Staking is a method of generating passive income in the cryptocurrency industry. The whole process involves a long-term investment in a project. Staking includes locking down a certain amount of capital in a smart contract. In return, we receive a certain dividend – a reward.
Today we will discuss what Liquid Staking is and how it works. We will also take a look at LSD tokens (Liquid Staking Derivatives).
What is Liquid Staking?
Liquid Staking is an enhanced version of classic staking. What is the main difference? We have constant access to our staked assets. Liquid Staking gives us the best of all worlds – rewards for staking and constant access to products from the world of decentralized finance (DeFi). As a reminder, you can read about decentralized finance here.
You may not be surprised to learn that Liquid Staking is based on Ethereum. What does it all look like? Let us say you own a certain amount of ETH. You can then lock in your ETH for an APY of between 5% and 10%. You then earn passive income and do not have to do anything. Sometimes the performance of ETH may be higher than the profits you make on the stake. This is an example of opportunity costs. With Liquid Staking, these costs do not apply. In this case, you can still lend your ETH or provide DEX liquidity. What is more – you can even sell your ETH! How is this possible? By getting a derivative token from the original ETH you used. But more on that in a moment.
Liquid Staking Derivatives (LSDs) – derivatives based on liquid interest rates
LSDs are synthetic assets that represent other assets. We will not go into this topic in detail. As a reminder and to complete your knowledge on this topic, take a look at our lesson [LINK – WHAT SYNTHETIC ASSETS ARE IN CRYPTOCURRENCIES – LEVEL MASTER].
The value of a synthetic asset is based on the value of the underlying asset it represents. LSD tokens are used for trading, lending or as collateral for DeFi or dApps.
This type of token gained popularity in 2020. Along with the introduction of DeFi’s derivative protocol, Synthetix. It is this protocol that enables the creation of synthetic assets.
The LSDs we are talking about today work very similarly to their derivatives. The difference, however, is that they work mainly on smart contract networks like Ethereum. Liquid Staking Derivatives (LSDs) offer the possibility to use these assets even if they are still staked.
Put simply, LSDs are tokens that represent a receipt for your deposited ETH on a particular platform. The value of an LSD token is closely linked to the price of ETH. Liquid Staking is available to anyone. This has led to a record amount of funds being deployed under these protocols. With the success of the protocols, LSD tokens have seen tremendous growth. Here are four LSD tokens to look out for in particular.
- Lido (LDO). The number one liquid staking token. The protocol is considered the safest place to stake your ETH. Users deposit ETH and receive a stETH token in return. Stakers earn about 5% per year on Lido. We can use stETH to ‘work’ with DeFi, resulting in extra profit. With the upcoming Shanghai update, the price of the LIDO token will increase.
- Rocket Pool (RPL). The protocol is slightly smaller than LIDO, but just as popular. First of all, it is more focused on decentralization. In this case, stakers only need 16 ETH to become a node operator. In addition to the rewards of ETH, we also get rewards in the form of RPL tokens, which gives us a higher return than LIDO. The disadvantage of Rocket Pool is that the user has to hold 1.6 ETH RPL, which unfortunately are unlimited. There is therefore a risk that the price of RPL will fall in the future. Stakers therefore have to buy more RPL to maintain the value of 1.6 ETH, and are thus deprived of their profits.
- Frax share (FXS). While waiting for the Shanghai update, Frax has gained its share of followers. The protocol has two tokens – FRAX, a USD-linked stablecoin, and FXS, a management token. Using ETH in the FRAX protocol offers us rewards in the range of 6-10% for using ETH per year. Users can earn an additional 10% by providing liquidity in Curve Finance with frxETH. They receive this token for deploying their ETH.
- StakeWise (SWISE). We can deposit any number of ETH into this token and receive sETH2 instead. We are then entitled to rewards in the StakeWise Pool. The rewards from StakeWise are accumulated in a separate token, rETH2. This is very different from other protocols and brings large profits very quickly. Users can deposit as much ETH as they like – there is no minimum amount in this protocol.
How does Liquid Staking work?
Liquid Staking grants users a derived asset to the one you stake on. This ensures that you do not ‘freeze’ your cryptocurrencies for the duration of the stake. You can use the derivatives in the same way as the underlying assets.
This approach encourages investors to participate in staking because it removes the time restriction is removed. Investors can further develop a particular network and improve its security while reaping the benefits of being able to use their tokens on DeFi markets.
Another advantage of liquid staking is that most Liquid Staking Derivatives platforms also offer fractional staking. Another advantage is the low entry threshold.
With LSD protocols, you can start your Liquid Staking adventure with as little as 0.01 ETH.
What are the risks of Liquid Staking?
LSD tokens are not as strongly linked to the ETH price as stablecoins are to the USD. Moreover, the dominance of LIDO in this market poses a huge risk. And why? Because the overall supply of ETH is so large, that LIDO is a tasty morsel for cybercriminals. The LIDO protocol is aware of this risk and is looking for an advantageous solution.
Advantages and disadvantages of Liquid Staking
Let us look at the advantages first:
- Liquid Staking encourages even more investors to block their capital. Staking is very important for Proof-of-Stake networks as it is the main method to secure the network against 51% attacks.
- Liquid Staking provides continuous access to assets by creating a derivative version of them.
- The development of this digital asset sector could lead to much more efficient cryptocurrency markets.
- Liquid Staking creates an environment that is more liquid.
- Most LSD protocols allow for staking without having 32 ETH.
Disadvantages
- The APY rate is much lower than traditional staking.
- The return on investment is much lower, as you can withdraw and repurchase your tokens at any time.
- Liquid Staking increases the rate of slashing. Slashing is a mechanism that removes malicious behavior from validators.
Summary
Liquid Staking is a great, and most importantly, new way to generate passive income without the limitations that traditional staking is subject to. However, whether you choose to invest in this way depends on whether or not you like the strategy and the potential risks. However, if you prefer a higher return and do not mind not having access to your money, you should choose classic staking.
