Is Liquid Staking the Future of DeFi? A Deep Dive into Protocols and Perks

Introduction

Proof-of-Stake protocols, as explained in our article about blockchain, are ecosystems where the consensus is reached between validators who lock their capital (tokens) on the blockchain. As the name suggests, their capital is “at stake” to validate blocks and keep the network safe.

Since validators need to lock their tokens to participate in the block validation process, these same tokens cannot be used in other activities, which decreases the liquidity floating on the blockchain. Knowing this issue, developers created a feature called Liquid Staking to solve it.

What is Liquid Staking?

The definition of Liquid Staking is “the act of delegating your tokens to a service that stakes for you without losing access to your funds.” This basically means that you can access the tokens that otherwise would be locked for a specific period of time without losing the rewards. Also, it’s possible to add or remove these tokens from the staking process at any time.

Another important point about Liquid Staking is that it enables retail investors to participate in the validation process. On the Ethereum blockchain, for example, a node needs 32 ETH to become eligible to validate blocks, which is not accessible for most people investing in crypto. As a way to earn a yield on the ETH held, investors can send them to a liquid staking pool and receive a proportional interest paid for the staking participation.

Main Liquid Staking protocols

• Lido Finance

Lido Finance (LDO) is the biggest protocol in the sector. Today, there are around U$9 Billion of ETH deposited in their ETH pool, which is their main product. When depositing for example 1 ETH, the user receives back 1 stETH that can be used across other DeFi applications. 

Lido also offers other pools different from Ethereum, such as Solana, Polkadot, Kusama, and Polygon, which all function in the same way.

If you want to participate in the governance of Lido Finance, you can buy the token LDO and vote on the proposals of the protocol, which could be such as introducing new staking pools, LDO utilities, validator nodes, and others.

• Rocket Pool

Rocket pool is another Liquid Staking protocol. According to Defi Llama, today there are around U$1 Billion locked in the protocol, which only offers ETH Liquid Staking.

Users can participate in the pool by depositing a minimum amount of 0.01 ETH in the protocol. After depositing, a token called rETH is deposited in the user’s wallet as the Liquid Staking token, which can be used across many DeFi products, just like Lido Finance’s stETH.

An interesting feature of Rocket Pool is that if someone wants to run a node, it’s possible to do so by providing 17.6 ETH (variable amount), which is almost half of the necessary to do directly on the blockchain. Today, there are 2171 Node operators working with Rocket Pool, according to their website.

To participate in Rocket Pool’s governance, you can buy the token RPL and vote on the protocol proposals!

• Coinbase

After the Ethereum Merge, the event that changed the Ethereum mainnet from Proof-of-Work to Proof-of-Stake, Coinbase announced that they’d be launching a Liquid Staking feature, in which users would receive a token called cbETH.

Coinbase is today the 2nd largest liquid staking platform, with U$1.8 Billion locked with them, only behind Lido Finance, according to DeFi Llama.

The cbETH works in the same way as both stETH and rETH, but the difference is that users have to trust a centralized institution, which may not always be transparent about their actions, while both Lido Finance and Rocket Pool are DAOs (Decentralized Autonomous Organizations), which have their smart contract codes all available to the public and also make their decisions based on the majority of token holders preferences.

Advantages of Liquid Staking

Liquid staking protocols are very important to the development of blockchains because these networks need liquidity to grow, especially in the beginning. Liquid tokens can be used as collateral in lending platforms and traded on DEXs, which boosts the numbers of these applications, bringing more users and generating more revenue in DeFi while still maintaining the network secured, because the native tokens are being staked by validators.

Retail investors benefit from Liquid Staking protocols because they can earn rewards with their tokens by just sending them to a pool, otherwise, they would need to set up a node with an expensive minimum amount and also be careful to stay updated and keep the node working aligned with the blockchain to not get slashed.

Slashing is a punishment method that blockchains use to prevent malicious nodes from acting harmful against the network by removing a percentage of the staked tokens from the validator. (Slashing punishments may vary from one blockchain to another).

There are multiple independent validator nodes in the main Liquid Staking protocols, which is good for the investors because if some of them do get slashed, the damage is remarkably reduced in the pool, affecting much less the investors than by delegating all of the tokens to a single validator.

Risks

• Smart Contracts

This type of risk is well-known in the Decentralized Finance space, and still, people many times ignore it. Smart contract risk means that an application is subject to a bug or hacking threat, which could result in big losses for the pool or the protocol in general.

It’s important to check if the platforms are audited by trusted companies, which is probably true when looking at the main DeFi protocols today. Still, it’s a risk that investors have to know and be willing to take to invest in these products.

• De-pegging

This means that there is a risk in the synthetic token. As explained before, when you deposit 1 ETH in a Lido Finance pool you receive 1 stETH, which should have the same value as the original ETH token, but as we’ve seen before in the crypto space with Terra Luna and Acala, de-peggings can happen and these tokens might lose their value.

This kind of problem could happen if there is a huge distrust in the protocol and people start to aggressively sell the tokens, like a bank run.

Another possibility is with a smart contract bug, which is what happened with Acala, a DeFi protocol built on Polkadot, where a bug found in a bridge minted large amounts of “Stablecoin” tokens without being backed by other assets, and this action resulted in an enormous supply of tokens in the market, making them lose their pegged value.

• Governance Risk

In Liquid staking, the tokens deposited in a pool are the ones that go to the validators to be used in the staking process on the blockchain. The problem with this activity is that it could give a lot of power to a small number of validators, which could together take control of the network as a whole, risking the entire system.

Decentralized applications like Lido Finance vote on the validator nodes that are implemented into the protocol, which helps minimize the risk. Also, taking control of Ethereum or other high-capitalized blockchains is a very difficult action.

Still, this kind of risk should be taken seriously when interacting with a Liquid staking platform that works on a small blockchain, where the probability of a 51% attack is way bigger than in the big ones.

Is Liquid Staking Worth the Risk?

This question should be made after reading this article, but we cannot make this investment decision for you.

We’ve presented the benefits and risks of interacting with Liquid Staking. If you constantly use DeFi applications, it may be the right product for you. If you are a more conservative and beginner investor in the crypto market but want to earn interest on your tokens, consider interacting with centralized exchanges’ staking pools. To understand more, feel free to read our article about DEX vs CEX.
    
Always remember to diversify. There are many products that you can benefit from, some of them are better at one thing while others at another. When you understand the risks and take advantage of each of them, you can maximize your Risk/Return trade-off and get awesome results!