Staking is crypto’s main method of securing a source of passive income, a process that also includes securing your favorite smart contract network. You invest in a project on which you’re long-term bullish and receive dividends from the network in return – what’s not to love?
The problem with staking is that it prevents you from using your capital as it is locked in a smart contract for a certain time period. Staking introduces an opportunity cost in which you must compare the benefits of yields compared to the token's potential price performance while staked. However, a new solution called liquid staking removes these limitations by allowing you to utilize staked tokens at any time.
In today’s article, I explain what liquid staking is and how it works. You will also learn about the new LSD (Liquid Staking Derivatives) narrative and why it’s so important for Ethereum.
Liquid staking is an upgrade over traditional staking that functions by enabling continued access to your staked assets. Liquid staking provides the best of both worlds: both staking rewards and the abillity to access DeFi products.
Let’s say that you own a certain number of ETH tokens. You can stake ETH for an APY of 5% to 10% and earn passive income without having to do anything. But you normally can’t access your staked ETH until your time lock expires.
What can happen is that the performance of ETH severely outpaces the rewards you receive by staking. Such an example comes with an opportunity cost that can be quite costly for those who didn’t time the market right.
Liquid staking removes the opportunity cost. You can still lend your ETH or provide liquidity to a DEX. You can even sell your staked ETH if you wish. This is made possible by receiving a derivative token of your originally staked ETH: a liquid staking derivative.
Liquid Staking Derivatives (LSD) are synthetic assets that represent another asset. Their value is based on the underlying value of the asset that they represent. This works similarly to how yield farmers receive a usable token that represents their stake in an LP. You can use an LSD to trade, lend or provide as collateral to DeFi dApps.
Such tokens first became popular in 2020 with the launch of DeFi derivatives protocol Synthetix. The protocol is a derivatives liquidity protocol that enables the creation of synthetic assets, giving you exposure to various blockchains and real-world assets. For example, you can trade gold and stocks on a crypto market simply by creating a tokenized version of the asset or commodity.
The current LSD fad functions similarly to derivatives and crypto synths, except that their primary exposure resides in smart contract networks such as Ethereum. Like mentioned earlier, liquid staking derivatives provide the opportunity of continuing using assets while they’re still staked.
Staking an asset means that you commit to having your capital locked inside a smart contract network for a certain period of time. You can neither trade nor withdraw assets while they’re staked. Staking has great implications on how flexible you can be inside the crypto market while making passive income.
Liquid staking removes this inefficiency by granting you derivatives of your staked assets. You can use your derivatives in the same fashion as your pre-staked assets.
Liquid staking incentives more investors to participate in staking by removing the limitation of the time-locked mechanism. They can still contribute to networks by improving their security while also retaining the benefit of being able to use their tokens in the DeFi market.
The other flexibility behind liquid staking is that most Liquid Staking Derivatives platforms also offer fractional staking. Staking can be very expensive on certain networks. For example, the minimum number of tokens you can stake on Ethereum is 32 ETH. At current market prices, this means that you need around $52,000 in crypto.
But certain LSD protocols have an incredibly low entry point for staking. For example, you can stake only 0.01 ETH on Rocket Pool, receive rewards from staking, and receive a token derivative that you can use in DeFi.
Liquid staking encourages even more investors to participate in staking. Staking is incredibly important for Proof of Stake (PoS) networks as it represents the main way of securing the network against 51% attacks and other malicious activities.
Some investors refrain from staking because the act bars them from selling or using their investment. Liquid staking provides continued access to assets by creating a derivative version of your staked assets.
The continued adoption of liquid staking can also lead to far more efficient crypto markets. Every financial market strives to maximize its liquidity. Liquid staking creates a market environment that’s far more liquid by allowing locked-in capital to be used in DeFi through derivative tokens.
Like mentioned earlier, most LSD protocols also enable you to stake without having to provide the full staking amount. Platforms like Rocket Pool let you stake on Ethereum without needing 32 ETH. You can stake as much as you want and still have a derivative token to sell or use.
Liquid staking obviously comes with certain cons that can turn away investors. The primary con behind liquid staking is that it offers an APY rate far lower than normal staking. The yield is lower because of the fact that you can turn away at any time and unstake your tokens.
The other downside to liquid staking is that it increases the rate of slashing. Slashing is a mechanism that prevents blockchain validators from practicing malicious behavior. For example, the Ethereum network can slash someone’s staked ETH if their validator node is down.
Slashing can take place even if the malicious behavior was not intentional. Investors might refrain from staking if they fear the chance of having their locked collateral slashed.
Liquid staking is a new way of earning passive income without succumbing to limitations imposed by traditional staking. Liquid staking derivatives help you have the best of both worlds by enabling you to quickly unstake or use staked assets in DeFi.
Whether liquid staking is for you depends on whether you favor the strategy’s risk and rewards. Regular staking might be a better option if you prefer higher yields and don’t mind not having access to your assets – which is often the case for long-term investors.
Short-term investors who want to sell their staked assets at any time will have a better time on liquid staking protocols. But beware, if 2022 taught us anything, it’s that giving custody over your assets to someone else is far riskier than it seems.
I recommend reading the following articles if you want to learn more about staking on Ethereum:
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