What Is Liquid Staking and How Does It Work?

Liquid staking is an innovative mechanism in the cryptocurrency ecosystem that allows the system to stake users' assets in a Proof of Stake blockchain. In contrast, this asset can be utilized across other decentralized finance applications. Traditional staking would require these tokens to be locked for some time, during which the tokens cannot be used for trading or lending. 

In contrast, liquid staking provides this extra layer of flexibility by issuing derivative tokens representative of those staked - sometimes referred to as LSTs or Liquid Staking Tokens. Such LSTs would mean they could be freely tradable or integrative into DeFi protocols without requiring any prior unstaking of the token. In other words, liquid staking allows you to stake your assets and still use them across other decentralized applications, like the Unizen trading app.

It addresses the defaults of traditional staking by offering a best-of-both-worlds solution: gaining staking rewards while still being liquid and flexible with one's tokens. In liquid staking, as the usage grows, there is a shift in how users interact with staking, capturing the trend of the increasing DeFi space and opening up newer capital efficiencies.

In this article, we are going to break down the concept of staking to see how it really differs from liquid staking and take you through all that is needed in liquid staking. Let's dive in!

Understanding Staking

Liquid staking can only be put into perspective when traditional staking in proof-of-stake (PoS) blockchains is first understood.

Staking on Traditional PoS Blockchains

Validators in proof-of-stake blockchain networks create new transactions and lock the network by means of a process called "staking," using their tokens as collateral with the desire to participate in this process. Validators get to be chosen based on the number of tokens they stake. That is the more tokens a validator stakes, the greater the chance that any given one of them gets picked to validate a block of transactions. The extra tokens are rewards for the participants, some form of incentive in token form. The more you stake, the better the possibility of getting selected for validation. 

Pros and Cons of Traditional Staking

Traditional staking has various benefits for users, but it also comes with its shortcomings.

Pros

There are some advantages that come with traditional staking. They are as follows:

• Network Security: This ensures malicious actors must own enough tokens to perform harmful activities and, therefore, secure the network.
• Governance: Most stakers are given voting rights on network decisions and upgrades.
• Staking rewards serve as passive income for users' staked tokens.

Cons

Limitations of traditional staking include the following:

• Illiquidity: Normally, a staked token is stuck in some form of lock-up period where its owner cannot transfer or trade it.
• Opportunity Cost: It is an opportunity cost in terms of what the stakers could have done with those assets that are now locked up.
• Delays in Unstaking: When the case is about unstaking, there is a certain waiting period before the tokens become available to the user.

These limitations make traditional staking unfavorable for users who rely on their deposits, as it reduces flexibility. However, the benefits still make it a desired option for multiple users, like the various gains users amass from staking Unizen’s token, ZCX.

What is Liquid Staking?

Liquid staking addresses this very problem of illiquidity in traditional staking. It lets the approach give users a way to stake their assets and extract value out of them. Here is how it works:

• Staking Tokens: In this, just like in traditional staking, a user locks tokens inside a smart contract.
• Liquid Staking Token Collection: In return, you receive Liquid Staking Tokens as representations of the underlying staked assets. These LSTs are tradable and hence can be utilized in the DeFi ecosystem.
• One-Step Liquidity and Flexibility: All at once, this very LST token can be sold or lent out, during which time the corresponding original tokens in the stake accrue rewards, freeing up the user for other financial uses with increased liquidity.

Liquid staking does away with the limitations of traditional staking; hence, access to more liquidity, flexibility, and higher capital efficiency.

How Liquid Staking Works

Liquid staking unleashes the full power of staking tokens by keeping the underlying asset liquid with the help of liquid staking tokens or LSTs. This would allow any user to receive rewards from staking their assets without fully locking them up and, in this way, may conveniently deploy one's staked tokens in a wide variety of DeFi applications for other use cases.

Now that you understand what liquid staking is let's proceed with discussing the processes it lays in store. They include the following:

Smart Contracts

The big idea lies in the locking of tokens in some smart contract whereby users stake their tokens for network security and validate a variety of transaction types. This in no way feels like traditional staking when your tokens can't remain available for further use.

Rewards through LSTs

Instead of getting the staked tokens, the user receives LSTs, which are the representation of ownership of the very staked assets. A common example could be getting stETH when staking ETH. Such tokens can be transferred or used within the DeFi space while base tokens gather rewards.

Utilizing LST in DeFi

Holders of these LSTs are able to utilize them in the following ways:

• Lend: One can lend LST in DeFi markets to earn interest.
• Borrow: Use the LSTs as collateral when borrowing other assets.
• Trading: Transfer the LSTs on DEXes.
• Yield Farming: For extra reward, lock the LSTs in pools.

Liquid staking offers higher capital efficiency, allows users to maximize the value of their staked assets, and run a wide array of financial strategies while still getting benefits accruing from staking.

Advantages of Liquid Staking

One immediate consequence was that, in a very short period of time, liquid staking overcame many of the drawbacks traditional staking had, mainly concerning its lack of liquidity. While traditional staking would necessarily lock up the tokens for a fixed period, liquid staking brings agility to the user through rewards for staking while still retaining the capability to use their staked assets in DeFi applications, as discussed earlier. In addition to this, functionality has caused liquid staking to be quite attractive in optimizing assets to maximize returns.

The major benefits attainable in liquid staking are outlined below:

Liquidity: Immediate Access to Staked Assets

Liquid staking boasts quite a number of advantages, majorly on liquidity. In regular staking, there comes a need to lock your assets for some time, which might range from some days to weeks and sometimes months. Such lack of liquidity could turn disadvantageous, especially in situations where market conditions change or users urgently need access to their funds.

Liquid staking provides participants with immediate LSTs - liquid, easily tradable, or usable in any DeFi application without getting stuck through some unstaking period. The potential upside of this liquidity could be the capability to act flexibly toward market opportunities and risks while benefiting from rewards associated with staking.

Flexibility: Earn Rewards and Engage in DeFi Simultaneously

Liquid staking completely removes the need to choose between earning staking rewards or participating in DeFi activities. This is because a user traditionally has to decide whether to lock up his or her tokens and get some rewards or remain liquid to spend in various DeFi protocols like lending, borrowing, or trading. Liquid staking simply gives a user the opportunity to do both.

It also allows for continued staking rewards in conjunction with the LSTs, which represent underlying staked assets across a wide array of different DeFi platforms. It brings better flexibility in the overall utility of their assets and maximizes the return potential from many avenues, giving a huge advantage over traditional staking.

Capital Efficiency: Gaining Value from Locked-Up Assets

The general process of staking involves locking up the assets for some period of time, usually at some sort of opportunity cost, as those assets could be held elsewhere. Liquid staking unlocks the capital that is tied up in staking.

LSTs can be used to unlock even more yield opportunities within the DeFi ecosystem. For instance, you might use LSTs as collateral to extend loans or stake them in liquidity pools for added income atop staking rewards. As capital efficiency has gone up, liquid staking has become yet another way to better utilize digital assets at lower opportunity costs compared to traditional staking.

Popular Liquid Staking Platforms and Cryptocurrencies

Liquid staking is literally the front-runner in the DeFi space, with many popular platforms and leading cryptocurrencies backing this solution. They include:

Lido Finance

Among the top players of decentralized Ethereum stakings under the ticker stETH, comes Lido Finance. Other leading cryptocurrencies include Solana under the ticker stSOL, Polygon under the ticker stMATIC and Polkadot under the ticker stDOT. The platform rewards stakers with more LSTs when they're active in DeFi with them.

Rocket Pool

Rocket Pool stakes in Ethereum, which it represents with the rETH token. It allows for staking less than the typical 32 ETH that is usually required, thus enabling those with less to be involved.

Supported Cryptocurrencies in Liquid Staking

Among many others, the major liquid-stake cryptos available up to today are Polkadot DOT, Cardano ADA, Avalanche AVAX, and Cosmos ATOM.

Centralized vs. Decentralized Liquid Staking

Liquid staking can be performed either through centralized exchanges or via decentralized protocols. And each of them has pros and risks. Let's do a comparison between centralized platforms and decentralized protocols in order to understand how each of these are providing liquid staking options.

Centralized Platforms

They include big exchanges like Coinbase, Binance, and Kraken. They save the hassle for their users by doing the staking on behalf of the users. Thus, in staking through them, they take funds pooled from the users, whereby the exchange then proceeds with all operations to give them some liquid staking token in return.

How It Works: Users deposit their tokens, and the exchange does the staking; hence, users can easily withdraw them or trade with them.

Decentralized Protocols

Lido Finance and Rocket Pool are decentralised protocols—there is no main operator. Smart contracts drive the automation of staking and, hence, its liquidity.

How It Works: The users are interacting directly with smart contracts. It will lock their tokens and return LSTs for their staked assets.

Centralized vs. Decentralized Liquid Staking: Pros and Cons

While both centralized and decentralized have their unique advantages, they also come with several limitations in their utilization.

Centralized Platforms

The following are the pros and disadvantages of using centralized exchanges for liquid staking:

Pros

• Ease of Use: Most convenient to use, especially for inexperienced users.
• Customer Support: May be contacted if one has issues with staking or other withdrawal issues.
• Convenience: The platform performs everything related to staking.

Cons

• Counterparty Risk: The users need to be certain about the security and management of the platform.
• Potential to Get Censored: Exposed to some kind of regulatory pressure that may change their services.
• The users have only limited control over the staking process or any other policy parameters.

Decentralized Protocols

On the other hand, there are pros and cons to using the decentralized protocols for liquid staking:

Pros

• Full Control and Transparency: The fact that users can actually self-verify staking is happening on-chain.
• Permissionless Access: All can be open to anyone with a compatible wallet.
• Lower Custodial Risk: The user keeps their tokens in personal wallets.

Cons

• Smart Contract Risk: It contains bugs in the code that can be exploited. Thus, it is more complex for new joiners to weave their way around it.
• Governance and Network Centralization: Large staked amounts lead to disproportional influencing of network governance.

After all, it would boil down to your personal preference and your take on the axis of control, convenience, and risk tolerance. You can trust third parties for ease of use in centralized platforms or complete transparency, and decentralized platforms under the control of their users do have risks inherent in smart contracts and are much more labor-intensive for users.

Risks and Challenges

Liquid staking is undertaken with a set of unique risks and challenges that you must be appropriately aware of so you can make clear-eyed decisions. Some of the key risks in liquid staking are as follows:

Smart Contract Risks

Liquid staking will involve smart contracts that are susceptible to bugs, coding errors, and many other factors that might enable the performance of attacks with partial losses of staked funds or liquid staking tokens. A user should do due diligence on protocols and make sure those protocols have gone through many audits for extra safety. 

Governance Implications

By making stakes through these liquid staking platforms, users deprive themselves of some of their rights in governance. What this precisely means is that their votes are limited whenever major decisions that may include protocol upgrades are made. It is expected that users look into the governance policies of the platforms that they use with respect to their voting privileges.

Market Risks

Market sentiment and overall outlook on the underlying blockchain network may trigger frenetic volatility upwards or downwards in LSTs. The resultant volatility of prices can lead to losses because of panic selling. In any case, such risks can be partly mediated by a number of diversifications in investments and knowledge about market trends.

Illiquidity Issues

While liquid staking improves liquidity, it can nonetheless turn out to be problematic in some aspects. Considering the low trading volume or market downturns, users might not be able to sell their LSTs easily; hence, the level of liquidity could be reduced. By judging in advance the trading volume and market depth that the user may evaluate for their LSTs, they would be in a position to make more efficient decisions over liquid staking with fewer challenges.

While liquid staking opens up new ways for you to maximize your staked assets, remember possible vulnerabilities in smart contracts, changes in governance, market volatility, and the problem of illiquidity, among many other types of risks. Understand the risk and mitigate it; this saves your investment and goes further to improve user experience in the crypto space.

Use Cases of Liquid Staking

LSTs have manifold opportunities to unlock value in the domain of DeFi, enabling users to capture maximum value over their staked assets. The following are the major use cases:

Applications in DeFi Protocols

LSTs have applications in various DeFi protocols. They include the following:

• Collateral for Loans: Users can get loans against their LSTs. In that sense, they get liquidity for their assets without actually unstaking them.
• Farming yield: this enables the supply of LSTs into pools and, through the earnings in transaction fees, garner value from staking rewards in the meantime.
• Swap and trade: with the ability to trade at some DEXs for this form of token, hence can lead to flexible management over investments.
• Governance participation: possibility given by taking part in governance, on some particular platforms, even while the assets are at stake.
• Integration with DeFi Strategy: In return, such LSTs can be used for option trading, among other uses, which increases user engagement in DeFi.

Less Capital Needed to Operate Nodes

LSTs also reduce the capital you will need to perform the following activities:

• Lowering the Barrier to Entry: This, in turn, greatly helps liquid staking make any user a validator node with less capital. Smaller investors will be in a better position to grab this opportunity.
• Pooling Resources Together: You can pool your LSTs together to meet the minimum staking requirement and further encourage participation.
• Operating Costs are Lower: Node operators might get rewarded, one way or another, by deploying LSTs while getting a difference in the revenue streams coming from DeFi services to optimize their costs.
• Increased Decentralization: This will bring online smaller node operators and thereby offer increased network security and decreased centralization risks.

Liquid staking opens up a floodgate of innovative new uses of the staked assets inside DeFi. Examples are collateral use and yield farming with LSTs. The barriers become lower for node operators, thus allowing for much more participation in the Proof-of-Stake networks with greater decentralization.

Conclusion

Liquid staking enhances the whole staking process with increased liquidity, flexibility, and better capital efficiency. While this, too, carries a number of risks, including smart contract vulnerability and market volatility, liquid staking is an innovative way for crypto holders to participate in staking without necessarily sacrificing liquidity. Liquid staking, therefore, is one of the hot options that make the most out of each asset staked, especially with wider adoptions being paved by platforms like Lido Finance and Rocket Pool. Stake, earn, and trade several tokens across different blockchains on Unizen today!