Liquid Staking

Key points

• Liquid staking is a way to take part in proof-of-stake consensus without having the committed assets fully locked up.
• In exchange for the deposited assets, the user receives a token that represents this position and can be used in other applications.
• This allows earning staking rewards while keeping liquidity, at the cost of adding new risks to the operation.

What is liquid staking?

Liquid staking is a solution that addresses a drawback of traditional staking: when a user commits assets to help validate a proof-of-stake network, those assets are normally locked up and unavailable. With liquid staking, the user receives in return a token that represents the committed position, and that token can circulate freely while the original assets keep earning yield.

How it works

The user deposits their assets into a liquid staking protocol, which commits them to the network on the user's behalf, operating or delegating to validators. In return, the protocol issues a token that represents the deposit plus accrued rewards. This token can be transferred, traded, or used as collateral in other decentralized finance applications.

In practice, this allows the same capital to serve two functions: contributing to network security while earning staking rewards, and remaining available for other uses through the representative token. When the user wants to recover the original assets, they return the token and go through a redemption process, which may involve a waiting period set by the network.

This combination expanded the use of staking, but it also chained together new risks: the representative token depends on the contract that issues it and on maintaining its peg to the underlying asset.

Why it matters

Liquid staking made capital committed to network security more efficient, which attracted significant volume to this model. For those evaluating these positions, understanding that the representative token carries additional layers of risk is essential before using it as if it were the original asset.

Risks and limitations

Liquid staking adds up risks: the risk of staking itself, with the possibility of slashing if the validator fails; the risk of the smart contract that issues the token; and the risk of the representative token losing its peg to the underlying asset during periods of stress. Using this token as collateral in other applications chains these exposures together even further. For this reason, these tokens require understanding the entire chain of dependencies before treating them as equivalent to the original asset.