What Is Liquid Staking?
|— Staking is an integral part of keeping proof-of-stake blockchains secure; the funds staked acts as collateral to encourage a validator’s good behavior.
— Staking usually requires you to lock up your coins, but liquid staking offers users a chance to use that source of value in multiple DeFi protocols and much more.
— Liquid staking in the Ledger ecosystem is easy and secure.
So you might already know about what crypto staking is. In short, it’s this mechanism that keeps proof-of-stake blockchains secure. And you might think that those tokens are stuck in the system hereafter. However, did you know that there’s actually a way of staking coins, receiving rewards, and yet still being able to use that source of value to take part in the blockchain ecosystem?
If that sounds unfamiliar to you, let’s start from the beginning, as understanding crypto staking in all its forms may help you make the most of the blockchain ecosystems.
Firstly, it’s important to understand that blockchains are secured using consensus mechanisms in one of two main types; proof-of-work or proof-of-stake. For the purposes of this article, though, it’s the latter consensus mechanism you need to know about: Proof of stake.
Proof-Of-Stake: The Origins of All Staking
To validate transactions and create blocks, proof-of-stake blockchains require participants to lock up a certain amount of funds to act as collateral. This is known as crypto staking. However, with native staking, you can no longer use your funds for blockchain apps or services. Basically, the coins are locked up to guarantee a blockchain validator acts with the best interests of the network in mind. If they behave badly, they lose their “stake”, so it’s imperative that the network has these coins. But that’s not the end of the story.
Since this method requires users to lock up a significant amount of liquidity, crypto innovators found a way around this disadvantage. Now, there’s a novel way to continue using these coins in the blockchain ecosystem without losing your stake. Plus, you can still receive the rewards. But how on earth is that supposed to work?
Put simply, this mechanism is called ‘liquid staking’, and it allows you to earn rewards from securing blockchains whilst using those same funds in DeFi protocols and blockchain apps. But, what is it exactly, and how does it work?
What Is Liquid Staking?
Much like native staking, liquid staking requires users to lock up their tokens in a smart contract on the liquid staking platform. Essentially they are providing liquidity to that reserve.
However, the biggest difference is what happens next. To explain, liquid staking platforms issue the staker separate tokens, similar to a receipt of their stake. These assets are called Liquid Staking Tokens (LSTs) or Liquid Staking Derivatives (LSDs) and they are pegged to the value of the initial asset. The interesting thing about these receipt tokens is they are just like any other blockchain token. Yes–you can actually use them in DeFi protocols and blockchain apps! However, there’s a bit more to it than that—let’s explore how it works.
How Does Liquid Staking Work?
Put simply, there are three key phases of liquid staking: the staking of the asset, then the issuing of liquid staking tokens (or LSTs) and finally the unstaking. It sounds simple, and largely, it is. So let’s see how these processes work together to provide stakers with extra liquidity.
The first step is the same as initiating a native staking process: The user sends their coins to their preferred platform, in this case, a liquid staking platform. From there, the platform will verify the tokens’ legitimacy and then store them in a smart contract. However, this is where the methods diverge. To explain, the platform then issues the user LSTs to represent the initial assets.
But what happens to all of those staked assets?
Simply, the Liquid staking platforms then use these funds for native staking. This means they use your funds to secure a proof-of-stake blockchain, for which it receives rewards in the form of newly minted crypto. In return, the platform periodically distributes portions of these rewards to the users staking assets on that platform. Users then receive these rewards in the form of more tokens (LSTs).
Obviously, this is a great benefit for DeFi-lovers, as it means the liquid staker still has receipt assets to trade with. Not only that, they also receive a small amount of value on top of their initial investment – a simple way to make some passive income.
What are LSTs?
Next comes understanding these receipt tokens. As mentioned, liquid tokens, liquid staking tokens (LSTs) or liquid staking derivatives (LSDs) are essentially blockchain receipts that prove your ownership of a staked digital asset. Plus, their value is pegged to that of the initial asset. Just like any other blockchain assets, LSTs are suitable for all sorts of purposes within the DeFi ecosystem. For example, you can use them to trade or even to swap for other crypto tokens.
In fact, you can also use LSTs for lending and even as collateral for borrowing other tokens. Essentially, they are tokenized assets and can be useful for a multitude of reasons. There are so many possible use-cases, it would be impossible to cover them all in this article.
A good example of an LST is stETH, which is the liquid staking token representing Ether. This is one of the most popular tokens today, and it is available on countless DeFi protocols and blockchain platforms.
So, what happens when a user wants their coins back? That’s where the unstaking process comes in. To explain, when a user wants to unstake their coins, they must burn the liquid staking tokens (LSTs). To do so, the platform will usually require the user to send the tokens to a specific address. From there, the staking platform verifies the assets are burned by checking the transaction on-chain. If the transaction is valid, the user receives their newly unstaked coins. It’s really as simple as that. However, it’s important to note that doing so usually costs a fee, and it’s not always cheap.
Advantages of Liquid Staking
So now you know what liquid staking is, what about some of its benefits? Actually, there are a ton of great reasons to use liquid staking platforms; let’s explore.
One key advantage of liquid staking is its accessibility. To explain, there’s no unbonding period, meaning when users unstake, they receive their staked assets back immediately. To clarify, most staking platforms will have a bonding period, which can mean that you will have to wait days or weeks in order to receive your staked tokens back.
The biggest advantage of liquid staking is simply the liquidity; you can use your staked tokens just like any other digital asset. That means you can still sell your tokens, swap them or even give them to someone else. While staking usually means these assets are locked up in a smart contract, liquid staking allows you to use the receipt tokens (or LSTs) for other means, thus providing the user with liquidity—and who wouldn’t want more of that?
The receipt tokens used for liquid staking are not just suitable for selling, you can also use them on countless DeFi platforms. This is known as DeFi composability. For instance, you can also lend LSTs to other crypto users, or even borrow other digital assets using your LSTs as collateral. This opens up a whole world of utility not previously possible for staked tokens.
One of the biggest benefits of liquid staking is the increased rewards. Firstly, you receive rewards just for liquid staking. Then, since this allows you to use your receipt tokens in DeFi, it’s also possible to increase the rewards you make without investing additional assets. For example, say you stake 1ETH on a liquid staking platform and then receive the LSTs in return. You will receive rewards for staking the original tokens, but you can actually use these LSTs on other staking platforms and receive even more rewards. If you do it intelligently, you can make much more passive income on the same investment than is possible with traditional finance or interest from banking services.
Disadvantages of Liquid Staking
Of course, with all the advantages of liquid staking, there are also some downsides. Let’s explore some of the risks involved with using liquid staking platforms.
Firstly, liquid staking involves sending the original assets to a smart contract. Unfortunately, this can be a risk, since smart contact bugs could leave the funds vulnerable to exploitation. For example, if a bad actor finds a mistake in the contract code, they could easily exploit it and access the funds.
Next, liquid staking also poses a risk of price volatility. To explain, since LSTs are pegged to the price of an asset using a smart contact, there’s a risk the token could depeg. If an asset depegs, it means it no longer has the same value as the asset it represents. If your LSTs are less valuable than the assets they represent, you could be inadvertently losing money!
Punishment via Slashing
Using liquid staking platforms means you don’t have to put up significant amounts of money to benefit from the rewards involved in securing a proof-of-stake network. However, that means that you are trusting the platform’s validators to behave well. If they decide to try and cheat the system, their stake will be slashed, as well as your portion of the rewards.
Finally, liquid staking generally costs a fee, which can vary from platform to platform. Although there are multiple benefits when using liquid staking platforms, these fees tend to be higher than with other types of staking and can be a deterrent to some. So, before you start accruing rewards, it’s important to work out if these outweigh the fees you’ll have to pay.
Staking Vs Liquid Staking: What’s the Difference
So now you understand liquid staking, you might be wondering how it differs from native, or traditional staking.
To clarify, traditional staking involves locking up an amount of crypto to take part in a blockchain’s consensus. This is only possible on proof-of-stake blockchains, and it’s this collateral that keeps the network secure. Essentially, the participants who validate transactions have the incentive to behave as they should. If a validator behaves badly, their “stake” is slashed. However, this stake must be large enough that it is a true deterrent. Plus, those assets are completely locked up in the smart contract. For example, to become an Ethereum validator, you must stake 32ETH. That means the whole 32ETH must stay locked up in the smart contract.
Participating in liquid staking, on the other hand, will mean you receive tokens in return. You can also stake as little or as much as you want, while still using the tokenized assets on Defi protocols and more. It’s similar to pooled staking, apart from you actually receiving something back immediately for using the platform.
How To Start Liquid Staking
Liquid staking is simple, but it’s not recommended for beginners. But if you have experience crypto trading, you may want to know where to begin.
Luckily, it’s possible to participate in liquid staking via Ledger’s ecosystem. All you have to do is connect your Ledger device to Ledger Live and navigate to the Discover tab. From there, you can start using Ledger’s partner, Stader. Stader currently supports liquid staking on Polygon, Hedera, BNB, Near, Terra 2.0 and Fantom. That means you have a great choice of assets and DeFi protocols to use with your new LSTs.
Staying Secure While Liquid Staking
Obviously, when staking, you want to be sure your assets are safe. With Ledger’s security model, you can rest assured that you keep custody of your assets. Not only that, but you can use the wider Ledger ecosystem to make sure you’re making the most informed decisions possible.
Whether you decide to start liquid staking, or go a more traditional staking route, the Ledger ecosystem can provide you with the security you need to navigate the space with confidence. It may seem complicated, but with the right tools you can stake crypto, earn rewards and actively participate in securing proof-of-stake blockchains. Ledger offers multiple crypto staking options directly through Ledger Live. From becoming a validator yourself, to funding one, to participating in liquid staking like this article explained, the Ledger ecosystem can provide you with the best security possible while doing so.
No matter how you decide to stake crypto, Ledger can support you to make the right choice for you—because that’s what self-custody on the blockchain is about.