Liquid Staking

Published in

The Polygon Blog

5 min readJun 7, 2022

What is staking?

Staking means giving the ownership of your token to some other contract in return for rewards. This comes from Proof of Stake, a consensus mechanism where users can stake their tokens to become a validator of the blockchain. The validator’s role is to order transactions in a block and produce the block, after which they are added to the chain. The user, in return, earns a yield in the token they staked for validating the chain.

The cost of running a validator node is high, so the only way by which an ordinary user can participate is by delegating tokens to other validators. These validators fees from the yield generated to the user.

In theory, the more supply is staked, the costlier it will be for an attacker to get control of the majority of validators. There can be long-range attacks where users are incentivised to unstake their token. To prevent this, delegating tokens comes with a lock-up period of 21 days (for most chains) which means one has to wait for the lock-up period to receive their coin back after unstaking it.

Once staked, the token is useless except for earning a passive yield. What if there is a way where users can earn staking yield and have the option to get the staked toke back without any lock-up. And using the derivative of staked token in DeFi primitives like providing liquidity, lending, or collateral. Big brain minds came up with liquid staking, which does precisely this.

What is liquid staking?

In liquid staking, you receive a synthetic version of the token you stake, whose price is pegged to the original token. The staked token remains in escrow. Rewards are earned by a daily rebase of the synthetic token, i.e. amount of synthetic token you own changes daily(account for reward and penalty, if any). This synthetic token can be used in any DeFi primitives while continuing to earn yield. To get the staked token back, you can either use DEX or wait for the lock-up period to end, like with delegation.

Benefits

This helps in decentralisation and security of the chain as supply staked increases. Validators who provide liquid staking service have a higher number of tokens staked, thus increasing their chance of becoming a block validator and earning higher yields. The user benefits from using the synthetic token in DeFi protocols. And the annualised yield is the same, if not more than what comes from delegating the token. (higher yield is due to rewards distributed by validators which they distribute to incentivise users to choose them)

Source: Staking Rewards, Lido Finance, Marinade Finance, Benqi Fi

Comparison of Liquid Staking protocols

Ethereum:

Ethereum has a merge update coming later this year where it will shift from Proof of Work to Proof of Stake. Merging will be between the beacon(PoS) chain and the current PoW run chain. Even without the update, the beacon chain sees a lot of activity.

With 4.11 million Eth staked, Lido finance dominates with 91% of the market share. One reason behind its dominance is integrating early with more than 25 protocols and incentivising staking liquidity positions through curve and balancer, thus creating a demand for stEth. Lido is centralised at the moment, with the plan to go fully decentralised in future. There is an ongoing debate on whether a single party should limit the amount staked by them.

A popular alternative is Rocket Pool, having 4% of the staked Eth. Other alternatives are Ankr, StakeHound, StakeWise and Temple DAO.

In total, 35.83% of Eth is staked through liquid staking.

Polygon:

Stader Labs and Lido finance are the significant protocols providing liquid staking.

Around 6.1 million Matic are staked with Stader Labs, and 19.44 million Matic are staked with Lido finance. Both have incentivised liquidity pools and plans to integrate with other protocols to provide benefits other than the yield. In total, .91% of Matic is staked through liquid staking.

Solana:

There are currently three active liquid staking protocols on Solana. Lido Finance, Marinade Finance, and Socean Finance. Around 6.29 million Sol are staked with Marinade, 2.35 Million with Lido and 373K with Socean. In total, 2.65% of sol is staked through liquid staking.

Avalanche:

At the moment, only Benqi finance provides liquid staking. Around 3.12 Million Avax are staked through it, making 1.12% of the total staked Avax.

Risks:

Despite the benefits, holding liquid tokens comes with risks.

The major risk is of losing the peg. Peg to the original token is kept by incentivising arbitrage and not in the control of an authority. A user might want to swap to the original token and sell it during volatile times, which creates a selling pressure on the liquid token, and it loses its peg. Recently, stEth:Eth was trading at a 4.2% discount, i.e. 1stEth = .958 Eth. In the stable market, there is an incentive to buy one stEth and swap it back after a lock-up period for one Eth, realising .042 eth gain. But in volatile markets cashing out .958 Eth may be more profitable than holding one Eth for the lock-up period. This creates a liquidation risk if the liquid token is used as collateral. Since merge is not live, unstaking staking of stEth for Eth is not active, which may have added to the situation.

Another risk can be of bad faith actor; at the time of staking, one trusts the protocol, accepts the smart contract risk, and if the protocol is new or not audited by a reputable agency. There can be a risk of losing all the tokens, or the node operator can act maliciously.

Conclusion:

Liquid staking gives the ‘real’ yield, which comes from providing security to the network, not from a farm and dump token. We can see that yield through liquid staking is similar to delegating token. On top of it, there are incentives to provide liquidity with the original token or lend it in the money market, thus making yield way more than yield through delegation.

Still, liquid staking has a low market share in Polygon, Solana, and Avalanche due to a lack of knowledge among participants since it is a recent development on these chains.

Once knowledge gets widespread, and these protocols integrate with the money markets, we can expect to see a parabolic growth as existing stakers through delegation might want to use LS protocols to earn extra yield and reflexivity to return to the original token at any time. This can force existing delegators to pivot into liquid staking if they see an outflow of funds.

To conclude, we cannon underestimate the ripple effects of liquid staking.