Earning methods in the world of cryptocurrencies are becoming increasingly diverse. One such method is staking. However, like any system, this method has its disadvantages. One of these drawbacks is the locking up of liquidity for an extended period, which prevents the investor from accessing their funds. To address this issue, a method called liquid staking has been developed. In this article, we will explain what liquid staking is, how it solves the problems of traditional staking, the various methods of liquid staking, and its disadvantages.

What is Liquid Staking?

Liquid staking is an innovative process in the realm of cryptocurrencies that allows users to delegate their tokens to a service and benefit from staking without losing access to them. In other words, with liquid staking, you can stake your tokens and simultaneously benefit from their price appreciation while being able to sell them whenever you want. In this method, unlike traditional staking where tokens are locked for a specific period, you receive new tokens called liquid tokens, which are tradable and usable on other platforms and exchanges.

Imagine you want to stake some Solana (SOL) cryptocurrency. In traditional staking, you would have to lock your SOL tokens for a period and during this time, you wouldn't be able to use them. However, with liquid staking, in exchange for staking SOL, you receive another token called mSOL, which you can trade like SOL and use on DeFi platforms. This allows you to engage in DeFi activities with mSOL, lend your new tokens, or use them in other economic exchanges.

Protocols that offer liquid staking services have become very popular due to providing greater liquidity and high flexibility. These protocols allow users to liquid stake native tokens from various blockchains such as Ethereum, Solana, Polkadot, Cosmos, Kusama, and Polygon (MATIC).

In conclusion, using liquid staking injects high liquidity into DeFi markets, which can help shape the future of this industry. This method allows users to benefit from staking without experiencing traditional limitations and at the same time take advantage of more opportunities in DeFi markets.

How Liquid Staking Works

Liquid staking involves three main steps: staking assets, issuing liquid tokens (LT), and unstaking. This process may seem simple, but understanding how these three steps interrelate is crucial.

Staking

In the first step, the user sends their cryptocurrencies to a platform that supports liquid staking. After the transaction is confirmed by the platform, the assets are stored in a smart contract. This step is similar to traditional staking, but with the difference that at the end of this process, liquid tokens are issued.

Liquid Tokens (LT)

Liquid tokens are a type of digital receipt representing your ownership of the staked assets. These tokens have value and can be used in financial exchanges like other cryptocurrencies. The value of these tokens is linked to the underlying assets.

Unstaking

If the user wishes to withdraw their assets, they need to burn their liquid tokens. To do this, the tokens are sent to a specified address, and after the transaction is confirmed by the platform, the original assets are returned to the user. This process may involve fees, which are usually significant.

Types of Liquid Staking

Liquid staking exists in several different forms, each with its own advantages and features. Here we examine the different types:

Native Liquid Staking

In native liquid staking, users stake the native cryptocurrency of a blockchain network directly on that network. This type of staking allows users to place their assets directly on the network and earn tokens in return. An example of this type of staking is Ethereum 2.0 staking, where users can lock their Ether (ETH) in the Ethereum 2.0 network and benefit from it.

Non-Native Liquid Staking

In this type of staking, tokens representing the staked assets are issued by third-party platforms or protocols. Users can share their assets and receive tokens that represent their stake in the underlying assets. An example of this type is the Lido Finance platform, which issues stETH tokens that represent staked Ether.

Synthetic Liquid Staking

Synthetic liquid staking involves creating synthetic assets that represent staked positions on a network. These assets are usually issued on decentralized finance (DeFi) platforms and allow users to trade these assets or use them as collateral for other activities. The Synthetix project is a prime example of this type, allowing users to create synthetic assets that represent staked positions on various networks.

Custodial Liquid Staking

In custodial liquid staking, users delegate their assets to a trusted third party or custodian to stake on their behalf. These services manage technical aspects such as running validator nodes, while users retain ownership of their assets and receive staking rewards.

Advantages of Liquid Staking

Liquid staking offers several advantages that provide users with access to various opportunities and capabilities. Here are some of these benefits:

Yield Farming

Liquid staking is a prerequisite for yield farming. In yield farming, users lock their assets in a DeFi protocol and receive tokenized versions of them. They then stake these tokenized assets on another platform to earn additional passive income. This method allows users to receive rewards from two different sources: the first platform where the assets are locked and the second platform where the tokenized assets are staked. Although this method has high income potential, it also comes with high risks and requires thorough research on the protocols and loan-to-collateral ratios.

Immediate Access to Staked Assets

One of the biggest advantages of liquid staking over traditional proof-of-stake staking is the ability to have immediate and unrestricted access to staked assets. With liquid staking, users can sell or use their assets in other exchanges whenever needed.

Ability to Obtain Loans with Staked Assets

In liquid staking, users receive a new token for every token they stake. These tokens can be used as collateral to obtain cryptocurrency loans. This allows users to gain more liquidity with their assets and take advantage of more financial opportunities.

Disadvantages of Liquid Staking

Although liquid staking addresses some of the problems of traditional staking in the cryptocurrency world, it is not without its drawbacks. Here are some of these disadvantages:

Increased Complexity and Systemic Risk

Liquid staking increases the complexity of the decentralized financial system by adding an extra layer. This complexity can lead to increased systemic risk, where a crisis or collapse in one part of the system can potentially affect the entire ecosystem like a domino effect. In other words, a problem in liquid staking can quickly spread to other parts of decentralized finance and cause market instability.

Vote Buying and Power Concentration

One of the disadvantages of liquid staking is the possibility of buying and selling voting rights. Participating in the governance decisions of a network is one of the most important features of staking. In liquid staking, voting rights can be sold and transferred to others. This mechanism is similar to proof-of-stake systems where the person with the most stake has the most voting power. The ability to transfer voting rights can increase the likelihood of power concentration, as large individuals or entities can buy voting rights to gain more decision-making power.

Slashing Risk

In proof-of-stake algorithms, one of the main risks is slashing. In proof-of-stake blockchains, slashing penalties are applied in case of dishonest behavior or inactivity by validators. These penalties can include losing a fixed amount of assets, a specific percentage of cryptocurrency, complete account termination for the validator, or temporary and permanent activity bans. These risks also exist in liquid staking, and users may be penalized in case of problems.

Reduced Profits Due to Intermediaries

In liquid staking, using platforms and intermediaries to manage assets can reduce user profits. These intermediaries usually charge fees for their services, which can decrease the overall profit for users.

Security Risks

Adding extra layers to the staking process can introduce new security risks. Intermediary platforms and protocols may be exposed to cyberattacks, putting user assets at risk. Additionally, potential errors and vulnerabilities in the smart contracts used in liquid staking can lead to asset loss.

Conclusion

Overall, liquid staking offers more advantages compared to traditional staking protocols. With this mechanism, investors no longer need to wait until the end of the staking period to access their funds. This method is not only more convenient but also allows for increased rewards by investing liquid tokens in other platforms.

However, it is essential not to overlook the potential problems and risks in this field. Issues with smart contracts, price fluctuations, high costs, and events like bankruptcy and problems with liquid staking platforms can ultimately lead to user losses.

Therefore, it is recommended to thoroughly research the platform's credibility, returns, costs, and existing rules before staking on these platforms. This careful review can help reduce risks and increase the security of your investment.