Staking and Liquid Staking: a Primer

Staking – the practice of providing one’s tokens to help operate and secure a network, usually in exchange for rewards – is rapidly becoming a substantial ecosystem of its own as the number and market capitalization of cryptocurrencies using a “proof of stake” (PoS) consensus mechanism to verify transactions continues to grow (in contrast to electricity-intensive “proof of work” chains like Bitcoin). Staked / Kraken’s State of Staking Q2 report cataloged a number of impressive growth stats.

While proof of stake’s share of the total crypto market cap increased only 2% quarter over quarter to 23%:

• The value of staked assets rose 61% to $68 billion
• Market cap of the top 35 PoS assets rose 49% to a whopping $288 billion
• Annualized staking rewards climbed 66% to $5 billion

It’s not surprising then that in addition to crypto believers flocking to staking, interest from traditional investors is growing, as well – including from institutional investors. In fact, last month German exchange Boerse Stuttgart and a leading re-insurance company Munich Re launched a product providing insurance to institutional investors in ETH that covers losses from “slashing”, saying “By leveraging their extensive expertise and long-standing experience in fintech and insurance, the partners aim to provide institutional investors with a secure one-stop-shop for staking solutions in the near future.” Slashing is the mechanism by which a staker, as a validator helping verify transactions, loses a portion or all of their staked assets for not performing according to the protocol, whether maliciously or not.

In the context of Ethereum, staking began on December 1, 2020 shortly after reaching the required minimum  524,288 ETH pledged to what was then called the beacon chain, and three days later those interested in supporting the network’s shift from proof of work to PoS – and earning a yield on their minimum 32 ETH deposit – had deposited a total of 1 million ETH in the “Ethereum 2.0” smart contract (worth $611 million at the time). This was all the more impressive given that at that point there was no definitive date when one’s stake would be eligible for withdrawal; in fact “the merge” that transitioned Ethereum to PoS did not occur till September 2022, while stakers were first able to withdraw ETH on April 12, 2023 with the Shanghai/Capella upgrade. As of today, 863,980 validator address representing fully 22.7% of all ETH have staked, on its own a market cap of $45B and an increase of 136% since the start of the year.

More than 1M ETH staked for Ethereum 2.0

Liquid staking is a mechanism that allows cryptocurrency holders to stake their tokens but also achieve liquidity by:

• receiving a new token, known as a liquid staking token (LST), proving ownership of the staked asset
• having the ability to store, trade or transfer the LST across the rapidly expanding DeFi landscape

These liquid tokens are a separate asset – essentially a derivative representing your original stake – but are pegged to the value of the staked tokens. Some protocols use oracles or other consensus mechanisms to keep the value of the liquid token in sync with the staked asset. You can’t spend the original staked tokens without first returning the liquid tokens to the smart contract, which then unlocks your staked assets.

Liquid staking has also gained traction as a way to mitigate the “lock-up” problem, where staked assets can’t be easily accessed or there is a delay once withdrawal is requested (currently about 8 days in the case of Ethereum, but it was as long as 17 days when first enabled). It’s a blend of DeFi innovation and traditional staking models, with the keys being the design of the smart contracts and the governance of the staking protocol.

For crypto investors seeking the best yield, liquid staking allows one to effectively double dip on earnings. First, in the case of Ethereum users  receive the protocol’s staking yield (currently 3.9%, lower if one is staking via an exchange like Coinbase, which currently offers 2.9%). Second, the LST can be deployed in dozens of DeFi protocols to earn additional yield.

Beyond yield there are other liquid staking value mechanisms such as decentralized stablecoin exchange Curve Finance‘s veCRV. When you lock Curve’s CRV token, you get veCRV (“ve” stands for “vote escrowed”). The longer you lock your CRV, the more veCRV you get, which amplifies your influence in governance decisions, giving you a greater percentage of trading fees, control over parameters and future CRV emissions, as well as boosts on CRV rewards. It’s basically a liquid representation of your stake in the Curve ecosystem. Curve’s veCRV model has inspired other protocols to adopt similar “time-lock for benefits” mechanisms – a fascinating blend of incentivizing long-term commitment while offering immediate utility.

While liquid staking offers tantalizing benefits such as amplified yields or voting power, it’s crucial to consider the associated risks. DeFi protocols expose users to potential smart contract vulnerabilities, which could result in the loss of funds. Additionally, the complexity of managing multiple yield streams can be daunting and may require active portfolio management to optimize returns.

Aside from these downsides, the popularity of liquid staking has also impacted the crypto ecosystem during times of extreme market volatility, and there are growing concerns that it is leading to increased centralization for Ethereum – topics we’ll cover in our next story in this series on staking’s pros and cons.