Intro to Liquid Staking Derivatives

They used to say The Beatles wrote Lucy in the Sky with Diamonds as an ode to LSD. Lennon denied it, but who’s Lennon to leave us without such a treasure of a piece of trivia?
LSD has other, more boring meanings. In this article, we’ll explain one of them: LSD stands for Liquid Staking Derivatives in crypto. They are the IOUs issued by liquid staking providers to investors who stake their tokens in Proof of Stake blockchains (boy, was that a dull sentence!). They are poised to become one of the hottest areas of crypto in the early days of 2023.

For starters, let’s get some help from chatGPT to explain on a basic level what liquid staking is.

Liquid staking is a feature of some Proof of Stake (PoS) blockchain networks. In a PoS blockchain, validator nodes (also known as validators or delegates) are responsible for creating blocks and validating transactions. In order to participate in the validation process, nodes must “stake” a certain amount of the cryptocurrency of the relevant blockchain, which is known as “staking.” In a normal staking system, nodes that want to participate in validation must “lock” or “freeze” their coins for a specific period of time. This means that they cannot transfer or spend those coins during the lock period, which can be a problem for some nodes that need access to those coins for their day-to-day operations.

Validators get paid for their contribution in three ways: they receive block rewards, validator tips, and have access to MEV.

Unlike in good old Proof of Work, Proof of Stake makes it easier, in theory, for any average Joe to participate in block validation and access the rewards. But there were still a few entry barriers:

• You need to hold a certain amount of funds to become a validator which can be prohibitive in some cases. In Ethereum’s PoS, you need 32 ETH. not everyone can spare 32ETH.
• You need to run the validator software and make sure you perform, otherwise, you get slashed (meaning the system takes some of your staked funds as a penalty).
• Your tokens are locked in the PoS contract and are subject to withdrawal delays. You cannot just get your tokens back immediately whenever you want.

Introducing liquid staking pools

Many companies (Lido, RocketPool, or Coinbase are three popular examples on Ethereum) have created liquid staking pools that gather funds from small investors in a win-win situation where the access to staking is democratized, and at the same time, blockchains get bigger portions of their tokens staked, therefore increasing their security. These liquid staking providers are generally projects that develop smart contracts that receive funds and distribute them among a set of validators who actually play the Proof of Stake game. Rewards are distributed between the validators, the liquid staking providers, and the actual stakers.

Liquid pools solve all the three problems above: they allow small investors to participate in staking pools with smaller contributions, they help users delegate the task of running validator software (even more so, they collaborate with many validators to increase decentralization and reduce slashing risk), and they solve the liquidity problem by creating Liquid Staked Derivatives, or, in crypto’s horrible habit of creating acronyms, LSDs.

What are Liquid Staking Derivatives

LSDs are derivative tokens issued by liquid staking providers representing the claim on the staked asset. That derivative token holds value because of the belief that it can eventually be traded on a 1:1 basis for the staked assets. And because it has value, it has a place in DeFi: it can be exchanged, traded, lent or borrowed, used as collateral…

If you stake your ETH through a Lido liquid staking pool, you will receive 1stETH (staked ETH). Your newly minted stETH will generate rewards, since Lido shares a portion of the staking rewards, and, at the same time, you can use your stETH as collateral on Aave, for example.

Liquid Staked Derivatives offer the double combo of participating in a fundamental activity in crypto, block validation while leaving the doors open to DeFi.