What Is Liquid Staking in Crypto? How It Works & Its Benefits

The use of cryptocurrency to generate passive income is growing in popularity. Staking, which involves locking up your cryptocurrency holdings to sustain a blockchain network and receive benefits, is one method to accomplish this. It's something similar to bank deposit, but at the same time, customers are able to use their crypto further by receiving a tokenised representation of the staked assets (liquid staking tokens or LSTs).

Therefore, liquid staking has emerged as a game-changer in the DeFi (decentralised finance) space. We will examine the fundamental principles, advantages, and possible drawbacks of this passive income in this post. Additionally, we'll contrast it with conventional staking and go into great depth on how to begin using one of these cutting-edge tactics.

What Is Liquid Staking?

Let’s dive into what exactly is liquid staking in cryptocurrency, and why is it becoming more and more popular?

First, let’s understand traditional staking. In a blockchain, staking allows users to support a network’s security and functionality. People block an amount. of their crypto by locking it up, usually for a fixed period, in order to help the network process transactions. In return, they earn rewards, usually in the form of more cryptocurrency or different tokens.

While staking has been a popular choice, it comes with a downside: the funds are locked up and can’t be used for anything else before the staking time ends. This limitation resulted in an innovative idea of liquid staking. This concept was implemented by the Lido Finance platform.

It is a form of staking that combines earning rewards with maintaining liquidity, or the ability to access and use assets. Think of it as staking without the long lock-up period.

How do tokens for liquid staking operate? They are unique tokens that reflect the amount of staked crypto as well as any benefits it accrues over time. Those tokens, also known as liquid staking tokens or LSTs, are frequently pegged 1:1 to the original cryptocurrency and can be used freely in the DeFi ecosystem.

Key Characteristics of Liquid Staking

• Accessibility. It allows users to participate in staking with smaller amounts of crypto, making it accessible to a wider range of investors.
• Versatility. While collecting benefits, users have access to their assets, which they can use as they want to (it's called restaking).
• DeFi Integration. The tokenised version of staked asset can be used across different DeFi platforms, enabling users to get the most out of their investments.
• Liquidity. This type allows investors the flexibility to use their assets even when they are locked, unlike traditional staking, and getting bounties at the same time.

Now, onto the most interesting part.

How Liquid Staking Works

Traditional staking frequently restricts the ability to access your cryptocurrency assets for a predetermined amount of time. An innovative approach addresses this issue by introducing special tokens (LSTs).

Here's a breakdown of the process:

• Deposit your crypto (Ethereum or ETH, for example) into a liquid staking platform.
• The platform pools your crypto with others and stakes it on a Proof-of-Stake (PoS) blockchain.
• Then you'll receive liquid-staked tokens that reflect both your initial investment and the profits you have accumulated.
• Because these LSTs may be traded on decentralised exchanges (DEXs), liquidity can be preserved and possibly more earnings can be made within the DeFi ecosystem.

So, here are the key components involved:

• Liquid-staked tokens (LSTs), which reflect the initial stake and earned rewards, allowing for easier management and trading.
• Then all deposited cryptocurrency assets are combined in liquidity pools to increase staking power and efficiency.
• Smart contracts automate the staking process and ensure secure distribution of rewards.

Let’s look on example with ETH (Ethereum tokens), one of the most widely staked cryptocurrencies: in traditional staking, Ether holders need to lock up a minimum of 32 ETH to participate, which is a substantial sum of money for most individuals. Liquid staking platforms, such as Lido, allow users to stake much smaller amounts and then receive a tokenised variant of the staked asset.

In this case, staking Ethereum will result in the obtaining of a token known as stETH (staked ETH), which stands for original Ethereum, along with any incentives. Those tokens are tradable and can be used for various purposes across the DeFi landscape, like lending, borrowing, or trading. The most widely used application of stETH is for supplying liquidity in the ETH/stETH pool on Curve. Also, stETH can be used as collateral for a loan on Aave. Learn about more options on the Lido website. However, there are many other platforms worth of considering: Rocket Pool, Frax, Ankr, EigenLayer, Jito, Ether.fi, and many more.

Benefits of Liquid Staking

What are the advantages of liquid staking tokens and liquid staking? They offer several pros over traditional methods:

Increased Liquidity

You can keep your assets flexible while earning benefits. Liquid staking offers special tokens, which may be sold or used in DeFi apps, in contrast to traditional staking, which locks down assets and prevents them from being accessed. This enables you to respond to market fluctuations without having to wait through an unstaking period, which typically lasts 15 days but can be longer.

Passive Income Potential

While your staked assets generate rewards, liquidity tokens can be reinvested in lending, yield farming, or used as collateral, increasing your return in effective ways. The potential for multiple sources of income raises the total worth of your assets.

Flexibility & Accessibility

For risk management, liquid staking offers flexibility. Since liquidity tokens are accessible even if the original assets are locked, trading strategies can be modified when market downturns. Diversifying these tokens across different DeFi platforms can reduce risk and cushion against volatility even more. Many liquid staking platforms also include protective features, such as protection against smart contract malfunctions, offering an additional degree of security above and beyond what conventional staking offers.

DeFi Participation

Because liquid staking keeps staked assets usable, it significantly increases liquidity in the DeFi ecosystem. LSTs can be traded, lent, or used across various DeFi platforms, creating a seamless connection between staking and DeFi. This integration increases market activity, improves yield prospects, and fosters ingenuity within DeFi by encouraging new products and services that leverage liquid-staked assets. In essence, liquid staking empowers users to engage more fully in DeFi while still earning staking rewards, encouraging involvement and expansion in the ecosystem.

Liquid Staking Risks & Considerations

Despite all of its benefits, this staking method has some issues to keep in mind:

Smart Contract Vulnerabilities

Activity involving smart contracts, just like any other in DeFi, carry inherent risk. Choosing a platform with a good security track record and regular audits is critical.

Market & Price Volatility

The value of liquid-staked tokens can fluctuate alongside the underlying crypto's price.

Impermanent Loss

This happens when the price of your underlying crypto asset skyrockets while the price of the liquid-staked token remains unchanged. This risk can be mitigated by holding for the long term and choosing a platform with minimal fees.

Platform-Specific Risks

Platforms for liquid staking are not all alike. It's essential to research the platform's reputation, security measures, and fees before committing assets. According to Sylvain Carre's and Franck Gabriel's research, liquid staking can be an excellent choice when:

1. fees are kept low, so the advantages of liquid staking (like flexibility and access to DeFi activities) become more appealing;
2. if DeFi lending rates (the interest or returns you earn on liquid-staked assets) are set thoughtfully, it can maximise rewards without compromising security.

However, liquid staking can also “backfire” if these conditions aren’t met. The increased flexibility may come at the expense of decreased security if DeFi rates are incorrectly set up or delegation costs are excessive. This isn’t just about fees, it’s about how coordination issues and risk management are handled, which are crucial to the success of liquid staking.

Liquid Staking vs. Traditional Staking

Liquid Staking

Advantages

• High Liquidity. Staked assets remain accessible through liquidity tokens, and can be traded, sold, or used in other DeFi activities.
• Versatility. Because liquidity tokens can be transferred or used on other platforms, a responsive approach to shifting market conditions has become possible.
• Double Profit Potential. E.g. receiving income while engaging in other DeFi activities, such lending or yield farming.
• Diversification. Liquidity tokens' cross-platform usage diversifies holdings and lowers the risk associated with reliance on a single platform.
• Immediate Access. You don't have to wait for an unstaking period to access funds, which adds an extra layer of financial flexibility.

Disadvantages

• Increased Complexity. Compared to traditional options, managing liquidity tokens across various platforms and comprehending how they operate can be more difficult.
• Extra Threats. Third-party platforms' smart contract risks are introduced by liquid staking, potentially exposing your assets to flaws or malfunctions.
• Market Volatility. The value of liquidity tokens is prone to fluctuation, exposing your holdings to market volatility.
• Extra Charges. Some platforms charge fees for managing your staked assets and liquidity tokens, which can lower your profits.

Traditional Staking

Advantages

• Simplicity. The process of locking up assets in exchange for benefits is simple and easy to comprehend.
• Stability. Investments will not be vulnerable to changes in the market, providing stability and predictability in the short term.
• Lower Risk. With fewer moving parts and no third-party platforms involved, traditional staking can be perceived as a safer and less complicated solution.
• Long-Term Focus. Traditional staking offers a set-and-forget approach that can work well for long-term investors.

Disadvantages

• Locked Funds. Staked assets are inaccessible until the staking period ends.
• Limited Flexibility. Once assets are staked, they cannot be moved or used in other DeFi applications, limiting the potential for diversification.
• No Dual Earning Potential. When assets are locked, rewards from other DeFi activities cannot be obtained.
• Risk Concentration. A single network's performance determines the performance of all staked assets, therefore any problems within the network could affect the entire investment.

Liquid Staking vs. Staking Pools

Liquid staking differs from traditional staking pools by offering more flexibility. It allows users to stake their assets while retaining liquidity by issuing LSTs that can be utilised in DeFi projects or traded. This increases flexibility by lowering the potential cost of locking up assets.

Traditional pool staking, on the other hand, involves users pooling their resources to stake collectively, with rewards allocated based on individual contributions. For people with limited resources who yet wish to receive incentives without engaging in independent staking, it could be optimal.

Therefore, liquid staking is better for those seeking flexibility in DeFi, while pool staking is more suitable for users with fewer assets to stake.

How to Start with Liquid Staking

Selecting a Platform

It’s essential to consider the following key factors:

• The DeFi platform should have a strong security record track and implement measures like insurance or multi-signature wallets to safeguard your money.
• Make sure the platform supports your token of choice.
• Compare fees across different platforms. These could include staking fees, platform usage fees, or withdrawal fees.

Setting Up a Crypto Wallet

You must have a suitable cryptocurrency wallet before staking. Here is a summary of the top 5 choices (as of November 2024):

• Coinbase Web3 Wallet connects seamlessly with multiple decentralised exchanges (DEXes) and supports a wide range of crypto assets, including those used for liquid staking.
• MetaMask is a popular browser-based wallet designed for Ethereum and ERC-20 tokens, including many used in liquid staking.
• Crypto.com DeFi Wallet supports over 700 crypto assets, including staking options for various cryptocurrencies and integration with DeFi platforms.
• Exodus Wallet. A universal wallet supporting over 100,000 cryptocurrencies, with built-in staking features and educational resources for new users.
• Gemini Wallet offers support for over 100 cryptocurrencies, with staking features and insurance for certain losses.

Staking Your Assets

After you've chosen a platform and set up your wallet, follow these steps to stake your assets:

• Transfer the cryptocurrency of your choice into your wallet (e.g., Ethereum, Polygon).
• Go to the liquid staking platform and connect your wallet (MetaMask, Exodus, etc.).
• Choose the token you want to stake and the amount to stake.
• Review the details, including any associated fees, and only then confirm the transaction.
• You will receive liquidity tokens that represent the assets you pledged after the transaction is finished.
• These tokens can now be utilised for staking rewards or used in other DeFi applications.

Popular Platforms

Top Liquid Staking Platforms

Here are the most popular protocols, according to DefiLlama (based on Total Value Locked (TVL), that is estimated by adding up all the assets that are locked or staked on a DeFi platform).

1. Lido is one of the most reliable and biggest platforms for Ethereum (ETH) liquid staking in particular. It enables users to stake their assets and obtain stETH tokens, that are applicable to a number of DeFi applications. Other assets is also supported by Lido.
2. Binance ETH Staking. The biggest exchange enables users to earn Wrapped Beacon ETH (WBETH) by staking ETH. The platform's usability and compatibility with other Binance services are well-known, making it a good option for both beginners and experienced crypto users.
3. Rocket Pool is a decentralised liquid staking platform that focuses on Ethereum.It enables users to earn rETH tokens by staking ETH. Rocket Pool offers users the option to become node operators with a smaller initial stake.
4. Jito offers Solana-based solutions, providing users with the ability to stake SOL and receive tokenised assets. Jito aims to offer faster transaction processing and enhanced scalability, making it a solid option for those interested in staking Solana.
5. mETH Protocol allows users to stake ETH and earn Mantle Staked ETH (mETH). This platform is focused on offering users with flexibility and liquidity while enabling them to participate in the broader DeFi ecosystem.

Evaluating Platform Security and Fees

When selecting the best liquid staking platform, it's important to consider both security and fee structures to ensure a safe and rewarding experience. Here are key factors to keep in mind:

1. Security Considerations

• Ensure the platform’s smart contracts have been thoroughly audited by reputable security firms. Audits help identify vulnerabilities and mitigate risks.
• Choose platforms with decentralised validators or node operators, as they are less prone to single points of failure and hacking. Look for platforms offering insurance coverage in case of security breaches or hack incidents. This can provide your funds with an extra degree of security.
• Opt for platforms with a disclosed history of security and accountability. Avoid platforms with past security incidents unless they have taken substantial steps to address vulnerabilities. Check news for any info about hacks in the past, for examples.

2. Fees and Charges

• Most platforms charge a fee based on a percentage of the rewards earned. For example, Lido charges a 10% fee on rewards. Understand the platform's fee structure to assess whether it aligns with your crypto investment goals.
• Some platforms may charge fees when withdrawing your staked assets or when converting liquid-staked tokens (LSTs) back to the original asset. Consider these fees when evaluating overall profitability.
• Ensure there are no hidden fees, such as transaction or network fees, that could eat into your crypto earnings.

3. Liquidity and Flexibility

• It's important to select a platform that supports highly liquid tokens to reduce risks related to depegging. Tokens with lower market caps and trading volumes can experience significant price volatility and liquidity issues.
• The flexibility and profitability of your staked assets can be increased by platforms that enable the usage of LSTs in decentralised finance (DeFi) applications. Seek out solutions that are compatible with widely used DeFi protocols.

4. Total Value Locked (TVL) and Project Health

• A higher TVL typically indicates greater platform adoption and stability, which can be a sign of reliability. However, a larger platform may also mean more competition, so weigh this factor carefully.
• Consider the platform’s plans for future upgrades, ecosystem growth, and support for multiple blockchains. Projects expanding into new ecosystems often provide better long-term prospects.

Conclusion

Liquid staking has emerged as a game-changer in the DeFi space, offering the best of the two worlds: keeping your cryptocurrency holdings flexible while receiving bonuses. Think of it as an upgraded version of traditional staking, where you're also receiving something beneficial: liquid staking tokens. However, as with most kinds of cryptocurrency, it's important to understand the full picture. Remember, the key to success isn't just about jumping in — it's about understanding the mechanics, staying informed about risks, and making strategic decisions based on your investment goals.

Want to explore further? Consider starting the liquid staking journey with the best platforms described above.