Liquid staking protocols are at the forefront of the cryptocurrency staking economy, revolutionizing liquidity access in the decentralized finance (DeFi) industry. One of the benefits of liquid staking is the ability to interact and use funds while simultaneously earning rewards. As a result, liquid staking protocols provide the foundations for activities such as lending protocols and yield farming activities. Therefore, users can interact with numerous DeFi platforms earning multiple rewards from one pool of funds.
In this article, we are going to dive deep into the world of staking and explore how liquid staking is different from other staking methods. Also, we’ll look at some of the existing liquid staking protocols and their ideal target demographic. In addition, we’ll evaluate the benefits of liquid staking and the drawbacks. First, we'll explore how traditional proof-of-stake (PoS) staking works and its benefits.
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What is Staking?
In the traditional financial industry, banks offer their customers returns for storing their hard-earned cash. They lend out their customers’ money to make a profit in a process called "fractional-reserve lending". Then, banks pay their customers a small percentage while the banks take the majority cut. A similar process occurs in the cryptocurrency industry. However, unlike the shady covert operations of the legacy financial system, cryptocurrency transactions are publicly transparent on the blockchain. In addition, with no third-party intermediaries or greedy corporations, DeFi protocols are notorious for their profitable returns and competitive interest rates.
“Staking” is a financial term specific to the cryptocurrency industry. It is the process of locking up crypto assets in a protocol to earn rewards in return. As such, staking cryptocurrencies can be a great way to earn a passive income by putting idle assets to work. In addition, staking protocols can assist with the PoS consensus mechanism that facilitates network agreements regarding the validity of blockchain transactions. As a result, this drastically reduces the energy requirements needed when compared to a PoW blockchain such as Bitcoin. There are hundreds of different staking protocols implementing various parameters, including supporting different assets, staking periods, and rewards. Staking is ideal for investors who are 100% sure they won’t need access to funds for a certain period of time.
However, the other side of staking is being unable to access funds for a certain period. After locking funds in a staking protocol, you cannot trade, sell, or transfer any of the assets. Also, many staking protocols (particularly PoS) include a “cool down” period or a penalty for withdrawing funds prior to completion of the staking period. As a result, liquid staking protocols have emerged to counteract some of these hurdles.
What is Liquid Staking?
Liquid staking, sometimes known as “soft staking,” is the process of locking up funds to earn rewards while still having access to the funds. Unlike proof-of-stake (PoS) staking that “locks” funds up in a protocol, liquid staking funds remain accessible in an escrow. Users will deposit their funds in a DeFi application escrow account and receive a tokenized version of their funds.
Liquid staking can be a profitable way to put idle assets to work and earn a passive income with crypto. Plus, there are several benefits to liquid staking over regular proof-of-stake (PoS) protocols. Also, investors can earn income on idle assets while simultaneously earning further rewards on the staked funds’ tokenized value in other DeFi protocols. According to Blockdaemon, $7.5B ETH, or 20% of the total share of ETH staked in ETH 2.0 contracts, is in liquid staking protocols. Thus, enabling liquidity and flexibility to staked funds and growth within the cryptocurrency markets.
How Does Liquid Staking Work?
Before we dive into the benefits of liquid staking protocols, let’s first break down how they work. Let's say Alice has one ETH, which she would like to put to work. She doesn't plan to spend it anytime soon; however, she wants the security of being able to access it whenever she needs to.
First, Alice carries out extensive research across different platforms before deciding on a platform she would like to try. Accordingly, Alice puts one ETH into a liquid staking protocol. Then, she receives one "stETH" (or "staked ETH") worth the equivalent value in return.
Alice will be earning rewards on the original ETH deposit that remains in the protocol. At the same time, Alice can use her one stETH like she could with her original ETH. While earning rewards on ETH via the liquid staking protocol, Alice can now trade, stake, or do anything else with her stETH. This includes using tokenized funds as collateral or earning rewards in another lending platform.
For Alice to gain access to her original one ETH, she will need to have the whole one stETH to exchange it back. This may vary slightly depending on the protocol. Some platforms remove the interest generated on the initial deposit from the amount needed to remove the funds.
Note: Before interacting with funds, be sure to read the terms carefully and understand how the protocol operates.
Benefits of Liquid Staking
Now we understand a bit more about how the process works; below, we'll explore some of the benefits of liquid staking.
Liquid staking is a fundamental cornerstone in the activity of yield farming. In short, yield farming is when a trader locks up funds in one protocol and receives a wrapped or tokenized version of these funds. Then, the trader will put the tokenized funds into another liquid staking protocol, receiving another tokenized asset representing the funds. As such, traders can earn a yield on numerous assets simultaneously by locking up essentially one lot of funds. However, yield farming is inherently risky. Make sure to do your own research and be aware of "loan-to-collateralization" ratios indicating liquidation risks.
Sometimes, investors will need to reshuffle their portfolios to make some assets more liquid (accessible) than others. For example, an unexpected circumstance could mean a crypto holder may need to gain access to extra fiat currency fast. However, many crypto investors are reluctant to sell their assets. As an alternative, investors can use their existing crypto assets to get a crypto-backed loan using a liquid staking protocol. As such, by locking up funds and receiving a tokenized liquid version of their assets, investors can then convert this into fiat currency.
Quick Access to Funds
Another benefit of liquid staking is the ability to gain access to funds quickly. This is in contrast to many proof-of-stake (PoS) protocols that include a lengthy un-staking process or penalties for un-staking prematurely. Gaining access to funds quickly can be helpful in times of market turbulence or for any unexpected payments.
While there are many benefits to liquid staking, it does come with some risks. However, through education, strategy, and self-awareness, the risk of loss can be minimized.
Yield farming is inherently risky, with each leverage in funds enduring a greater risk of liquidation. Liquid staking protocols require collateral underpinning the liquid token with different loan-to-collateralization ratios depending upon the protocol. If a black swan event occurs, resulting in a drastic bear turn in the markets, the asset value may drop below the necessary requirements for collateralization. As a result, this may end in the liquidation of all assets.
Every trader gets excited seeing the value of their funds go up. However, without a strategic investment plan in place, greed can take over. As such, this can lead to negligence and risky decision making resulting in the loss of funds. Without prior research and education, attempting to operate and interact with numerous liquid staking protocols simultaneously is likely to be unprofitable.
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There are many liquid staking protocols, with the number rising rapidly. Like proof-of-stake (PoS) protocols, there are different parameters to each individual project. Moreover, specific blockchains enable liquid staking on the protocol level by default (e.g., Cardano). Conversely, other blockchains such as Polkadot and Solana rely on third-party projects to facilitate liquidity with staking.
The number one smart contract chain, Ethereum, is in the process of transitioning to a solely PoS consensus mechanism. Accordingly, the ETH 2.0 chain requires nodes to stake a minimum of 32 ETH to become validators and participate in the network. Blockdaemon, in partnership with StakeWise, provides the world’s first ETH 2.0 (formerly Eth2) liquid staking solution for financial institutions. A pioneer in institutional-grade liquid staking products, Blockdaemon ensures full AML compliance for institutions to participate in DeFi staking protocols.
Another popular channel for liquid staking, ideal for beginners, is KuCoin's crypto exchange. Preferring the term “soft staking”, KuCoin allows its users to stake numerous cryptocurrencies with full liquidity from 2019. This includes the likes of Ethereum (ETH), Algorand (ALGO), and Cosmos (ATOM). Each asset varies with the reward rates and fees.
Another crypto exchange that offers liquid staking is Crypto.com. Also a fantastic avenue for beginners, Crypto.com offers liquid staking with some of the leading cryptocurrencies. This includes Bitcoin (BTC), Litecoin (LTC), Ripple (XRP), and various stablecoins with different rates and rewards depending on the asset.
As centralized crypto exchanges, KuCoin and Crypto.com offer securities most newcomers search for when entering the world of blockchain. As such, it provides a safe and intuitive introduction to liquid staking. However, the rule of “not your keys, not your coins” applies.
Exploring Liquid Staking - Summary
The crypto industry is notorious for creatively producing ways to generate passive income with idle assets. The concept of staking is critical to the security and operations of proof-of-stake (PoS) consensus models in many crypto projects. As such, it is highly commonplace for educated crypto investors to put their assets to work by locking up funds and earning rewards.
Liquid staking takes this one step further. Investors are able to earn a passive income on idle assets while still having liquid access to the value of their initial funds. As such, these protocols play a fundamental role in yield farming activities, crypto-backed loans, and other novel DeFi protocols. Also, popular crypto exchanges, including Crypto.com and KuCoin, offer users an easy introduction to liquid staking. As a result, users can earn rewards for holding some of the most significant cryptocurrency projects while maintaining liquidity and flexibility.
Liquid staking maintains the benefits of PoS staking while removing most of the challenges. For example, it is often far easier and quicker to remove funds from liquid protocols than PoS protocols. Plus, this is without incurring un-staking penalties. As a result, these protocols are at the forefront of the next evolution in the staking economy.
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