Liquidity Staking Tokens Are Transforming DeFi on Ethereum

Since Ethereum moved from a proof-of-work (PoW) consensus mechanism to a proof-of-stake (PoS) consensus mechanism, the new emerging trend of liquid staking tokens is arguably the biggest thing in decentralized finance (DeFi).

Ethereum holders, in this instance known as validators, lock up assets for a specified period to help secure and operate the blockchain, in return earning ETH from gas fees paid to process every transaction.

However, the initial cost of becoming a full node operator is 32 ETH – a pretty steep barrier to entry, and stakers will also not have access to their assets until the staking period matures, depriving them of liquidity.

Moreover, stakers need to have a certain level of technical knowledge and may need specific computer hardware, which again tends to lock out many interested people.

So, enter the age of liquid staking protocols and liquid staking tokens, again opening the doors to people who want to be involved.

What Are Liquid Staking Tokens?

Liquid staking platforms such as Lido emerged to fill the gap for investors who may want to stake Ether but do not have the financial muscle of 32 ETH, approximately $49,920 in October 2023, or are not interested in running a full ‘validator node’.

Instead, users lock up their assets in liquid staking platforms, in return receiving IOU tokens with a value equivalent to the staked ETH.

IOU tokens, such as stETH issued by Lido, can freely be traded, sold, and used as collateral to borrow other tokens or provide liquidity on other platforms. This allows investors to have freedom and flexibility even as they earn passively from their locked assets. Tokens such as stETH are similar to LP tokens used to provide liquidity on decentralized exchanges (DEXs).

Liquid staking tokens also accrue yield, which is automatically sent to the holder’s wallet, skipping the manual withdrawal process entirely. Although there is a service fee charged of between 5 to 10% by liquid staking platforms, it is a small price to pay for enjoying the flexibility that comes with having access to liquidity, which can then be used to earn more in other DeFi protocols or used to take advantage of changes in market trends.

With liquid staking tokens, there is no barrier to entry. Investors can stake any amount of ethereum and earn yield while holding onto the liquidity of their staked Ether.

There are three types of liquidity staking tokens, also known as liquid staking derivatives: The rebasing token, the value-accruing token, and the two-token system.

Rebasing Token

A rebasing token is known for adjusting its supply systematically based on predetermined periods to reflect the changes in its value. Lido’s stETH falls in this category.

As the staked ETH accrues yield, the value of stETH subsequently increases. Rebasing tokens are easier to track but require a complex support architecture unlikely to be available on most DeFi protocols, especially those that run on fixed supply.

A Value-accruing Token

The value of a value-accruing token increases over time without any changes in its supply. For example, swETH on Swell shows the value of the ETH staked plus the value of all the accrued rewards. It is the most popular and is supported by all DeFi protocols. However, it limits the intuitiveness of tracking staking rewards, requiring an oracle to set the exchange rate.

Two-token System

This method uses two tokens, one representing the staked assets and the other the accrued rewards. Frax’s sfrxETH is an example of this token system, containing sfrxETH and sfrxCRV.

sfrxETH is tethered to the staked ETH, while sfrxCRV is the token that represents the staking rewards – it varies in value and can be used in DeFi or traded on multiple platforms. It stands out for the flexibility it offers, but it is cumbersome and complex to manage.

The State of Liquid Staking Tokens In 2023

The Shapella upgrade, which allowed investors to withdraw staked ETH for the first time from the Beacon Chain, fueled the popularity of liquid staking protocols. This previously locked ETH was swiftly redirected to platforms like Lido, Rocket Pool, and Binance Staked Ether.

According to?Bitcoin.com, at least 370,000 ether was sent to the platforms in five days, boosting the total value locked (TVL) above the $12 million mark.

At the time, WBETH, Binance’s liquid staking token, was at the peak of the trend, accounting for 86% of the flow, roughly 318,605 ether.

DefiLlama, a leading staking protocols aggregator, shows there is currently $19.81 billion staked within the ethereum DeFi ecosystem. Lido is the largest liquid staking platform, boasting $13.84 billion in TVL, significantly ahead of Rocket Pool with $1.69 billion and Binance Staked Ether with $1.19 billion.

Platforms with substantial TVL but less than $1 billion include Frax Ether with $426 million, Coinbase Wrapped Staked Ether with $317 million, Stakewise with $158 million, Marinade Finance with $121 million, Stader with $119, ParaX Super App with $112 and Acala LCDOT with $112 million.

How To Stake ETH and Receive Liquid Staking Tokens?

Lido is the biggest liquid staking platform and offers investors a token called stETH for the assets staked. stETH is one of the most liquid tokens in the crypto market used in various sectors, including DeFi, and trading, and, according to Nasdaq, accounts for over 70% of the entire liquid staking space. Below is a step-by-step process to get liquid staking tokens:

• The user deposits ETH on a liquid staking protocol, like Lido.
• The user receives a liquidity token, such as stETH, equivalent to the staked ETH.
• The staking protocol will delegate the staked ETH to select validator nodes.
• The node sends the ETH into a deposit contract.
• The validator node begins to accrue yield on the staked ether.
• The liquid token also accrues value.
• The user is allowed to redeem the underlying ether against the liquidity token together with the yield generated.

The Future of Liquid Staking Tokens

Liquid staking platforms are popular due to the benefits they bring to the ethereum ecosystem, helping ensure security and decentralization of the network.

Investors are incentivized to stake their assets, which dilutes the impact of large validators and exchanges, making the network resilient to censorship and attacks.

Stakers will often need access to liquidity, and liquid staking platforms allow them to earn passively while using liquid tokens to participate in other activities in the market.

Liquid staking protocols will continue to grow thanks to the transparent nature in which they operate. They are also excellent liquidity providers while enhancing the compatibility of DeFi, creating innovative use cases and value generation for staked assets.

The sector is also paving the way for a new category referred to as LSTfi. This new sector, according to Staking Rewards, encompasses “Structured Products that use Liquid Staking Tokens (LSTs) as a primary source of collateral. These Structured Products provide extra utility and yield-earning opportunities to holders of Liquid Staking Tokens (LSTs).”

#LSTfi is now the largest category of DeFi on Ethereum.

Before we dive into some of the top projects forming in the space, let's see where LSTfi fits within the wider staking landscape.

Behold… the #Ethereum Staking Ecosystem pic.twitter.com/WhcqitV2Fq

— Staking Rewards (@StakingRewards) October 9, 2023

The Bottom Line

Liquidity staking tokens are adding immense value to the Ethereum blockchain. While the transition to a PoS protocol allowed users to stake ether, it also introduced key barriers to entry, such as needing 32 ETH required to become a validator.

Liquidity staking tokens allow for flexibility while enhancing the network’s decentralization, not to mention the provision of liquidity in the DeFi sector.