6 Use Cases of Liquid Staking that Set it Apart from Traditional Staking

In Q3'23, Ethereum finished its green transaction to PoS consensus, significantly decreasing the risks of liquid staking. Since then, liquid staking is rapidly gaining traction in the crypto space.

TL;DR In this blog post, we will explore six compelling use cases that distinguish liquid staking from its traditional counterpart.:

1. Liquidity: Liquid staking tokens can be easily purchased on both centralized and decentralized exchanges (CEX or DEX), offering flexibility that traditional staking cannot match.
2. Looping: By leveraging staking rewards, you have the potential to earn impressive returns, ranging from 6% to 8%. However, this strategy comes with its own set of risks.
3. Lending: Liquid staking tokens can serve as collateral for obtaining loans in DeFi lending protocols. And they are already the primary choice as collateral.
4. Minting Stablecoins: LSTs can be used as collateral to mint decentralized stablecoins.
5. Yield Farming: Liquid staking tokens can be used for yield farming, a popular DeFi activity. However, caution is advised, as yield farming of LSTs can be less profitable than just holding them in the wallet.
6. Running Nodes with Less ETH: Liquid staking protocols like RocketPool enable node operation with just 8ETH, significantly less than the traditional 32 ETH requirement, further democratizing network participation.

Introduction

Ethereum Goes Green

The arrival of the Merge upgrade has been the talk of the crypto community throughout 2022 and the early months of 2023. This significant development marks Ethereum's transition from its energy-consuming proof-of-work (PoW) consensus mechanism to an eco-friendly proof-of-stake (PoS). Despite multiple postponements, the upgrade has ultimately proven to be a tremendous success, aligning Ethereum (along with all the DeFi projects running on it) with ESG criteria.

In tandem with this monumental shift in the infrastructure layer, the DeFi space has also been evolving to adapt to these changes. Traditional staking had its drawbacks, most notably the requirement to lock up your ETH tokens, often necessitating a waiting period of around 1 day to unstake (with variable queue times). Liquid staking protocols (LSPs) emerged as a solution to address these challenges, with notable protocols such as Lido, RocketPool, StakeWise, Liquid Collateral, and DIVA leading the way.

AuM (aka TVL) of Liquid Staking

Traditionally, the finance world measures assets under management (AuM), while decentralized finance (DeFi) uses the metric of total value locked (TVL). While DeFi's TVL has remained relatively stable over the past year, liquid staking has been on a remarkable growth trajectory, making it the largest category in terms of TVL within the DeFi space.

Background

Before we delve into the benefits and risks associated with liquid staking , let's provide a brief overview of "normal" staking for context.

What is Staking and POS Blockahins

A blockchain is a decentralized network that maintains a tamper-proof database. Transactions are grouped into blocks, and secured using cryptographic methods and digital signatures. Blockchains are public, trustless, and permissionless.

Consensus mechanisms, such as proof-of-work (PoW) and proof-of-stake (PoS), define how transactions and blocks are validated. In PoW, miners solve complex puzzles, consuming electricity. In PoS, validators stake tokens, earning rewards and facing penalties for malicious behavior (slashing).

Staking involves providing tokens to validators, allowing you to participate in block rewards that validators receive for producing a block. Staked tokens are typically locked for a period of time, and blockchain participants pay gas fees for transaction processing. These mechanisms ensure network security and integrity.

Understanding Liquid Staking Tokens (LSTs)

Liquid staking allows users to stake their assets in a blockchain network while maintaining the flexibility to trade, lend, borrow, or use them in various DeFi protocols. Unlike traditional staking, where your assets are locked up for a specific period in a validator, liquid staking enables you to have your cake and eat it too, offering a wide range of possibilities for your staked tokens.

Liquid staking tokens (on ETH) are pegged to the staked ETH. They are similar to US-stablecoins whose value is pegged to 1 USD. There are two major types of LSTs:

• rebase LSTs that are pegged to 1 ETH and every day do airdrops with staking rewards, e.g Lido stETH, a 7th largest in MarketCap crypto-currency today (source CoinGecko)
• rewards LSTs that accumulate staking rewards in the token value (token value is higher every day by the staking rate)

Rewards-based LSTs are generally better as they are compatible with DeFi protocols. Most of LSTs today are rewards-based (wstETH, rETH, sfraxETH) and the use cases below are applicable to this type of LSTs.

Use Cases of LSTs

Use Case 1: Liquidity On-Demand

Traditional staking requires you to lock up your assets, often for extended periods. With liquid staking, you can buy and sell liquid staking tokens (LSTs) on centralized or decentralized exchanges (CEX or DEX) anytime you wish. This liquidity on-demand feature allows you to adapt to market conditions swiftly.

There are two ways to buy (or sell) your LSTs:

• at the exchange (CEX or DEX) for the market price
• or at the liquid staking protocol website for the protocol price

Prices of liquid staking tokens vary between DEX and liquid staking protocol websites. Check both before you buy/sell.

You might wonder if the prices at these two venues are the same. The answer is - not always! I studied these differences and the factors that cause them in one of my PhD research. You can find some more information on this topic in my presentation just before summer in Zurich in this post:

Use Case 2: Looping for Increased Rewards

Liquid staking tokens can be leveraged to enhance your staking rewards, potentially yielding returns between 6-8%. However, it's essential to remember that leveraging comes with risks, as you could also incur losses if the market goes against your position.

There are two ways of leveraging LSTs - with lending protocols or with flashloans. You can automate these strategies with ETHSaver, as described in the previous blog post.

Use Case 3: Lending with Liquid Staking Tokens

Liquid staking tokens can serve as collateral in lending protocols, allowing you to borrow other tokens or stablecoins. Already liquid staking tokens are the primary collateral choice in the DeFi lending landscape. As they accumulate value (from staking) every day, it is like self-paying dept against ETH.

Use Case 4: Minting Stablecoins

One of the most exciting applications of liquid staking is the ability to use LSTs as collateral to mint stablecoins. This process enables users to create decentralized stablecoins, adding to the ever-expanding universe of stablecoin options in the crypto market.

LSTs accumulate value from staking, so their value over ETH constantly grows (unless de-peg happens). This makes LSTs perfect collateral (better than just ETH), and more and more stablecoins accept them, e.g. mkUSD from PrismaFinance.com and lUSD v2 (from Liquity) is going to accept LSTs as collateral.

Use Case 5: Yield Farming with LSTs

Yield farming has become a popular DeFi activity, and liquid staking tokens can be farmed at Curve and Uniswap, and other AMM-based DEXes. However, it's crucial to exercise caution, as yield farming can both increase and decrease your rewards.

Farming of liquid staking tokens can both increase and decrease your rewards! Sometimes it is more profitable not to farm but to hold LSTs

In our recent research at university, we compared the rewards from farming (liquidity provision strategies) of LSTs at Uniswap v3 and Curve v2. The conculsions are:

• Uniswap v3 is a very powerful venue for LPing (farming) LSTs, as you can set the range for which you provide the liquidity and you know that the LSTs value will increase according to staking rewardsthe more often you rebalance your LP-position, to more you earn, but you also pay more gas fees (for rebalancing)
• Curve v2 does not require rebalancing, but thanks to its innovative curve - the crypto-swap invariant (which I introduced in the previous posts) offers a similar impermanent loss to Uniswap v3 without the disadvantage of rebalancing (and paying gas fees for that)

• LPing pair of two LSTs is worth considering:AMM-DEX works that way that ca 50% of your wealth is split between LST and ETH (in LST-ETH pools), so only 50% of your wealth is staked.When you go for LST-LST pool, all tokens generate staking rewards, plus you receive the farming rewards
• In times of low trading volumes and oversubscribed pools on AMM-DEXs on Ethereum mainnet, it is better just to hold 100% of your wealth in LSTs in your wallet (and/or to leverage it)

Use Case 6: Running a Node with Less ETH

Traditionally, running a node on the Ethereum network required a minimum of 32 ETH. Liquid staking protocols like Rocket Pool allow users to operate a node with 8ETH significantly less than 32 ETH, as the protocol itself provides the remaining stake. This lowers the barrier to entry for node operators and decentralizes the network further.

Future Predictions

Compared to other Proof-of-Stake (PoS) Layer 1 networks, the percentage of ETH used for staking is still ca 20%. If we are to assume that ETH staking will eventually align with the PoS majority, there is more TVL to come to LSTs.

As DeFi continues to evolve, we'll likely see more applications and platforms built around liquid staking, particularly within Layer 2 blockchains.

However, investors should remain vigilant, as there may be instances of LST pegs breaking, similar to the challenges faced by stablecoins in the past.

Conculsions

Liquid staking has rapidly gained the trust of retail investors, and its influence is spreading to institutional players. Projects like Liquid Collective are working to bridge the gap between traditional finance and the exciting world of liquid staking.

In my future post, I will compare various liquid staking tokens, highlighting their differences in token models, governance, architecture, validator selection processes, and more, so please make sure you subscribe to the newsletter.

Don’t hesitate to contact me if you want to chat on these topics.

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