What is liquid staking and how does it work?

Liquid staking, also known as soft staking, is a more advanced form of traditional staking that's available on many new-generation smart contract protocols. With liquid staking, users can access their locked funds for other crypto-based activities while still earning rewards from their original deposit.

Liquid staking experienced massive adoption in 2022 following the boom of decentralized finance (DeFi) opportunities. This article will explore the concept of liquid staking, its merits and drawbacks, and the best liquid staking providers in the market.

Ethereum's switch to PoS

The Ethereum network is crucial to our discussion, as it ushered in a new era of financial applications. Launched in 2015 by a team of eight developers, Ethereum is an advanced version of the Bitcoin network. According to principal founder Vitalik Buterin, Ethereum aims to expand the use of blockchain technology beyond value transfer.

As a result, Ethereum was created to be a more open and fluid crypto project, enabling the development of other applications on its principal software. This was possible due to its integration of smart contracts — bits of computer code that can self-execute based on predefined rules. Following its success, Ethereum became the hotbed for decentralized applications (DApps) and DeFi.

However, Ethereum was built using the same consensus mechanism as the Bitcoin network: the Proof of Work (PoW) system. The PoW mechanism promotes competition among mining nodes spread across the globe, making it highly secure and decentralized. But this resulted in slow transaction speeds and high network fees.

Furthermore, Ethereum's role as the facilitator of more value-added services resulted in high gas fees, slow throughput, and high energy demands.

The team officially began transitioning from a Proof of Work protocol to a Proof of Stake (PoS) in December 2020, when they launched the Beacon Chain (Ethereum 2.0). The transition process was completed two years later, in September 2022, when the Ethereum network joined the ranks of Proof of Stake blockchains. Commenting on the migration, Buterin noted that the network now consumes 99.9% less energy than its previous consensus mechanism.

What is staking?

Staking borrows from the traditional concept of a yield-bearing savings account. In a bank, customers deposit their funds into an account and earn a certain percentage for keeping it there. Meanwhile, the bank loans this money to businesses as debts through the fractional reserve system. In return, the bank earns high interest and pays the customer a little token in interest rates.

However, staking differs from what is obtained in the traditional sense in a few ways. Crypto assets — digital assets — are used to stake instead of fiat money.

Another major difference is that users earn higher staking rewards due to the principles that bind this practice. All blockchain systems are transparent and lack a central authority, so staking protocols operate without a go-between. This way, users earn the rewards that would have been used to settle intermediaries.

In its most basic form, staking requires users to lock up their crypto assets for a particular period to secure a network. Users are rewarded with newly minted coins of the underlying network for pledging their digital currencies. Staking is fast becoming an independent industry, with over $18 billion recorded in the ecosystem.

Ethereum staking options

There are now several staking offerings. Each option caters to a particular preference and is geared towards optimizing their potential growth. Below, we explore the different forms of staking and their potential limitations:

1) Self-staking

This involves an individual becoming a validator on the Ethereum PoS blockchain. Validators are users who stake a large amount of the network’s underlying asset to verify transactions on the platform. Instead of competing, validators take turns confirming transactions, thereby reducing the network’s carbon footprint.

Self-staking on the Ethereum network comes with a high threshold. To become a validator and be accepted into the Ethereum ecosystem, one must stake a minimum of 32 ETH. This makes self-staking a capital-intensive exercise.

Another issue with this system is that a validator’s staked ETH could be grossly impacted if there is a network issue or the validator makes a mistake when working. The Ethereum network will automatically slash the validator’s staked ETH by half, forcing them to buy more ETH to continue operating.

Additionally, when a validator locks in their ETH, they can only unstake or access them once the lock time frame is completed. This can significantly impact them in the short term, as they can’t move their assets to another platform if needed.

2) Exchange staking

A less capital-intensive staking option is exchange staking. Typically, this option involves a centralized crypto exchange creating a pool where customers can deposit their assets for staking. The exchange then takes these crypto assets and deposits them in a network to become a validator.

The upside to exchange staking is that users or pool contributors can easily unstake anytime they want. This doesn't affect the exchange pool due to the large amount of staked tokens.

Another benefit is that users can stake any amount of the crypto asset they have. They don’t have to meet the 32 ETH threshold imposed on self-stakers or validators. In return, these exchanges reward pool contributors daily or monthly for trusting them with their crypto assets.

But this option isn't entirely rosy. Given the centralized nature of this system, stakers are often left in the dark as to how the exchange utilizes its funds. They also trust a centralized party with their funds. Another issue is that the platform could easily be breached or folded due to insolvency, making it impossible for users to recover their assets.

The last limitation of using an exchange staking medium is that most charge a withdrawal fee when users want to remove their funds.

3) Locked staking

Although not an outright staking system, locked staking comes with many limitations. Staked assets in this system will be largely inaccessible until the staking time frame elapses. This is ideal for users who want to build up their financial discipline and don't intend to access their funds for a long period.

Locked staking usually ranges between one and three months on most exchanges. Validators who staked directly on the Ethereum protocol have a longer withdrawal window than most.

What is liquid staking?

Liquid staking is the newest staking service. This staking option requires users to pledge their funds to secure the network, but it's liquid or fluid in the sense that users can still access their funds.

Unlike the traditional PoS system, liquid staking involves the storage of funds in DeFi escrow accounts. This allows users to access their tokens whenever they want, as the funds are highly liquid.

With liquid staking, users can generate multiple revenue streams from their crypto assets because they can lock their assets and still access them. They can use the liquid versions of their assets on other DeFi protocols and earn more on their initial deposits.

How does liquid staking work?

While liquid staking shares similarities with other staking options, the methods used for execution are quite different. A new generation of protocols, known as liquid staking protocols, has been developed to provide the potential for traders to grow their crypto holdings.

These protocols allow users to stake any amount of an asset and unstake them without impacting the initial deposit. This way, deposits are locked on liquid staking platforms, and users are issued a tokenized version of their crypto assets. This derivative form carries the same value and operates one-to-one with the original asset. However, they're usually pegged with a different emblem to identify them.

For instance, if a staker deposits 1 ETH into one of such liquid staking services and requests a derivative, the user will receive one stETH, with the "st" representing staked ETH.

These new tokens can then be transferred out of the protocol, stored elsewhere, traded, or even spent without disrupting the initial deposit. The fluidity that liquid staking services offer isn't the only thing that makes them unique. Users will earn staking rewards on their initial deposits and generate more funds from their derivative tokens simultaneously, making it a win-win situation.

If a staker wants to withdraw their initial deposit, they must return an equivalent deposit valuation to access their funds. Some liquid staking protocols charge a fee for using their platform, but the fees vary.

Advantages of liquid staking

Staking introduced a new experience for coin holders, allowing anyone to put their assets to work and potentially see them grow. However, liquid staking has taken the system even further. One of the benefits of liquid staking is its mobility.

Locking funds for a long period can become a bad financial decision due to the volatile nature of crypto assets. When digital currencies are locked, their valuation also changes based on the underlying asset’s performance. If a bear market is in full swing, staking, in the traditional sense, could result in a loss for a user. However, with liquid staking, users can easily withdraw a tokenized version and deposit it in more income-generating systems to cover such losses.

Another benefit is the multiple income streams liquid staking affords. Stakers can easily lock their funds on one platform and use a tokenized version as collateral to get crypto-backed loans. These loans can then be deposited on higher growth accounts, thereby providing more turnover. This makes liquid staking a huge favorite among DeFi-facing users.

Disadvantages of liquid staking

Much like every financial-based system, liquid staking has its downsides and risks.

One such risk is that the tokenized asset could depeg from the original staked token. This happened with the Ethereum network, where stETH traded lower than ETH. This was due to extensive use of the tokenized version, resulting in an elastic supply.

Another risk of liquid staking is that if a user loses their tokenized asset in a trade, they also lose access to their deposited funds. The only way to retrieve the earlier deposit is to make another deposit equivalent to it.

While liquid staking is innovative, it's powered by smart contracts. Smart contracts are highly efficient; however, they can be riddled with bugs, creating a pathway for hackers to drain users’ funds. If this happens, users could lose all their funds with no means of retrieving them.

Top liquid staking providers

Liquid staking is an advanced crypto staking service, exclusively provided by a few platforms. Below, we list some top liquid staking protocols and the assets users can stake on them.

1) Lido — overall best platform for liquid staking

Lido Finance, Lido for short, is the most well-known liquid staking provider. The platform, launched in 2020, allows users to stake their Ether tokens without locking them up. Lido launched by providing liquid staking services for the Ethereum network but has since expanded its offerings to Ethereum, Solana, Polygon, Polkadot, and Kusama.

On Lido, users can stake across the PoS blockchains and deploy their crypto assets in other activities. This includes accessing lending platforms, like Aave, and participating in other high-growth opportunities. Once users stake their funds, Lido presents them with a tokenized variant depicted as "st+the asset ticker." Stakers can then withdraw these derivatives and use them in 27+ DeFi applications and crypto wallets.

Staking rewards on Lido range from 4.8% to 15.5%. Besides offering a liquid staking service, Lido also runs a decentralized autonomous organization (DAO) powered by its network token LDO. With the digital token, users can vote on network proposals and potentially see growth in their assets through staking.

For its liquid staking services, Lido charges a 10% fee.

2) Rocket Pool — Ethereum liquid staking protocol

An alternative liquid staking service is Rocket Pool. This protocol, launched in 2016, provides a user-friendly process for users to stake their ETH tokens on its platform. Rocket Pool operates as a base layer for trustless and decentralized ETH2 staking. The platform only caters to the Ether crypto asset.

Nonetheless, it offers dual services for its customers. Users can either stake their ETH directly on Rocket Pool and get a tokenized version of their asset pegged as rETH or directly run a node on the Rocket Pool ecosystem.

Given its dual-service offerings, Rocket Pool rewards users separately. For those who only stake ETH in return for rETH, the Rocket Pool service rewards them with a 4.16% annualized potential reward. On the other hand, those who stake ETH while simultaneously running a node earn a fixed 6.96% annualized potential reward plus a variable RPL reward issued by the platform for securing the Ethereum network.

With Rocket Pool, node operators don't need to submit the entire 32 ETH needed to run a node before operating on the Rocket Pool space. Instead, Rocket Pool lets validators start with half, which is 16 ETH. This makes it a more cost-effective option for node operators in the Ethereum PoS protocol.

3) Tempus Finance — fixed income for tokens

The next top liquid staking protocol for DeFi users is Tempus. This new generation DeFi tool makes it possible for users to earn a fixed income on their tokens. This way, users can earn a fixed amount of passive revenue from their digital assets across all the protocols they deploy them on.

According to the Tempus team, their multi-chain solution can be deployed in three different use cases.

1. Users can fix their future growth on their crypto assets.

2. They can also speculate on the rate of their future growth.

3. They can deploy their tokenized assets into liquidity pools and earn trading fees.

Tempus supports most reward-giving tokens on the Ethereum and Fantom blockchains, including stETH, yvDAI, xSUSHI, and aUSDC. Meanwhile, the protocol also operates an automated market maker (AMM), making it easier to provide liquidity on tokens that provide earnings.

The protocol doesn't charge any fees for staking. However, users need to pay swap fees to provide liquidity in the AMM pools.

4) Hubble Protocol — borrow against staked crypto

The hubble protocol gained traction after participating in a Solana hackathon. Since then, the new liquid staking platform has gained massive popularity.

Hubble protocol has become popular because of its borrowing services. Users can borrow against their crypto and use the borrowed tokens as collateral on other DeFi platforms. This way, users can multiply their staking exposure as they earn from both their initial deposits and the loans they can access. The USDH stablecoin plays a crucial role in the hubble protocol as it is used in crypto loan services.

Hubble supports multiple assets and enables users to deposit from different networks. The platform then provides up to 11x leverage on the collateral, which users can use to trade. This exponentially increases their potential growth from their deposits.

Hubble charges a 0.5% fee on loans.

5) Meta Pool — liquid staking for near protocol

Meta Pool caters to the Near smart contract network. The liquid staking service allows users to stake their Near assets and get stNEAR in return. stNEAR can then be used for DeFi activities in the larger Near ecosystem and its growth-aggregating system, Aurora.

Meta Pool delegates users’ deposits to 65+ validators who monitor the performance of the deposited assets. In return for locking up funds in the DeFi protocol, Meta Pool rewards users with a 9.76% annualized potential reward, exclusive of the staking rewards from other growth activities. If the tokenized asset is deployed on the Aurora protocol, users can also gain 9.76% in rewards.

Much like all protocols reviewed in this article, Meta Pool provides immediate unstaking for assets. However, this comes with a 0.3% charge.

6) OKTC liquid staking — stake and earn OKT with ease

OKTC liquid staking is a cutting-edge liquid staking solution on OKT Chain (OKTC). Provided by OKX it allows users to stake and earn OKT tokens while maintaining liquidity.

In return for staking OKT, users will receive staked OKT (stOKT), a versatile KIP-20 token that can be freely traded and utilized within the OKTC ecosystem. Additionally, users can earn swap fees by providing liquidity to OKTC Swap.

Ready to get started? Explore our comprehensive tutorial for detailed guidance.

Whether you're an existing OKX trader or new to the platform, join us and start earning rewards with OKTC liquid staking.

Using liquid staked ETH for DeFi

One of the most viable ways users tap into the potential of liquid staking is its use in DeFi. This is largely executed through yield farming, as the pegged assets can be used in growth-generating protocols.

Yield farming allows users to lock up their funds and use a wrapped version of their assets elsewhere. As a result, they can use their wrapped assets as collateral to obtain crypto loans and execute trades, earning revenue both actively and passively.

Final verdict on liquid staking: an advanced staking strategy

Liquid staking is a new generation system that enables users to put their assets to work and potentially see them grow. Instead of locking their funds with no access to them, liquid staking provides users with a liquid version of their assets to be used on other platforms. This makes the staking service a favorite among users, as they can easily redeem their assets anytime they want.

While the process can bring gains, liquid staking is an advanced strategy and should only be used by advanced stakers.

FAQs

Is liquid staking risky?

Yes, liquid staking comes with risks. The tokenized version could easily depeg from the original asset or lose its value. Another issue is that users can only redeem their assets if they return the equivalent value of their initial deposit. Meanwhile, these liquid staking platforms can easily be hacked if poor security measures are in place.

What's the difference between liquid staking and staking?

The major difference between liquid staking and staking is that the former is more liquid. Liquid stakers receive a tokenized version of deposited crypto assets, which they can use on other platforms. However, staking doesn't offer this privilege.

What are liquid staking tokens?

Liquid staking tokens are tokenized versions of users’ deposits. With the initial deposits locked, users are issued liquid staking tokens, which can be transferred, traded, and used on other platforms.

Is liquid staking good?

Liquid staking can be a viable method of generating growth from digital assets. This staking method allows users to access their tokens while securing the network with them. However, it's better suited to advanced stakers due to its inherent complexities.

Is liquidity better than staking?

This largely depends on a user’s needs. Liquid staking can be a better option for experienced DeFi users. In contrast, staking is better for retail traders interested in making their idle crypto assets work for them in the long term.