You may have heard of staking before, but have you heard of liquid staking? It is an astonishing addition to the decentralized finance (DeFi) ecosystem that takes staking to a whole new level.
To refresh your memory, staking is the mechanism by which proof-of-stake (PoS) networks are kept secure.
People called validators stake their assets as a way of showing allegiance to the network and are then qualified to validate transactions on behalf of the network.
The thing with staking however is that once you stake assets, you cannot access them for any reason until the staking period is over.
In other words, the assets become illiquid. That didn’t sit right with DeFi developers, so they came up with the idea of liquid staking.
What Is Liquid Staking?
Liquid staking works just like traditional staking – you stake assets. However unlike traditional staking the staker can access and use the staked assets in some other ways without having to stop the staking.
This is made possible through liquid staking derivatives. Liquid staking derivatives are derivatives or versions of the staked assets that you can use for other purposes.
You can only practice liquid staking on liquid staking platforms because only such platforms can allow you to obtain liquid derivatives.
By minting the new derivative token, liquid staking platforms solve the problem of liquidity for stakers by allowing them to use derivatives of their staked assets for other purposes which can increase the user’s earning potential.
For example as a user, you can deposit ETH to the Lido staking pool and receive stETH (staked ETH) tokens in return, then deposit the stETH to Aave to earn yield.
This means that even though your ETH is staked on Lido, you can use a version of it (stETH) to still earn yields on another platform.
Apart from being able to deposit and earn yields on the derivative tokens, you can also trade them on supported platforms.
You may also use them as collateral on DeFi protocols to take loans, since they are evidence that you own the staked ETH or whichever asset you staked.
Types of Liquid Staking
Even though all liquid staking is done within the DeFi ecosystem, it can be divided broadly into centralized and decentralized liquid staking.
The usual decentralized liquid staking protocols like Lido and Rocket Pool are the most commonly known.
However, centralized exchanges can also offer liquid staking opportunities. The only difference is that in decentralized liquid staking, the user has full control of your assets since it is non-custodial.
In contrast, centralized liquid staking gives full control of your assets to the platform because they are custodial. If you’re the type that prefers to maintain full control over your assets, it is advisable to stick with the decentralized platforms.
Pros of Liquid Staking
Liquid staking has several advantages over traditional staking, at least for the user who enjoys the following benefits.
Unlocked Liquidity
With liquid staking, there is no “lock period” when you stake assets on the platform. Your liquidity is unlocked, and your assets are available for you to use in other ways and other platforms to earn more.
Reward Opportunities
In traditional staking, stakers get rewarded for verifying transactions. Liquid staking offers the same opportunity in addition to earnings on different other platforms.
Simplicity
Liquid staking allows anyone to earn from staking without having to run a node or any complex infrastructure.
Cons of Liquid Staking
Liquid staking has the following disadvantages.
Slashing
Liquid staking entails trusting another validator to run a node for you. If they breach rules, your funds can be slashed.
Exploits
Another thing is that the validator you’re depositing your assets to can be exploited if their private keys are compromised. This exposes your funds to risk.
Secondary Market Volatility
Derivative tokens are not pegged to the staked assets they represent. Therefore the price of the derived tokens can be exposed to volatility that reduces the price which should be equal to or just slightly different from that of the staked assets.
