A Dip into Liquid Staking
What It Is
With the transition to the Proof-of-Stake consensus mechanism, many blockchains are gearing up to introduce liquid staking to their protocols, effectively allowing locked-up crypto to flow back into the market.
In the example of Ethereum 2.0, users (called validators) place a minimum of 32 ETH of stake into a deposit contract. However, as of right now, those funds cannot be transacted—locked away until Ethereum 2.0 introduces this functionality. Other blockchains like Solana have warmup/cooldown periods before transacting staked. So, what’s with the illiquidity? For many popular PoS networks, the lock-up feature serves as a safety mechanism, giving a network time to punish bad nodes. In the specific case of Ethereum, withdrawing stake funds is pending on the full transition to Ethereum 2.0. This means that users must depend on trust that their stake custody will return at a later date.
As blockchains depend on stakers to secure their networks, blockchain foundations will attempt to incentivize their users to contribute as much of their crypto as possible. However, due to the inability to instantly transact their staked funds, users might be discouraged due to the lack of liquidity. Furthermore, the locking of large portions of crypto means a weaker DeFi and Dapp ecosystem.
This introduces the solution of liquid staking. Essentially, stake funds are tokenized, allowing users to transact these funds instantaneously. This schema relies on the 1:1 value that stake tokens have with the locked funds. We call these tokens staking derivatives.
Financial Benefits
Liquid staking allows users to stake and unstake their crypto at any time. It also allows the user to earn staking rewards while retaining the ability to use their funds on other platforms—potentially generating even more profit. For example, the popularity of yield farming has taken off recently. With liquid staking, users can earn stake rewards and DeFi yields simultaneously. With this, liquid staking solves one of the largest drawbacks of PoS: saving. For a healthy DeFi ecosystem, users must have an incentive to spend their cryptocurrency. However, if saving crypto to stake is more financially attractive than spending, users will hoard their coins. With liquid staking, users are incentivized to spend for more financial gain.
Security Benefits
In a blockchain, security accompanies decentralization. However, there will always be centralized points within blockchain governance. In the Proof-of-Stake consensus model, exchanges manifest as centralized entities that hold massive governance rights due to user crypto. With liquid staking, users retain their governance rights, leading to a more secure network. In the example of cryptocurrency exchange Huobi, users’ voting rights were sold without their permission. Block producers bribed Huobi to elect them using users’ crypto holdings. This was brought on by the fact that Huobi is a custodial entity, allowing them to assume full control over their users’ cryptocurrency. Liquid staking would encourage users to choose non-custodial solutions.
Liquid Staking Solutions
One possible solution is Delegation Vouchers. In this system, a validator pool would be introduced. Instead of delegating directly to a validator, users would deposit their stake into the validator pool first. They would then receive a validator-specific voucher token that can be exchanged with any other user.
Another possible solution was introduced by StakeDAO, a smart contract-governed Decentralized Autonomous Organization. In this model, users deposit their stake into the StakeDAO contracts in return for what are called LTokens. They essentially buy into pools at a discount to what the pool will eventually be worth pending staking rewards. The StakeDAO operates on the idea that early backers will receive more rewards due to a lack of early liquidity. As time passes and the pools reach their projected value, LTokens will increase in value so that they equal the pool.
The Bottom Line
Liquid staking has grown to be a prospective solution to many PoS/DPoS drawbacks. While it is not the only solution, it has gained immense popularity as evidenced by the many liquid staking solutions in development. Liquid staking could prove to be a game-changer in incentivizing more users to secure PoS networks and support DeFi solutions.
Further Reading
Liquid Staking and its Benefits: A Deep Dive by Lido
Liquid Staking Legal Considerations
Comparing Staking Rewards – Is Liquid Staking Better Than Proof of Stake
Awesome Liquid Staking - A Curated List of Liquid Staking Projects, Ideas, Papers, and More
Liquid Staking Report [Chorus One]
On Staking Pools and Staking Derivatives [Paradigm Research]