Liquid staking solves the dilemma between network security and DeFi ecosystem growth on Proof of Stake networks. Liquid staking allows token holders to stake their assets while having a liquid representation or derivative of that asset that they can use in DeFi applications. If done properly, this can ensure that the network maintains a high level of security while unlocking new liquidity that would otherwise be inaccessible in the underlying staked asset.
Importance of Staking
Proof of Stake networks allow token holders to choose which validators are able to perform work on the network by staking/bonding/pledging their tokens to a specific validator. The amount of tokens staked is usually a good way to gauge network security. Networks with higher staked value have higher security, as the costs to attack a network rise in concert with the amount of value bonded to validators on the network. This is due to the fact that the cost of an attack becomes more expensive as more tokens, or value, are staked to validators in the active set.
In order to incentivize staking, PoS networks distribute rewards in the form of network inflation and a share of transaction fees to token holders who decide to stake. This allows token holders to earn a “yield” and grow their position on the network in comparison to a token holder that does not stake.
Having high staking rates early on in a network’s life cycle ensures that the network remains secure. But high staking rates and yields also lead to a liquidity problem over time, while forcing DeFi applications to compete with the yields generated through staking.
For many PoS networks, the majority of the network’s value is locked due to staking. Although this keeps the network secure, it also limits ecosystem growth due to staking’s illiquid nature. This is not the case for a PoW network like Ethereum. In PoW, miners devote hash power to the network which means all ETH in circulation can be used in DeFi applications built on Ethereum.
DeFi applications on PoS networks must compete with the yield generated from staking. This can range anywhere between 5% to 25% on most Layer 1 protocols. A higher yield from staking will result in DeFi yields becoming less attractive.
A lower yield from staking will result in DeFi yield becoming more attractive, but this becomes an issue as well. As the staking rate lowers, the network becomes equally less secure. This is due to the fact that the cost of attacking the network becomes less expensive as more tokens, or value, is staked to validators in the active set. This threatens the security of the network as well as the DeFi applications that exist on the network. This is one of the many problems liquid staking is trying to solve.
Liquid staking allows networks to maintain a high staking rate while unlocking otherwise illiquid value within the network’s ecosystem. This allows a network to maintain a high level of security without hindering the growth of the network’s DeFi ecosystem. Liquid staking is still a relatively new concept, but there are plenty of protocols being built that plan to offer a liquid staking solution across many PoS networks.
Lido, one of the largest depositors of ETH into the ETH 2.0 contract, is by far one of the most used liquid staking solutions on Ethereum. From an end-user perspective, staking ETH via Lido is relatively simple. A token holder looking for liquidity while staking ETH would need to deposit their ETH into the Lido staking contract. In return, users will receive a 1:1 representation of their staked ETH in the form of stETH.
The stETH can then be used in DeFi protocols, and can be freely traded. stETH balances are updated daily to reflect the staking rewards earned by the underlying ETH.
Token holders who decide to stake via Lido share 10% of their ETH rewards. These rewards are split evenly between Lido validators and the Lido DAO. The DAO governs the DAO treasury and makes decisions on network parameters, and policies like providing insurance on staked ETH via Unslashed Finance.
Lido is planning to launch a similar liquid staking solution on Solana and Aave in the coming months.
pStake is a liquid staking solution built by the Persistence team, and will likely be the first liquid staking solution for Cosmos ATOM stakers. A unique characteristic of pStake is that it’s design is centered around a bridge between Cosmos and Ethereum, and will feature a dual token model.
ATOM token holders who decide to stake via pStake will deposit their ATOMs onto the pStake application. In turn, they will receive a 1:1 pegged ERC-20 version of unstaked ATOM on Ethereum represented as wATOM.
wATOM token holders can then choose to burn their wATOMs and mint pATOMs. pATOMs are a 1:1 pegged ERC-20 version of staked ATOMs on Cosmos. pATOMs are liquid, but will receive rewards overtime in the form of wATOMs. This process mimics how staking rewards accrue on Cosmos with the only difference being that the staked position is also liquid.
pStake will initially support Cosmos with plans to support other chains such as Persistence, Solana, Polkadot, and Terra.
Acala, an upcoming parachain built on Polkadot, will feature a liquid DOT staking protocol known as HOMA. The HOMA protocol allows DOT holders to stake their DOT via a staking pool on Acala. In return, DOT holders receive L-DOT, which they can lend or use as collateral for a stablecoin loan on Acala. L-DOTs will be liquid and tradable across all chains on the Polkadot network.
L-DOTs are unique because they do not have a 1:1 peg with DOT. Instead, they represent a share of the staking pool. This means that the value of L-DOT is likely to increase as staking rewards accrue in the DOT staking pool.
By staking DOT via HOMA, L-DOT holders can also bypass the 28-day unbonding period when redeeming L-DOTs for DOT by paying a premium. This eliminates the risk of price depreciation during unbonding periods when staking DOT.
Acala’s sister network, Karura, will also be providing a liquid KSM solution on Kusama.
Things to Consider
Liquid staking has the potential to be a great solution for token holders, networks, and the DeFi ecosystems built on top of them. That said, token holders who are looking for a liquid staking solution must understand the nuances with different solutions, and the potential risks, like slashing and smart contract vulnerabilities when interacting with liquid staking protocols. We will be publishing more in-depth pieces on liquid staking over time, but for additional information now, I highly recommend reading “Why Stake When You Can Borrow?” by Tarun Chitra and Alex Evans and the Liquid Staking Research Report by Chorus One.
Additional resources on Lido, pStake, and Acala: