What Is Liquid Staking in Blockchain and How It Works?

Staking in crypto has evolved from a specialized concept to a crucial mechanism for securing blockchain networks. Yet, traditional staking requires locking assets for long periods. This is precisely where a more targeted solution was needed, and liquid staking met the requirements.

Liquid staking revolutionized the way crypto staking is done without compromising on liquidity. In this article, we will explore the concept and step-by-step mechanism of liquid staking. So let’s get started!

What is Staking?

Staking involves locking up crypto to support the security and operation of proof-of-stake (PoS) blockchain networks. Players “stake” their tokens to help in validating transactions and adding blocks to the blockchain, and earn rewards as a result. Staking yields stable income, yet the locked assets cannot be spent or used as collateral within the wider DeFi ecosystem. 

It also involves risks, as staked tokens may be slashed in the event of malicious or unreliable behavior by validators. It can be done on an individual basis by operating a validator node or through staking-as-a-service providers, making it more available to a broad user base.

Key Takeaways:

• Liquid staking enables users to claim staking rewards while preserving liquidity using tradable liquid staking tokens (LSTs).
• It eliminates technical barriers, making it easy for anyone to engage in staking without operating validator nodes.
• Centralized liquid staking is based on custodial platforms, whereas decentralized staking is based on non-custodial smart contracts.
• LSTs can be utilized in DeFi for trading, lending, or generating additional yields, thereby maximizing returns.
• The users must be aware of smart contract exploits, slashing penalties, and LST price volatility to minimize risks.

What is Liquid Staking?

Liquid staking enables users to stake their cryptos without losing the liquidity of their assets on other platforms. When users stake using a liquid staking protocol, they obtain a derivative asset in the form of a liquid staking token (LST). These LSTs represent the user’s staked assets and can be freely traded or used in DeFi applications.

For instance, in the Ethereum ecosystem, users staking ETH are rewarded with a tokenized version of staked ETH (stETH). Solana also has mSOL for staked SOL. These tokens enable users to retain liquidity, participate in lending pools, or access other opportunities to generate returns.

With this system in place, users can retain the staking benefits while maintaining control to invest their assets in other financial pursuits simultaneously. Additionally, it minimizes technical hurdles to entry, allowing even individuals without the means to operate validator nodes to receive rewards and contribute to network operations.

Centralized vs. Decentralized Liquid Staking

Liquid staking can be done in two ways, with the primary difference being asset custody.

• Centralized: Liquid staking is done via custodial platforms or exchanges that manage the staking process on behalf of users. This arrangement involves users depositing their assets with the provider’s custodianship, and the platform does the staking and validator operations.
• Decentralized: Liquid staking, or dStaking, utilizes non-custodial smart contracts, allowing users to retain full control over their private keys. Validators are controlled through decentralized protocols instead of a centralized entity.

How Does Liquid Staking Work? Step-by-Step Mechanism

Liquid staking functions via a well-engineered system that involves validator operations, consensus mechanisms, and issuance of derivative tokens.

Step 1: Validators

Validators help with network security and operations in PoS (Proof-of-Stake) networks. Platforms collaborate with experienced node operators who oversee technical staking processes and secure assets.

Step 2: Consensus Mechanisms

The mechanism is based on PoS, in which validators are chosen depending on the amount of staked assets. This helps the network stay decentralized and tamper-proof.

Step 3: Liquid Staking Tokens (LSTs)

As users stake their assets, they are given liquid staking tokens to represent their holdings, like stETH or mSOL. The LSTs are tradable, eligible as collateral, or used within DeFi protocols.

Step 4: Liquid Staking Derivatives (LSDs)

Advanced platforms offer liquid staking derivatives with fractional ownership of staking rewards. These derivatives offer even more flexibility for advanced users.

How Does Liquid Staking Work With Different Cryptocurrencies?

The basic idea behind liquid staking is consistent across various blockchains: it offers liquidity in return for staking rewards. However, the way it is done can differ from one network to another.

• Ethereum: Platforms generate stETH as an asset to track the staked ETH. Users can earn rewards through staking as they participate in the DeFi ecosystem.
• Solana: It refers to SOL staking and mSOL earning. These can be traded in liquid pools and lending platforms.
• Polygon and Other Networks: Certain networks utilize liquid staking to enhance liquidity and boost network engagement.

Advantages of Liquid Staking

Liquid staking has become a go-to for modern investors due to its numerous benefits as discussed below:

1. Liquidity: Liquid staking keeps staked assets available for use. Members can utilize liquidity and participate in DeFi without waiting for lock-up periods to expire.
2. Accessibility: Liquid staking reduces barriers to entry (bonding periods), and users without advanced technical knowledge or significant capital demands can stake.
3. DeFi Composability: LSTs can be utilized across multiple DeFi platforms for various applications, thereby enhancing their utility.
4. Increased Rewards: Users not only receive staking rewards but can also reinvest LSTs to earn further returns, optimizing their overall holdings’ return.
5. Improved Capital Efficiency: By enabling users to earn staking rewards while keeping their tokens available for DeFi activities, liquid staking maximizes overall capital efficiency. 

Limitations of Liquid Staking

Here are some liquid staking limitations one should consider before getting started.

1. Smart Contract Exploits: Liquid staking relies on smart contracts, which are susceptible to bugs and attacks. One vulnerability can leave funds open to exploitation.
2. Price Volatility: The market price of LSTs may fluctuate or diverge from the underlying asset, potentially leading to losses.
3. Slashing Risks: Validators can get penalties for malicious activity, which means participants associated with those validators may lose funds.
4. Fees and Costs: Platform fees are typically a part of liquid staking and can decrease overall returns.
5. Centralization Risk: There is a centralization concern as staking power is consolidated within a few platforms or validators, which can reduce decentralization.

How to Start Liquid Staking

Here’s a step-by-step guide to begin liquid staking:

• Step 1: Select a Reputable Liquid Staking Platform: Select a protocol that supports liquid staking on your preferred blockchain. Find a protocol with a good security history, high-quality validators, transparent fees, and decent integration in DeFi.
• Step 2: Install a Compatible Crypto Wallet: Obtain a blockchain and token-supported wallet that you plan to use for staking. Ensure it supports connections to external DeFi applications, if needed.
• Step 3: Get the Token(s) to Stake: Purchase or otherwise obtain the native coins that you wish to stake. Ensure that you have sufficient to stake and a sufficient amount for paying the fees.
• Step 4: Link Wallet to the Liquid Staking Platform: Visit the selected platform’s official website/application. Link your wallet with it. Ensure that you are on the official, verified app to prevent phishing attacks.
• Step 5: Input the Amount to Stake and Check Terms: Determine the number of tokens you’d like to stake. Check the anticipated LST you’ll get, platform charges, validator charges, risks such as slashing, and confirm.
• Step 6: Get Liquid Staking Token: Once staking is validated, the protocol rewards you with a liquid staking token that is equivalent to your staked position. Your LST can aggregate staking rewards or correspond to claims in the staking pool.
• Step 7: Utilize Your LSTs in DeFi (Optional): If you wish, you can utilize your LSTs to engage in other DeFi processes such as yield farming, liquidity pools, lending, or trading, based on what protocols they support. That’s how you can earn extra yields over the staking rewards.
• Step 8: Unstaking / Redeeming Your Original Tokens: Once you’re ready, trigger the redemption or unstake operation to return your LSTs to the original token, along with rewards, minus fees or slashing impacts. Keep the cooldown or unstaking periods of the network in mind.

Choosing a Liquid Staking Platform

Consider the following features and factors when choosing a liquid staking  platform:

• Security: Go for platforms with audited smart contracts and trusted validators to counter risks.
• Liquidity: Ensure the platform offers LSTs that are widely accepted across DeFi applications.
• Supported Networks: Select liquid staking platforms that have supported blockchain networks in which you are interested, for example, Ethereum, Solana, or TON.
• Fees: Compare the fee structures, including staking fees, unstaking fees, and transaction fees of different platforms to determine the most affordable choice.
• Rewards: Look for platforms offering competitive annual percentage yields – APYs and additional rewards via DeFi integrations.
• Decentralization: Choose platforms that support decentralization to minimize the possibility of censorship and increase network security.
• Unstaking Flexibility: Check the platform’s unstaking policies, including any bonding times or fees charged.

Why Choose CoinDCX?

It provides a user-friendly liquid staking platform, opening up staking rewards on Proof of Stake tokens such as EOS, Tezos, and Tron. Security is guaranteed through compulsory two-factor authentication, and we also have insurance coverage for client assets.

CoinDCX has also launched a liquid ETH-backed token, allowing customers to earn staking rewards while retaining the ability to trade within the CoinDCX ecosystem. As a whole, CoinDCX brings accessibility, security, and liquidity to the table, making it a popular option for liquid staking in India.

Conclusion

Liquid staking provides staking rewards and helps retain asset liquidity. This way, users can keep funds active in DeFi while supporting network security. With the convenience and accessibility, risks of smart contract vulnerability, validator penalties, and more exist that users must be mindful of while engaging in staking.

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