What is the difference between liquid and classic staking?

Liquidity staking is the process of issuing a “derivative” token that is backed by the collateral of the cryptocurrency involved in the staking. The resulting token can be used for profitable transactions in DeFi applications. However, the risks with this method of earning money are much higher.

Benefits of liquid staking

The practice of staking is widespread in the cryptocurrency industry, in which holders of crypto assets operating in Proof-of-Stake networks can receive passive income for participating in the validation process or delegating their cryptocurrencies to the node operator. However, to do this, it is necessary to block cryptocurrencies in a special smart contract for the period established by the protocol. Before it expires, it is impossible to use your coins to complete the ETH to SOL exchange operation.

Liquid staking is different in that it provides the opportunity to use crypto assets even after they are blocked. This is achieved by creating a tokenized version of the underlying asset, which opens up new prospects for investors. Thus, thanks to liquid staking, investors can simultaneously receive a fixed income and use the derivative asset in various DeFi applications.

Another important advantage of this method of earning money is a lower entry threshold. For example, to stake ETH, an investor does not have to save 32 coins.

How it works

Liquid staking is a relatively new practice that is actively used in some DeFi projects. An example of such a project is Lido Finance, which allows users to stake various cryptocurrencies and receive an equal amount of a liquid derivative asset in return. The user can use this derivative asset at his own discretion, while he retains the ability to dispose of the funds received. During the staking process, Lido receives a commission of 10% of the rewards received.

One of the most popular coins for liquid staking through Lido is Ethereum (ETH). Users can send ETH to an Ethereum 2.0 contract and receive stETH tokens in exchange. These stETH tokens can be further used for various purposes such as yield farming or lending on various DeFi protocols such as Aave, Maker, Compound, yearn.finance and others. Each stETH token is backed by ETH locked in staking, and its quantity changes in accordance with ETH rewards. After the full launch of Ethereum 2.0, each stETH token can be exchanged for real ETH, and at the moment such tokens can be exchanged on the secondary market.

The Lido protocol is not limited to just Ethereum. Liquid staking is available on the platform for Solana (SOL), Polkadot (DOT), Kusama (KSM) and Polygon (MATIC).

In 2023, a similar service for ETH owners appeared on top centralized cryptocurrency exchanges. Derived tokens can currently only be exchanged for ETH.

Key risks of liquid staking

Risk is an integral component of any systemic interaction with any market. When it comes to the crypto market, it’s worth immediately taking note that working with crypto assets is still considered high-risk, be it SOL to UNI trading or passive income. The main risks of the digital asset market do not bypass liquid staking.

Smart contract vulnerability

The risk is that the protocol’s smart contract may contain vulnerabilities that become accessible to attackers. Poor contract code can become a source of potential security threats.

Blockchain risk

Particularly relevant for ETH staking via Lido. Users may face a time limit, as withdrawal of ETH from the staking contract will only be possible after the launch of the Ethereum 2.0 mainnet. The exact timing of this event is unknown and the update may cause unexpected network outages.

Market risks

Liquid staking involves issuing derivative assets based on cryptocurrencies, making it subject to market fluctuations. Volatility in the underlying asset can have serious consequences, especially if derivative tokens are used to support open positions.

Systemic risks

Due to the interconnectedness of DeFi protocols, problems in one project can affect several others. This creates systemic risks, where problems in one protocol can affect the entire ecosystem.

Liquid staking, despite its advantages, requires careful risk analysis and user awareness in order to effectively manage their cryptocurrency assets.