In early April, Ethereum completed the long-awaited Shapella upgrade for the network’s first major upgrade since The Merge. Just as The Merge fundamentally altered the network’s technical properties, Shapella reshaped Ethereum’s economic properties. Previously, staking on Ethereum was a one-way street; ETH holders could stake their ETH to the network to earn rewards, but they could not unstake their funds. Post-Shapella, ETH holders can redeem their ETH. The redemption timeline has been reduced from *maybe never, let’s hope the upgrade happens soon* to a few days.
While Shapella highlights the basic principles of Proof-of-Stake staking – stake your assets, earn additional tokens for helping secure the network; unstake your tokens after a network-defined waiting period – there are other ways to earn staking yield without sacrificing liquidity even the few days that is required in most networks. Starting with the launch of Lido in late 2020, liquid staking has fundamentally altered staking dynamics for token holders. In this post, we examine the benefits and drawbacks of liquid staking; stay tuned for a future post on native network staking, which contains its own set of interesting pros and cons.
Liquid Staking Overview
Liquid staking follows the basic idea of:
- Contribute your tokens – let’s use ETH as an example – to a liquid staking service – for this example we will use Lido.
- In exchange for contributing n ETH – the Principal Tokens – you receive n staked ETH, specifically stETH in this example; this represents a claim on the underlying tokens contributed. We’ll call these “Receivable Tokens” in the rest of this post.
- The Principal Tokens are staked by the shared pool service and begin to earn yield, which is distributed back to the Receivable Token holder.
- Receivable Token holders are free to do whatever they want with the Receivable Tokens: hold them, trade them, borrow against them, etc.
- If Receivable Token holders would like to redeem, they can unstake their underlying tokens via the liquid staking service and receive them in exchange for the Receivable Tokens. This process is subject to the delays present in the underlying blockchains. For some networks, this can be weeks; for others, it’s days.
Lido is not the only liquid staking protocol for Ethereum (see: Rocketpool, Stakehound), and similar protocols have been launched on other networks (see: Lido on Solana, Quicksilver on Cosmos, etc.).
Like most digital assets, liquid staking operates in several places along the decentralized <–> centralized and permissioned <–> permissionless spectrums:
- Decentralization vs. Centralization: while the Lido example above highlights a decentralized protocol, Coinbase also offers a staked ETH variant (cbETH) where Coinbase acts as a middleman in the equation.
- Permissioned vs. Permissionless: different versions of liquid staking protocols use permissioned validator fleets vs. a permissionless architecture.
Altogether, liquid staking protocol tokens (LDO, RPL, etc.) have a combined market capitalization of over $1B and the protocols control billions more of underlying assets. And – important for the next section – these chit tokens are traded frequently with millions of dollars in volume being transacted every day.
Benefits of Liquid staking: Liquidity (Duh?)
Liquid staking occupies a crucial position in the crypto ecosystem. As the name suggests, these protocols add liquidity to the crypto ecosystem. Users can earn a yield on staked assets while retaining the ability to instantly “unstake” by trading their staked asset token for the underlying on the open market.
Normally, the spreads between asset pairs like ETH and stETH are fairly tight – sometimes just a few dollars difference – and major marketplaces – both centralized and decentralized – list tokens for both the underlying asset and the staked asset. The spread represents the “price” of this liquidity – along with a few other things that we will return to in a minute. In times of volatility, the spread widens as investors place a greater premium on liquidity. It’s a mistake to think that one asset is “pegged” to another: the difference in price is a feature, not a bug. When prices deviate, this is the system working as intended and proof of the value offered by liquid staking: token holders can always turn their staked assets into unstaked assets instantly, even if that conversion comes at a price. If token holders want to redeem 1–1, they can always wait out the required unbonding time. The below shows the ratio of ETH to stETH over time; unsurprisingly there is significant movement on volatile days with a tighter range otherwise.
Liquid staking also allows for different dimensions of liquidity. Ethereum notably requires staking a minimum of 32 ETH. This makes native staking prohibitively expensive for most retail holders. Liquid staking fractionalizes the staking process and allows token holders to stake or acquire staked assets in much smaller increments. For example, Rocket Pool users only have to contribute 8 ETH vs. the 32 ETH requirement for solo stakers.
Holders of assets staked via liquid staking protocols also have a liquid token. Tokens such as stETH can be used as collateral for decentralized protocols such as Aave.
These benefits scale as more token holders use liquid staking protocols. Yields compress, but additional users generate more liquidity and usage of the receivable token, which entices more adoption and users.
Fees and Risk of Loss: Drawbacks of Liquid Staking
Liquid staking would ideally be purely accretive for an individual user. Users that participate in staking via a liquid staking project gain the option to sell their receivable tokens for the underlying asset while always retaining the ability to unstake their original assets through the project. However – as always – the devil is in the details.
The main issue is that liquid staking projects act as middlemen in this equation. In exchange for giving users liquidity, they take a fee. For example, Lido takes a 10% cut, as does Ankr, StakeWise, and Stader. While one might expect this to be a race to the bottom in terms of fees, dominant players have been able to retain their fee structure. There are notable benefits to working with larger liquid staking providers: the specific Receivable Token is more liquid and more likely to be integrated into other DeFi protocols.
Users do take on additional risk when working with liquid staking providers. In the case of a protocol-based project like Lido, users are taking on smart contract risk. Despite numerous audits of top-tier projects, DeFi exploits have demonstrated that this risk can be reduced but is always present. Users also take on risk due to the presence of the middleman in the centralized trust model. An example of these risks occurred in late 2022 when Ankr suffered a major exploit that drained $24M across several liquidity pools. The hack was ultimately due to the loss of private keys through a phishing attack versus a smart contract exploit.
Lastly, while liquid staking protocols can significantly benefit users, these projects present challenges to the underlying networks. While an increase in staked tokens positively impacts network security, consolidation of staking in a single project can present additional centralized layers. Lido represents about 1/3rd of all staked ETH, placing significant control in the hands of the project and the underlying validators.
For these reasons, many token holders still stake their assets directly using their own nodes or node providers like Blockdaemon. As more companies innovate in this space, non-custodial, native staking continues to compete with liquid staking.
Wrapping Up: Vision for the Future
Liquid staking providers generate the opportunity to add incremental yield for previous non–stakers and liquidity for stakers. These protocols represent one of the few fee-generating and self-sustaining project types in the digital asset ecosystem. Their explosive growth demonstrates their clear product-market fit. We believe liquid staking will be around for the long term.
Despite downward fee pressure and new entrants, we expect to see consolidation in the largest protocols given the benefits of scale. More users will stake with the same protocols, boosting liquidity and adoption of the Receivable Tokens, making those protocols more attractive. Large protocols also have clear roadmaps for expanding into new networks, meaning users will see the same names across ecosystems.
Even with increased market share for prominent players, there is still hope for increasing decentralization. Decentralized validator technology can help strengthen the resilience of the nodes underpinning these protocols. Protocols are also searching for more ways to enable permissionless validators, with Lido notably working on their effort. We’re excited to follow these developments in the coming months.
Hopefully, the combination of these factors will lead to a future in which the proportion of users staking will continue to rise, networks will continue to decentralize, and security will continue to strengthen. Liquid staking – together with increased native network staking – will continue to power our vision for a permissionless, decentralized future.
Written by Jake Greenstein, Partner and Head of Infrastructure at Hivemind. Jake leads Hivemind's staking activities - stay tuned for more exciting developments here soon.