Elk Academy Lesson #9: What is Liquid Staking?
Dear Prof. Elkstein,
I took a short break from DeFi recently. Now I’m back now and trying to catch up, but things move so fast! I keep hearing about liquid staking. Is this something I should care about?
Late for lunch,
@ButchieY0st
Dear Butchie,
It’s not my job to tell you whether you should care about something, but I can help you understand so that you can make your own judgments.
Your question is a good one. “Liquid staking” may be one of the most confusing terms in DeFi. The trick is to see it as a clever oxymoron, like “natural selection” or “jumbo shrimp.”
Liquid in this context describes an asset that can easily be exchanged or sold for other assets. Staking, by contrast, describes making tokens unavailable for transacting. By definition, then, to stake a token is to make it illiquid–the opposite of liquid. “Liquid staking” is therefore a contradiction in terms.
In DeFi, staking generally involves locking tokens as collateral for lending, borrowing, or bridging (though we advise against using bridges that require staking!). Staking also plays a key role in proof-of-stake (PoS) blockchains, where stakers (often called “validators”) risk tokens as collateral and support the consensus process by verifying new blocks in exchange for a small reward. This use is where liquid staking originated.
Currently, the rewards earned by validators are often less than the potential rewards from other activities like liquidity provisioning or yield farming. Validators, however, play a key role in making blockchains decentralized.
Liquid staking solves this dilemma.
What is liquid staking?
Liquid staking allows individuals to deposit funds into a shared staking contract while keeping access to those funds for use elsewhere. Sort of.
After depositing tokens into a liquid staking protocol, you’ll receive a receipt token in return. This receipt token is basically the same as the LP tokens that you receive from pooling liquidity, which you can then deposit into a farm for additional rewards. The only difference is that you are depositing a single token rather than a pair of tokens. The receipt token becomes a new liquid asset, meaning that you can trade it or farm with it. Its value is directly linked to the staked token, forming a new derivative asset.
As an example, let’s take the first popular liquid staking protocol, Lido, which is on Ethereum. Lido allows users to deposit ETH tokens into the ETH 2.0 staking contracts. Normally, this ETH would become locked until ETH 2.0 launches. When you deposit your ETH with Lido, however, you receive a receipt token, stETH (staked ETH), which you can then use to trade, pool, farm, or lend elsewhere. Another upside to this model is that Ethereum requires staking 32 ETH, but since Lido pools ETH in its staking contracts, users can stake smaller amounts.
Following Lido’s success, liquid staking protocols have started to appear on other PoS chains. For example, Benqi, a lending platform on Avalanche, lets users to stake AVAX into crowd-funded validator nodes on Avalanche P-chain in exchange for sAVAX tokens, which are issued on Avalanche C-chain where all the DeFi activity takes place. Yield Yak, a popular auto-compounding protocol on Avalanche, has a similar option, which distributes yyAVAX tokens in exchange for staking AVAX into validator accounts.
Each liquid staking platform sets up their contracts differently. Sometimes, the validator rewards are only released when you unstake your tokens. In another common set-up, the rewards earned from validating are automatically added to the dynamic price of the receipt token, meaning that the value of the receipt token constantly increases relative to the staked token.
What are the drawbacks of liquid staking?
Everybody loves a double dip, right?
By liquid staking, you earn rewards from participating in the network’s consensus algorithm while also keeping your funds liquid for use on DeFi protocols.
What’s the catch? As always, whenever you layer more contracts, there is added complexity, you increase your risk of exploits. Also keep in mind that receipt tokens from staking are only useful if protocols offer liquidity options for them. Since liquid staking is relatively new, in many cases the only farming options are pools paired with the staked token (e.g. stETH-ETH).
While these pools benefit from little or no impermanent loss, as you remember from our previous discussion, lower risk nearly always translates into lower yields. In practice, this means that liquid staking and yield farming with the receipt tokens may result in yields that are marginally better–or in some cases worse–than more simple lend/borrow strategies.
Of course, as liquid staking becomes more popular, DeFi platforms will likely start to accept receipt tokens for other uses, which may make it an increasingly attractive option.
Who knows, Butchie, maybe in the future we’ll all be validators and everything will run on liquid staking.
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