What Is Liquid Staking? Unlocking Liquidity in Crypto Staking

1. What is Liquid Staking?

Liquid staking is an evolution of traditional staking that solves the issue of illiquidity associated with staked tokens. In liquid staking, users deposit their tokens into a staking provider who stakes those tokens on their behalf. In return, users receive a liquid staking token — essentially a receipt for their staked tokens.

These liquid staking tokens represent the staked assets and can be redeemed later for the original tokens, along with any rewards (or penalties). Unlike traditional staking, liquid staking allows users to:

Trade the liquid staking token on exchanges.
Use it as collateral for DeFi lending or borrowing.
Participate in liquidity pools across various DeFi protocols.

Thus, liquid staking unlocks the liquidity of staked tokens, making them usable while still earning staking rewards.

2. How does Liquid Staking work?

Liquid staking allows users to participate in proof-of-stake (PoS) blockchain networks while retaining the flexibility to use their staked assets within the broader DeFi ecosystem. Here's a step-by-step overview of how liquid staking typically works:

Connecting Wallets to a Liquid Staking Protocol

The first step in liquid staking is connecting your cryptocurrency wallet (such as MetaMask, Ledger, etc.) to a decentralized finance (DeFi) protocol that offers liquid staking services. Popular platforms like Lido, Rocket Pool, and Frax ETH facilitate liquid staking for tokens like Ethereum (ETH).

Choosing the Amount to Stake

Once connected, users decide how much cryptocurrency they wish to stake. The staked tokens are then locked up to help secure the network or validate transactions on the blockchain.

Receiving Liquid Staking Tokens

After staking, users receive a liquid staking token issued by the protocol. This token represents the staked assets and is typically pegged 1:1 to the underlying cryptocurrency (e.g., 1 liquid ETH for every 1 ETH staked). These tokens can now be freely traded or used across various DeFi protocols, giving users liquidity while their assets remain staked.

Redeeming Staked Assets

When users wish to redeem their staked tokens, they can burn their liquid staking token to receive the original staked assets, along with any staking rewards or penalties. The burning of the token effectively unlocks the staked assets.

Leveraging Liquid Staking Tokens

While the staked assets remain locked, the liquid staking tokens allow users to participate in the DeFi ecosystem without losing their staking rewards. These tokens can be used for:

Crypto trading
Yield farming
Lending and borrowing
Liquidity provision in decentralized exchanges (DEXs)

In essence, liquid staking tokens give users the flexibility to earn additional rewards or yield from other DeFi opportunities while still earning staking rewards.

Protocol Fees and APR

Many liquid staking protocols charge a fee for facilitating the staking process. For instance, Lido, one of the largest liquid staking platforms, charges a 10% fee on staking rewards. This fee is distributed between Lido's node operators and the Lido DAO (Decentralized Autonomous Organization).

Before participating in liquid staking, it’s essential to check if the Annual Percentage Rate (APR) advertised by the protocol accounts for these fees. In many cases, the APR listed by the protocol might be after the fee has been deducted, so it’s important to understand what you’re actually earning.

3. Benefits of Liquid Staking

Unlocked Liquidity
In traditional staking, once tokens are locked, they cannot be traded or used for any other purpose. Liquid staking solves this by issuing a receipt token that represents the staked assets. This token can be freely traded or used across the DeFi ecosystem, which means users can take advantage of new investment opportunities without losing their staking rewards.
Composability in DeFi
Liquid staking tokens integrate seamlessly into the DeFi space, where they can be used for a range of activities such as lending, borrowing, and participating in prediction markets. By turning staked tokens into a liquid asset, users can leverage the power of composability — the ability to combine various DeFi products to increase yield or reduce risk.
Reward Opportunities
Traditional staking gives users the opportunity to earn rewards for validating transactions and securing the network. Liquid staking lets users continue earning these rewards while also gaining additional yield by using their liquid staking tokens in DeFi applications. This increases overall earnings potential by combining the benefits of staking with the ability to earn from other DeFi strategies.
Outsource Infrastructure Requirements
Liquid staking providers handle the technical infrastructure of running a validator node. This means that even users who don't meet the minimum staking requirements for a solo validator (e.g., Ethereum's 32 ETH) can still stake their tokens and participate in the rewards without the need to run complex validator setups.

4. Risks and Limitations of Liquid Staking

While liquid staking offers many benefits, it also introduces some unique risks and considerations:

Slashing Risk
Users who participate in liquid staking are outsourcing the responsibility of running a validator node to a third party. If the service provider's node acts maliciously or fails to operate reliably, the user's staked assets may be slashed, meaning a portion of their staked tokens could be lost as a penalty.
Exploits and Security Risks
By depositing tokens with a liquid staking provider, users place their assets at risk if the provider's smart contracts or private keys are compromised. A bug in the staking protocol or a breach of security could expose users to the risk of losing their funds. It's important for users to choose reputable liquid staking services with robust security measures in place.
Secondary Market Volatility
The price of liquid staking tokens is not always directly pegged to the underlying staked asset. While these tokens may usually trade close to the value of the staked asset, they can deviate from the expected value due to liquidity issues, market conditions, or unexpected events. For example, during times of market volatility, the price of liquid staking tokens may be more volatile than the underlying asset, leading to potential losses for holders.

5. Popular Cryptocurrencies that support liquid staking

Several major cryptocurrencies now support liquid staking, providing token holders with the opportunity to earn rewards while maintaining flexibility. Some of the most notable examples include:

Ethereum (ETH): After the Ethereum network transitioned to proof-of-stake with The Merge, it introduced liquid staking, enabling ETH holders to stake their tokens while retaining the ability to use them across the DeFi ecosystem. Providers like Lido and Rocket Pool offer liquid staking services for ETH.
Polkadot (DOT): Polkadot supports liquid staking, allowing users to stake their DOT tokens and still participate in the network’s governance and other DeFi applications while maintaining liquidity through liquid staking tokens.
Cardano (ADA): While still in its early stages compared to other blockchains, Cardano offers liquid staking options via third-party providers, unlocking staking rewards without sacrificing liquidity.
Avalanche (AVAX) and Cosmos (ATOM): Both of these projects also support liquid staking, with protocols designed to unlock liquidity while allowing token holders to stake and earn rewards.

6. Conclusion

Liquid staking represents a game-changing innovation that combines the benefits of staking with the flexibility of liquidity. It allows crypto holders to earn staking rewards while still utilizing their tokens in DeFi protocols, lending platforms, and other financial strategies. As more blockchain projects implement liquid staking solutions, users will have even more opportunities to maximize the potential of their assets.

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