the increasing demands of its community.
Liquid staking tokens have come into DeFi to offer a new way to get yield on your cryptocurrency investments.
In addition to liquifying staking, which was initially illiquid, they have also given users more opportunities to field returns and flexibility in where and how they invest their assets.