What is liquid staking?

Traditionally, staking involves locking up a certain amount of cryptocurrency to support the operation and security of a blockchain network. This process rewards participants with interest or transaction fees in exchange for their locked assets and their role in validating transactions. However, traditional staking comes with a significant limitation—illiquidity. Once cryptocurrency is staked, it typically cannot be used for other purposes, which can deter potential stakers who are concerned about losing access to their assets for extended periods.

Enter liquid staking, a novel concept designed to address this very issue. Liquid staking allows participants to stake their cryptocurrency assets without sacrificing liquidity. This is achieved by issuing synthetic assets or derivatives that represent the staked holdings, which can then be freely traded or used in various decentralized finance (DeFi) applications. This innovation not only preserves the underlying principles of staking but also enhances the flexibility and utility of staked assets, broadening the appeal of staking to a wider audience.

Traditional Staking

Staking in the context of blockchain technology is a process where cryptocurrency holders commit their tokens to a blockchain network to support operations and security. This is predominantly seen in Proof of Stake (PoS) networks where instead of miners (as in Proof of Work systems like Bitcoin), validators are chosen to confirm transactions and create new blocks based on the amount of cryptocurrency they hold and have "staked" or locked up as collateral.

• The purpose of staking is twofold: it helps secure the network by incentivizing validators to maintain honest, reliable nodes because their own funds are at risk if they act maliciously; and it supports the network through the validation of transactions and creation of new blocks, which in turn ensures the integrity and continuity of the blockchain.

While traditional staking supports network integrity and security, it also introduces significant limitations, primarily illiquidity and inflexibility. When tokens are staked, they are locked up in the network and cannot be easily accessed or traded. This can be problematic for holders who may need to access their capital quickly or want to respond to market fluctuations. This lack of liquidity can deter potential participants who are uncomfortable with the inability to move or use their assets freely.

Liquid Staking Explained

Liquid staking is a modern approach that seeks to address the limitations of traditional staking by allowing participants to stake their assets while retaining liquidity. In liquid staking, when users stake their cryptocurrencies, they receive a representative token—often referred to as a staking derivative or a liquid staking token. This token represents their staked investment and can be traded, sold, or used in other DeFi applications, thereby maintaining liquidity.

Benefits of Liquid Staking

The primary benefit of liquid staking is that it allows users to have their cake and eat it too; they can contribute to the security and efficacy of the blockchain while still having the ability to utilize their staked assets. This flexibility opens up several advantageous scenarios:

• Participation in DeFi: Users can use their liquid staking tokens as collateral or in lending protocols to generate additional yield, compounding their staking rewards.

• Enhanced Liquidity: Since the staking derivatives can be traded, users can convert their staked assets into other forms of value quickly if needed, without having to un-stake and possibly miss out on rewards or pay early withdrawal penalties.

• Risk Mitigation: Liquid staking can also provide a way to mitigate risk by diversifying the use of staked capital without diminishing the underlying security contribution to the network.

Delegated Staking vs. Liquid Staking

Delegated staking and liquid staking are two prominent models used to engage with blockchain networks, each with its own set of features and benefits.

Delegated Staking:

• Control: In delegated staking, cryptocurrency holders delegate their staking power to a validator who participates in the consensus process on their behalf. This typically results in less direct control over the staking process since the validator makes all pertinent decisions.

• Flexibility: Tokens are often locked in during the staking period, limiting the holder’s ability to trade or use them for other purposes.

• Rewards: Stakers earn a share of the rewards generated by the validator, which are distributed after deducting the validator’s commission.

Liquid Staking:

• Control: Liquid staking provides stakers with more direct control over their investments. Stakers can freely trade or utilize their staked tokens in the form of staking derivatives.

• Flexibility: Offers enhanced flexibility as staked assets are tokenized, allowing stakers to use these tokens in various DeFi applications without unstaking their principal investment.

• Rewards: In addition to staking rewards, liquid staking often includes additional incentives such as liquidity pool rewards, increasing the potential return on staked assets.

Key Differences:

The primary distinction between delegated and liquid staking lies in the liquidity and usage of staked assets. Liquid staking addresses the liquidity issues inherent in traditional and delegated staking models by providing stakers with derivative tokens that represent their staked holdings, which can then be used just like any other cryptocurrency.

How Liquid Staking Works?

Lido is one of the leading platforms offering liquid staking solutions, particularly for Ethereum. It allows ETH holders to stake their assets without locking them up, enabling participation in network security without sacrificing liquidity.

Process:

• Staking: Users deposit ETH into Lido’s staking contract. In return, they receive stETH tokens in a 1:1 ratio to their staked ETH. These stETH tokens represent the user's staked Ethereum and accrue staking rewards over time.

• Tokenization: The stETH tokens are ERC-20 tokens that can be used like regular cryptocurrencies. They can be traded, used in DeFi protocols, or even used as collateral for loans.

• Validation: Behind the scenes, the deposited ETH is pooled together and staked with various validators on the Ethereum network. This pooling allows users to participate in staking without meeting the 32 ETH minimum required to operate an independent validator node.

• Rewards Distribution: As validators generate rewards, these are distributed back to the stETH holders, increasing the value of each stETH token over time relative to ETH.

Role of Smart Contracts and Tokenization:

• Smart Contracts: Lido utilizes smart contracts to automate the staking and reward distribution processes. These contracts handle the pooling of ETH, the distribution of stETH, and the allocation of staked funds to validators.

• Tokenization: By issuing stETH tokens, Lido creates a liquid derivative of the original staked ETH. This tokenization is critical as it maintains the liquidity of staked assets, allowing users to benefit from staking rewards while retaining the flexibility to use their assets in the broader crypto ecosystem.

Staking-as-a-Service

Staking-as-a-Service platforms serve as intermediaries that simplify the staking process for individual investors. These platforms allow users to stake their cryptocurrencies through a third-party service that handles all technical aspects of the staking process, from validator operations to reward distribution. This service is particularly appealing to those who wish to participate in staking but lack the technical expertise or desire to handle the day-to-day management of staking resources.

• Custodial Staking Services: In this model, the staking platform takes custody of your cryptocurrencies, meaning they control the private keys. This setup simplifies the staking process for the user but introduces risks related to the security and integrity of the service provider. Custodial services often manage the entire staking operation, including choosing validators and distributing rewards.

• Non-Custodial Staking Services: Non-custodial staking services allow users to participate in staking without relinquishing control of their cryptocurrencies. Users retain their private keys, and the staking service merely acts as a facilitator, providing technology and infrastructure support. This model is preferred by those who prioritize security and control over their digital assets.

Risks and Considerations

• Technical Threats: Liquid staking platforms rely on complex smart contracts that can be prone to bugs or vulnerabilities. These technical risks could potentially lead to the loss of staked assets if exploited by malicious actors.

• Market Risks: While liquid staking allows for greater flexibility, it also exposes users to market volatility. The value of staking derivatives can fluctuate significantly, and leveraging these assets in DeFi applications can lead to compounded risks, including liquidation if collateral values fall.

Strategies for Mitigating These Risks

• Regular Audits: Ensuring that the staking platform and its underlying smart contracts are regularly audited by reputable security firms can help identify and mitigate vulnerabilities.

• Diversification: Participating in multiple staking pools or using various liquid staking platforms can help spread risk and reduce potential losses from any single point of failure.

• Education: Keeping informed about the staking process, understanding the specific risks associated with liquid staking, and staying updated on market conditions are crucial for managing investments wisely.

Conclusion

Liquid staking marks a significant evolution in the staking landscape, offering enhanced liquidity and flexibility that traditional staking methods cannot match. By enabling participants to retain active control over their investments while reaping the benefits of staking, liquid staking could potentially transform how assets are managed on blockchain networks.

Kauri Academy provides a wealth of resources designed to deepen your understanding of liquid staking and its place within the broader cryptocurrency ecosystem. We encourage you to explore these educational materials to make informed decisions and participate safely and effectively in liquid staking. Embrace the opportunities presented by this innovative staking model, and consider how you can integrate liquid staking strategies into your investment portfolio for greater yield and flexibility.