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What is Liquid Staking?
Liquid staking, also known as soft staking, is a variant of token staking operational in the decentralized finance (DeFi) ecosystem.
Like the standard staking system, users can lock up their funds to secure a blockchain network.
However, the key distinction is that in liquid staking, users can maintain access to virtual funds even while staked. This allows them to access a ‘liquid version’ – a form of receipt – of the principal assets they initially pledged in securing the network.
Techopedia Explains
Soft staking came into the spotlight following the launch of the Ethereum Beacon Chain in 2020. However, the crypto boom of 2021 and the rise of decentralized applications (dApp) focused on trading and providing liquidity on the Ethereum network made it gain widespread appeal.
This surge in popularity stemmed from concerns among many investors who feared that their funds would become inaccessible once locked on the Beacon Chain.
The Beacon Chain was Ethereum’s strategic move towards transitioning from a proof-of-work (PoW) model to a proof-of-stake (PoS) consensus network.
In response to this concern and the desire to make locked funds more accessible, liquid staking emerged. Now, liquid staking is offered on the Solana, Polygon, and a number of other networks.
With this staking approach, investors can secure the blockchain network, earn rewards from staking, and still access the liquid versions of their tokens on other blockchain-based applications like Aave, Curve, or Convex Finance.
How Does Liquid Staking Work?
While the basic idea around liquid staking aligns with regular staking, its operational methods are fundamentally different.
Liquid staking operates as follows:
- Firstly, users head to a liquid staking platform and lock their digital assets.
- The digital assets’ legitimacy is then verified and kept in a smart contract – bits of immutable computer code that self-executes based on preset commands.
- Once completed, the platform issues the user liquid staking tokens (LSTs), such as Lido Finance’s stETH (staked ether), replicas of their locked assets. These tokenized versions are pegged on a 1:1 basis to the original digital asset. Users can withdraw these replica tokens whenever they need them on other platforms.
- The liquid staking platform then uses the initial assets for native staking on the underlying smart contract network. As a result, the funds are permanently locked on the primary blockchain network to secure it. In return for pledging these funds, these platforms are rewarded with newly minted crypto assets.
- Finally, investors who stake their assets receive portions of the staking rewards the liquid staking platforms earn. For instance, if a user stakes 1 ETH (ether) on the Lido Finance platform, they will be issued one stETH. This represents the staked ETH and a portion of the staking rewards they earn.
However, LSTs can lose their pegs if too many users want to redeem their staked assets at once. To address this issue, most liquid staking platforms typically release staked assets at particular periods.
Benefits of Liquid Staking
Staking enables investors to put their idle crypto assets to work. By pledging these digital funds to contribute to the security of a blockchain network, they are duly rewarded with more of the blockchain’s native assets.
However, liquid staking provides even more mobility for investors’ digital funds.
Below, we cover some major benefits of this staking mechanism:
- Unlocked Liquidity
Liquid staking allows investors to stake their digital assets, access a representative of their digital tokens, and utilize them on other platforms to earn more yields. This provides them with the needed liquidity to transact on other platforms. - Multiple Income Streams
Another significant benefit of liquid staking is its capacity to unlock multiple streams of cryptocurrency income for users. This is achieved by allowing LSTs to be easily withdrawn and used as collateral to secure crypto-backed loans from platforms like the Aave protocol. These obtained loans can then be placed in higher-yield cryptocurrency platforms, thereby generating additional returns on the original deposits. - Outsource Infrastructure Requirements
Staking on networks such as Ethereum requires users to possess a minimum of 32 ETH, translating to a significant investment worth thousands of dollars. This requirement does not account for the infrastructure needed to effectively validate transactions.
In contrast, soft staking offers a more inclusive approach, enabling individuals to deposit fewer assets on a liquid staking platform and still partake in the staking rewards.
Disadvantages of Liquid Staking
While liquid staking is the next generation in passive revenue generation, it also comes with its specific drawbacks:
| Disadvantage | Explanation |
| Loss of peg to staked asset | Liquid staking tokens (LST) can lose their peg to the original asset, causing the LST’s value to fall below the value of the digital asset it is linked to. An example is stETH trading lower than ETH after the Terra blockchain collapse in 2022. |
| Risk of slashed funds | Liquid stakers outsource their funds to validator nodes, making them vulnerable to malicious or unreliable validators. In cases of misbehavior, the deposited funds can be subject to reduction by the underlying network. For example, in the Ethereum protocol, offline validator nodes may see half of their ETH deposits slashed. |
| Loss due to unprofitable trades | If a user engages in an unprofitable trade, leading to the loss of their liquid tokens due to poor decision-making, they risk forfeiting access to their initial deposits. |
| Security vulnerabilities | Finally, liquid staking platforms with poor security protocols can easily be compromised. If this occurs, users will lose access to their deposited assets. |
Top Liquid Staking Providers
Below, we delve into two popular liquid staking providers in the nascent industry:
- Lido Finance: launched in 2020 as the Ethereum blockchain’s de facto liquid staking platform. It has since expanded its staking services to Solana and Polygon networks. On Lido Finance, investors can use their LSTs (stETH, stSOL, or stMATIC) to access Aave, Uniswap, MakerDAO, Balancer, 1Inch, and several other DeFi protocols. The platform rewards users with a 3.6% annual percent rate (APR), 4.2% APR, and 6.2% APR for Ethereum, Polygon, and Solana, respectively.
- Rocket Pool: launched in 2016, Rocketpool is a user-friendly liquid staking platform solely focused on the Ethereum protocol. The platform enables users to run a decentralized staking node on Ethereum or deposit as low as 0.01 ETH for staking. In return for staking, users get the rETH representative asset. Rocket Pool allows users to earn 3.24% APR for regular ETH staking and 7.01% APR plus its native RPL rewards for running a validator node.
The Bottom Line
Liquid staking offers investors unrestricted access to earning potentials within the decentralized economy. This innovative staking method allows users to lock up their assets securely, contribute to blockchain network security, and earn rewards. It also provides them with liquid digital assets that can be strategically utilized elsewhere.
However, liquid staking also comes with its drawbacks, which prudent investors should thoroughly evaluate before engaging in this approach.
