Liquid Staking Derivatives: Explanation and Examples

Staking is one of the fundamental aspects of many cryptocurrencies. It contributes to the system’s stability while offering investors ways of earning passive income. However, the system is not without drawbacks. That’s one of the reasons why liquid staking derivatives were invented.

Liquid staking derivatives (LSD) represent one of the biggest steps toward flexible wealth generation in the world of decentralized finance (DeFi). They represent an overhaul of the traditional staking system, alleviating some of its disadvantages while simultaneously fostering financial inclusion.

LSD is a relatively new concept, even relative to crypto standards. Understanding it thoroughly can help you take advantage of it while it's in its early stages and hopefully prosper by utilizing these innovative digital assets.

What Are Liquid Staking Derivatives?

Liquid staking derivatives (commonly referred to as LSDs) are an innovative type of cryptocurrency created to make staking more flexible. You can think of them as blockchain versions of promissory notes or IOUs obtained when staking other assets, like Ethereum’s ETH or Polygon’s MATIC.

These tokenized IOUs were designed to address several issues that come with regular staking, such as:

• Liquidity concerns. Traditional staking implies a complete lock-up of one’s assets. When staking ETH, users are unable to access their coins until the lock-up period ends. Their crypto is essentially completely removed from circulation, which means there’s no selling or trading whatsoever.
• Financial exclusion. To become an Ethereum validator, a participant needs to stake at least 32 ETH. At its peak, Ethereum was worth more than $4.800, which means a single user had to lock up more than $150,000 worth of ETH to start staking.
• Expensive yield accrual. With traditional staking, users need to pay gas fees when they want to withdraw rewards. In periods of extreme network congestion, these fees can become prohibitively high, taking considerable amounts from these earnings.

Crypto holders can use liquid staking derivative tokens like any other cryptocurrency while having their initial assets staked to earn passive income. LSDs can be bought, sold, and otherwise traded on exchanges like many other crypto coins and tokens. They can be used as collateral for borrowing purposes or added to liquidity pools for yield farming.

Their utility and flexibility extend beyond that, as they automatically accrue yield, saving their owners all the crypto that would otherwise be spent on gas fees. Moreover, liquid staking derivatives are issued by decentralized platforms that allow anyone to participate. Even users who don’t have enough coins to become validators can submit their holdings to a pool and start staking.

LSD Demand Surge

The demand for LSDs surged after the Ethereum network’s recent Shanghai upgrade. It is Ethereum’s most significant update since the London hard fork, which changed the blockchain’s proof-of-work (PoW) consensus mechanism to proof-of-stake (PoS).

To participate in the staking introduced by the London hard fork, users needed to lock up at least 32 ETH to become validators. Not only that, but the lock-up period was indefinite, as there was no clear information on when validators would be able to withdraw their funds. That changed with the Shanghai hard fork, which took place on April 12, 2023.

The Shanghai hard fork is often referred to as the Shapella update. The name combines Shanghai, where the Ethereum developer conference, Devcon 2, took place, and Capella—the most prominent star in the Auriga constellation.

The Shapella upgrade introduced several Ethereum improvement proposals to the network, with EIP-4895 being the most important. Its implementation finally allowed validators to withdraw their staked ETH along with any rewards gained.

With their ETH holdings finally unlocked, many users started looking into more liquid options of staking, which caused the demand for LSDs to surge. Platforms like Lido and Rocket Pool, which facilitate this staking method and issue liquid staking derivative coins, now have more than $10 billion in total value locked (TVL).

Liquid Staking vs. Regular Staking

Liquid staking and regular staking both refer to the same core principle of participating in a network that features a proof-of-stake consensus mechanism.

Regular staking is the traditional method of locking up assets to support the network’s security and facilitate its operations. Essentially, the users stake their assets as a guarantee that they’ll honestly validate transactions without trying to manipulate the system. In exchange, they get a portion of fees paid by participants who use the network’s services.

If a validator is discovered trying to perform malicious activities, they lose some or all of their staked tokens. Meanwhile, their assets are locked up and illiquid. This is the main limitation of regular staking, especially in ecosystems that feature lengthy unstaking periods.

On the other hand, liquid staking allows participants to freely use liquid staking derivative crypto while having the original coins locked up. Moreover, the value of LDS tokens is usually pegged to the staked assets. For instance, Lido Staked ETH (stETH) is pegged 1:1 to ETH.

As a result, ETH holders can leverage liquid staking to participate in the network and earn passive income while utilizing their assets to their full extent. Instead of locking potential thousands of dollars, they can trade them, provide liquidity, borrow against them, and more.

Liquid Staking Protocols

Liquid staking protocols are smart contract-powered dApps that facilitate the process. They allow users to submit their crypto and get LSDs in return. Let’s examine some of the most prominent.

#1. Lido

Lido is the most popular liquid staking protocol and the biggest one based on the total value locked. With almost $19 billion in ETH and more than $100 thousand in MATIC locked, Lido is at the forefront of liquid staking.

The dApp allows users to connect many different wallets, including MetaMask, Exodus, Ledger, and Coinbase wallet. After integrating their wallets, users simply select how many coins or tokens they want to stake, and they’ll get the same amount of stTokens in return. Afterward, they can use received stTokens in the DeFi ecosystem to compound rewards.

The platform is governed by the decentralized autonomous organization called Lido DAO. The participants have a forum where they can discuss ideas before giving proposals and voting on them.

#2. Rocket Pool

Rocket Pool is an Ethereum-only decentralized staking platform. Participants can start staking with as little as 0.01 ETH. In return, they’ll get rETH liquid staking derivative, which they can use in other DeFi protocols.

While Rocket Pool allows anyone to stake Ether, those who can submit enough to create a node will get much higher returns. Essentially, they take on the responsibility for their ETH, but also the ETH of other liquid stakers who join their node.

In addition to wallets like MetaMask, Phantom, and Crypto.com wallet, Rocket Pool integrates with many other DeFi platforms. There are exchanges like Uniswap, Curve, and Balancer, lending platforms like Maker and Vendor Finance, oracles such as Chainlink, etc.

#3. Frax Finance

Frax Finance is a multi-purpose DeFi platform that features a self-sufficient inner economy. Its protocol operates using three stablecoins:

1. FRAX is a crypto-backed stablecoin pegged 1:1 to the US dollar
2. FPI is the Frax Price Index stablecoin pegged to CPI (Consumer Price Index), or the market basket of consumer goods and services
3. frxETHis Frax Ether, which is an LSD version of ETH and is pegged to its value

The platform also features the Fraxswap exchange, Fraxlend lending platform, and Fraxferry, which facilitates transfers of Frax Protocol-issued tokens across multiple blockchains.

Finally, Frax Finance features two governance tokens:

1. Frax Share (FXS) is used in governing stablecoins and protocols
2. Frax Price Index Share (FPIS) is focused on the innovative FPI token

#4. Coinbase

Coinbase is one of the world’s largest centralized exchanges, and it offers liquid staking services. Unlike previous examples, which were all decentralized platforms governed by DAOs, Coinbase is a private company that allows individuals and entities to buy and sell cryptocurrencies and NFTs, earn rewards, trade, and more.

Like most centralized exchanges, Coinbase is more intuitive and user-friendly than decentralized platforms. However, creating an account requires having an email and performing KYC verification, which clashes with some of the core DeFi principles.

Once you have an account, you can stake your ETH to get cbETH. You can then use this liquid staking derivative on different platforms, such as Uniswap, Curve, Yearn, Aave, Compound, and so on.

How to Stake ETH and Get an LSD

The exact process of staking ETH to get their LSD version will depend on the platform and protocol that you’re using. Here are the general steps to follow to start liquid staking on most major DeFi platforms:

1. Fund your Ethereum-compatible wallet with ETH
2. Go to a designated platform, such as Lido or Rocket Pool
3. Initiate the staking process, and you’ll be prompted to connect your wallet
4. After connecting the wallet, select the amount of ETH you want to stake
5. Confirm the action to receive a liquid staking derivative version of ETH
6. (Optional) Use LSD ETH in other DeFi protocols to trade, lend, provide liquidity, and more

The process is even simpler if you’re using a centralized exchange. Here are the steps:

1. Create an account with the centralized exchange using your email or phone number
2. Perform KYC verification
3. Buy ETH with fiat using your payment card, bank transfer, third-party services, etc.
4. Find the liquid staking feature on the exchange’s website
5. Submit your ETH and get LSD ETH in return

Pros of Liquid Staking Derivatives

Liquid staking derivatives were invented to improve the traditional staking method. Here are some of the biggest pros that they bring:

• Enhanced liquidity. For conventional staking, a user needs to lock up their assets, effectively making them unusable. Certain staking methods also feature rigid unlock periods, where users can’t withdraw their assets whenever they want. LSDs allow holders to gain all the benefits of staking while freely using these tokens in DeFi.
• DeFi access. LSDs aren’t just tradable in decentralized finance; they can be used in a variety of protocols, just like the majority of regular cryptocurrencies. Holders can submit them to pools to provide liquidity, use them as collateral to borrow against, practice yield farming, and more.
• Improved network security. The rigidity of traditional staking can sometimes tempt users to manipulate the network in an attempt to earn bigger rewards or unlock their assets faster. By giving these participants LSDs to use in exchange for their locked-up tokens, the network eliminates the need for these malicious attempts.
• Additional utility. Many liquid staking protocols give LSD tokens bonus features. For instance, holders can use them for governance purposes, to vote on proposed changes to the protocol or its future development. That way, they get to improve the network’s stability, earn passive income, and have decision-making power.

Cons of Liquid Staking Derivatives

Being novel concepts, liquid staking derivatives aren’t without cons. Before they are to see wider adoption, they need to address some of the risks, such as:

• Smart contract vulnerabilities.Smart contracts, which are at the core of most liquid staking protocols, remove the need for third parties and eliminate the chance of human error and manipulation. However, improper coding can leave them vulnerable and open to exploits. Attackers can use these flaws to destabilize the network or steal funds.
• Regulatory concerns. Many aspects of cryptocurrencies are still in the grey area when it comes to regulation. The complexity of DeFi and LSDs creates further confusion among participants. However, the IRS sees digital assets as property for tax purposes, meaning liquid staking derivatives may need to be reported on tax returns.
• Learning curve. Participating in DeFi can be a challenging endeavor, especially for entry-level users. Even simple acts, such as setting up a wallet and connecting it to a decentralized exchange, require multiple steps. The process becomes exponentially more difficult with liquid staking derivatives, which can deter less experienced users.
• Intermediary risk. Liquid staking derivatives are products of platforms that issue them. As a result, they depend on the platform to remain stable and operational. That adds another point where a failure can happen to an already complex and volatile system.

Is Liquid Staking Worth Doing?

Whether liquid staking is worth doing depends on your needs, circumstances, and risk tolerance. Since these are unique to every individual, you should start by examining the list of pros and cons of liquid staking derivatives outlined in the above sections.

As a general rule of thumb, better rewards and higher yields in the crypto sphere are often associated with more risk. Traditional staking is an established way of attributing to the network’s security and facilitating its operations. While this method is not without flaws, it’s been tested much more and for far longer than liquid staking.

On the other hand, liquid staking platforms add unprecedented levels of utility to conventional staking. The ability to provide yield, trade assets, or use them as collateral while still earning passive income from your ETH (or other cryptocurrency) holdings should not be understated.

Ultimately, like with any other novel concept (especially in DeFi), you should approach liquid staking with caution. Make sure to do your own research, choose an approved platform, and keep an eye on the news and development. That way, you can stay one step ahead and maximize your earnings while minimizing the risk.

Key Takeaways

Liquid staking derivatives are much more than just another type of cryptocurrency. They stand as a testament to the innovation and flexibility of the crypto sphere.

LSDs have taken the established concept of staking and improved on it in multiple ways. These tokens give holders enhanced flexibility and allow them to have more streams of income while not stopping their staking endeavors.

Ultimately, liquid staking derivatives have the power to revolutionize the world of DeFi completely. While there are still challenges ahead, the future looks bright for these assets and their holders!