What is a Liquid Staking Token (LST)?
What is Liquid Staking?
Staking refers to a popular strategy within the crypto ecosystem to earn interest on holdings. Staking secures Proof-of-Stake (PoS) blockchain networks; simply put, network participants can run a validator node by staking tokens which can be slashed or taken away as a penalty if the node does any malicious activities. Typically, staked tokens cannot be used for transactions or as a collateral to earn yield within the space of decentralised finance (DeFi).
Liquid staking presents an innovative solution that improves the way users approach staking. Liquid staking service providers solved the liquidity issue by minting a new token that represents a claim on the underlying staked crypto asset, which can be traded or deposited in DeFi staking pools.
If you are a frequent reader, you might remember our article on liquidity providers. To learn more about this topic, we suggest reading this article: 'What is a Liquidity Provider in Cryptocurrency?'.
When a user stakes their tokens via a Liquid Staking protocol, LSTs are programmatically minted in return. Liquid staking protocols build on existing staking structures by providing liquidity for staked tokens.
As a variant of token staking used within the DeFi landscape, liquid staking is also known as soft staking. It came into the spotlight following the launch of the Ethereum Beacon Chain back in 2020. The rise of decentralised applications (Dapps) focused on providing liquidity and crypto trading on the Ethereum network made it even more popular.
The Beacon Chain refers to Ethereum’s move towards shifting from the Proof-of-Work (PoW) consensus mechanism to the Proof-of-Stake (PoS) model. In response to the liquidity concern and the requirement to make locked tokens more accessible, liquid staking came to the scene.
What is the difference between staking and liquid staking?
To grasp the concept of liquid staking, you must first understand how traditional staking works. Instead of relying on mining for security purposes, PoS blockchain networks have users lock their tokens into smart contracts to participate in transaction validation processes.
While staking in general seems as a rewarding option, not all aspects of the crypto ecosystem utilise it. To find out more, why not read this article: 'Why Can't All Crypto Switch to Staking?'.
Traditional staking implies that staked assets must be locked in a smart contract for a predetermined period of time. In exchange for locking up crypto assets, users receive rewards in forms of tokens.
Unlike traditional crypto staking, liquid staking enables token holders to trade their tokens and enjoy staking rewards at the same time. While it is about maintaining flexibility and the possibility to actively manage assets, the rewarding system might be slightly lower when compared to traditional staking methods. Liquid staking doesn’t involve the same level of active participation in governance decisions.
What are Liquid Staking Tokens (LSTs)?
A Liquid Staking Token (LST) refers to a tokenised representation of staked assets. Liquid Staking Tokens (LSTs) get issued to stakers when they participate in a liquidity pool, and they include a direct value correlation with the tokens staked. Liquid Staking Tokens can be purchased, sold or used in other DeFi protocols.
They are often referred to as liquid staking derivatives; similar to other derivatives, LSTs enable users to access liquidity and market opportunities without holding the assets directly. Users’ original digital assets remain staked while they get a tokenised version.
Main architecture models of LSTs
LSTs come in different architecture forms and provide divergent opportunities for users. Let's check out the three main models.
Rebase tokens
Rebase tokens refer to assets that automatically adjust their balance in response to deposits and rewards. The process in question, known as rebasing, usually happens daily. During the rebasing process, there is no visible activity for token holders.
Rewards-bearing tokens
Rewards-bearing tokens refer to tokens that increase in value over time, along with the value and rewards earned by the changing exchange rate between the token and the staked assets. In other words, the quantity of LSTs stays the same, yet the rate changes.
Wrapped tokens
Particular LSTs are available as wrapped options. After a token is wrapped, it doesn’t experience automatic balance adjustments. Changes in the balance of such tokens are achieved through particular activities such as minting, transferring or burning. They are integrated into the exchange rate.
Why are LSTs gaining popularity?
There are many reasons why LSTs have become a common sight in the DeFi market. LSTs gained popularity because they provide liquidity, and liquidity ensures that users can engage with various DeFi protocols without the need to unstake their assets. Simply put, LSTs make sure that users don’t miss upcoming investment opportunities.
The interoperability of Liquid Staking Tokens enables them to be utilised across a wide array of DeFi platforms, enhancing integration with the whole DeFi ecosystem. A Liquid Staking Token offers a unique combination of increased liquidity, capital efficiency and direct participation in network rewards and security. LSTs trade on most decentralised exchanges (DEXs) and can be staked in a wide array of pools.
Another attractive feature of these tokens is linked to yield farming; when users hold LSTs, they can delve into yield farming or other strategies, and potentially increase their returns. LSTs can also be employed as collateral in DeFi lending and borrowing protocols as well.
LSTs enable DeFi customers to react to market conditions properly and offset any losses incurred due to the value of staked assets dropping during market downturns.
Advantages of Liquid Staking Tokens (LSTs)
Liquid staking provides more flexibility and mobility for investors’ digital assets. Let's take a look at several advantages of this staking mechanism.
Unlocked liquidity and multiple income streams
As described above in the text, Liquid Staking is based on allowing users to stake their crypto assets, receive an equivalent amount of digital tokens and utilise them on other DeFi platforms.
Therefore, it brings to the table a possibility to unlock multiple streams of crypto income for token holders. LSTs can be easily withdrawn and used as collateral to secure crypto-backed loans as well. Obtained loans can be further invested to generate additional returns on the original deposit.
Capital efficiency
Liquid Staking tokens can help users with improving their capital efficiency. These tokens allow users to extract additional utility and earn rewards from staked assets without breaking their original staking commitment. Because of this feature, a user’s capital becomes more useful compared to traditional staking strategies.
There are also Liquid Staking Token Finance (LSTfi) protocols that further enhance this capital efficiency via platforms that provide opportunities for DeFi users to put their ETH and LSTs to work. Such DeFi protocols utilise novel mechanics to maximise yield by deploying staked tokens to a wide range of other protocols.
Liquid Staking Token Finance (LSTfi) protocols basically exploded after the Ethereum network conducted its Shanghai upgrade in April 2023 which enabled staked ETH withdrawals.
Proof of staked assets
LSTs assume another important role within the DeFi landscape; they present a blockchain-backed proof of ownership of the staked assets. Digital ownership can be confirmed rapidly using a blockchain explorer.
Another attractive feature of LSTs refers to their ability to transfer ownership of staked assets simply. Traditionally staked tokens are inaccessible; if you try to access your staked funds, you will be prevented or fined for not meeting your commitment.
On the other hand, LSTs provide a more fluid version of digital ownership which prevents non-responsive scenarios where tokens are inaccessible during times of market volatility.
Drawbacks of Liquid Staking Tokens (LSTs)
Although LSTs have proven to be an efficient manner of improving liquidity and utility for numerous DeFi activities, they are not perfect. Here are some concerns that you should be aware of before engaging in liquid staking.
Slashing risks
Despite interesting staking incentives, validators can still be penalised for bad behaviour that may affect network performance in a bad way. This sort of penalty is known as slashing; it results in the validator’s removal from the DeFi network and the loss of a portion of their staked tokens.
Since users stake their assets to validators, their funds can be exposed to slashing as well. Therefore, users that outsource their funds to nodes are vulnerable to unreliable or malicious validators. For example, Ethereum penalises a malicious validator with slashing half of their staked ETH.
Loss of value
LSTs can lose their peg to the original asset which causes the tokens’ value to fall below the value of the digital asset it is linked to. For example, staked ETH traded lower than ETH following the Terra collapse in 2022.
Additionally, if users engage in unprofitable trades, this could lead to the loss of their LSTs and forfeit access to their original deposits. When it comes to LSTs as collateral, some protocols might require higher collateral when using LSTs compared to more traditional assets, which can be less capital efficient.
Which cryptocurrencies support Liquid Staking?
Several blockchain networks have introduced Liquid Staking Protocols, allowing users to benefit from this novel crypto market strategy. One significant example is the Ethereum network; after the Merge, Ethereum transformed into a PoS network, and enabled token holders to stake ETH and earn rewards while maintaining the flexibility to utilise their digital assets further.
Another popular crypto network that supports liquid staking is Polkadot; users can stake their DOT tokens and actively participate in the governance process while being able to access their assets.Other crypto platforms that support liquid staking include Avalanche, Cosmos, Lido and Cardano.
Due to its popularity, many other blockchain networks are implementing this flexible strategy. However, before investing into crypto, keep in mind that it is always the best option to conduct a due diligence analysis to reach a responsible and informed decision whether liquid staking is the best option for you.