Liquid Staking Explained: What Is It and How It Works?

Cryptocurrency investors often seek passive income opportunities, and staking has always been a go-to option for many. Unlike traditional proof-of-work systems, proof-of-stake blockchains like Ethereum rely on staking for security. This involves participants locking up their tokens to validate transactions and earn rewards. However, a drawback of conventional staking is that the locked tokens can’t be easily used elsewhere. Liquid staking addresses this by introducing a solution to the liquidity problem. But what exactly is liquid staking, and how does it work? In this article, we will dive into these questions to provide a clear understanding of this concept. Let’s take a look:

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What Is Liquid Staking?

Liquid staking is a method where cryptocurrency holders can stake their tokens in a proof-of-stake blockchain and receive a tradable asset in return. It’s gaining popularity because it lets users actively participate in securing the blockchain while still having access to the value of their staked assets. Essentially, it converts staked assets into liquid tokens, allowing for flexibility in their use. Unlike traditional staking, which can involve waiting periods to start earning rewards or unstake, liquid staking offers greater liquidity and capital efficiency. This allows users to engage in activities like lending and trading without long delays. The Liquid Staking Tokens are also referred to as LSTs.

How Does Liquid Staking Work?

Before we explain how liquid staking works, it’s essential to grasp the fundamentals of staking and its advantages. Staking involves validators locking up the native token of a Proof-of-Stake (PoS) blockchain to be eligible for randomly selected opportunities to validate blocks in the network. This process, known as consensus, is vital for maintaining the security and integrity of the blockchain.

By requiring validators to stake their own tokens, PoS blockchains incentivize them to act in the network’s best interests. The benefits of staking are twofold: validators receive rewards for their contributions, and the network benefits from increased security and decentralization.

Now, in liquid staking, holders of native coins of a PoS blockchain deposit their tokens with a staking service provider. These tokens are then delegated to one of many validators participating in the consensus protocol. In exchange for their staked assets, the service provider issues a ‘receipt’ in the form of a liquid synthetic token. This token represents the staked assets and can be traded or used in other activities while still potentially earning staking rewards.

The innovation of liquid staking extends beyond traditional staking models by offering token holders increased flexibility and utility. Unlike traditional staking, where tokens are locked up for a predetermined period, liquid staking allows holders to maintain liquidity while participating in staking. This means that users can continue to benefit from the value of their staked assets, even while they are staked, opening a wealth of possibilities for earning rewards and engaging in other financial activities.

In simple words, liquid staking enhances the staking experience by providing users with the opportunity to earn rewards without sacrificing liquidity. This innovation not only benefits individual token holders but also contributes to the overall growth and development of PoS blockchain ecosystems.

Benefits of Liquid Staking

Liquid staking provides several benefits, including:

Increased Flexibility

Liquid staking offers traders enhanced flexibility by allowing them to utilize their staked assets for various financial activities without the need to unstake. This flexibility enables efficient capital allocation and maximizes the utility of staked assets.

Unlocking Multiple Income Streams

Liquid staking facilitates the unlocking of multiple streams of cryptocurrency income. Liquid Staking Tokens (LSTs) can be easily withdrawn and used as collateral to secure crypto-backed loans from platforms like Aave. These loans can then be deployed in higher-yield cryptocurrency platforms, generating additional returns on the initial deposits.

Eliminating Opportunity Cost

Unlike traditional staking, where tokens are locked up for a specific period, liquid staking potentially eliminates opportunity costs by allowing token holders to access the value of their staked assets while still earning rewards. This feature makes staking a more attractive strategy for individuals seeking flexibility and liquidity.

Reduced Barrier to Entry

Staking on networks like Ethereum typically requires a significant investment, often thousands of dollars, due to the minimum token requirements and infrastructure costs for validating transactions. Liquid staking reduces this barrier to entry by enabling token holders to use their staked assets as collateral, thereby increasing accessibility to staking participation.

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Enhanced Utility and Value

By providing a mechanism for using staked assets as collateral, liquid staking improves the utility and value of cryptocurrencies. This additional use case attracts more participants to the ecosystem, raising liquidity and contributing to the overall growth of the cryptocurrency market.

Drawbacks of Liquid Staking

While liquid staking offers a promising avenue for passive revenue generation, it also presents specific drawbacks:

Slashing Risks

Validators can face penalties, known as ‘slashing,’ for bad behavior that negatively impacts network performance. This penalty includes the removal of the validator from the network and the confiscation of a portion of their staked tokens. As users stake their crypto assets to validators, their funds are also susceptible to slashing risk if validators are not selected carefully.

Loss of Peg

Liquid staking tokens (LST) may lose their peg to the original asset, resulting in the LST’s value falling below that of the digital asset it is linked to. For instance, stETH traded lower than ETH following the collapse of the Terra blockchain in 2022.

Vulnerability to Malicious Validators                                                                   

Liquid stakers entrust their funds to validator nodes, making them vulnerable to malicious or unreliable validators. In cases of misconduct, the deposited funds can be subject to reduction by the underlying network. For example, in the Ethereum protocol, offline validator nodes may see half of their ETH deposits slashed.

Security Concerns

Liquid staking platforms with inadequate security protocols are susceptible to compromise. In the event of a security breach, users risk losing access to their deposited assets.

Top Cryptocurrencies That Support Liquid Staking

Several cryptocurrencies have implemented liquid staking protocols, enabling token holders to leverage this innovative market strategy. These include:

• Ethereum (ETH)
• Cardano (ADA)
• Polkadot (DOT)
• Cosmos (ATOM)
• Avalanche (AVAX)

Top Liquid Staking Providers

Liquid staking is an advanced crypto-staking service offered exclusively by a select few platforms. Below, we highlight some of the top liquid staking protocols and the assets users can stake on them:

• Lido Finance
• Rocket Pool
• Hubble Protocol
• OKTC

Final Takeaway

In summary, liquid staking revolutionizes crypto staking by providing users with rewards and liquidity simultaneously. This innovative approach enhances the utility of staked assets and reduces opportunity costs. With increasing adoption and implementation across projects, the future of liquid staking looks promising. Nevertheless, it’s crucial for users to conduct thorough research and comprehend the risks before diving into any kind of cryptocurrency investment. Happy trading!

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