Ethereum Liquid Staking: Is It Right for You?
With the upcoming Shanghai upgrade for Ethereum comes the ability to withdraw staked ETH, allowing for new possibilities in staking and the ability to access capital. Liquid staking is one of these options, allowing users to pool their coins together to manage validator nodes on their behalf. In this post, we’ll discuss the mechanics of liquid staking; how it offers convenience, cost-effectiveness and liquidity, as well as the trade-offs and drawbacks to consider.
Generally, staking represents locking a blockchain’s native token as a way of participating in the network’s consensus process. In a conventional staking process tokens are completely locked and it is impossible to use the staked assets for any other activity in parallel. This is the default staking process on Ethereum. As a solo-staker, running an Ethereum validator entails meeting certain hardware and software requirements for operating a validator node, as well as a minimum stake of 32 ETH. This process requires a certain level of technical expertise. There is also a similar option available known as staking-as-a-service for users that have 32 ETH but do not feel comfortable with the technical aspects of operating their own node. This allows them to deposit 32 ETH with an existing node operator that will run the necessary software for a fee based on the staking rewards.
For those who do not have the technical expertise, time, and/or financial resources necessary for operating a validator node, liquid staking provides an alternative. Liquid staking is an option that is useful for users who do not have 32 ETH, or who have a sufficient amount of ETH but do not feel comfortable with operating their own validator or utilizing a staking-as-a-service provider. Liquid staking allows like-minded members of the Ethereum ecosystem to instead pool their coins together in a manner that allows dedicated liquid staking pool solutions to manage validator nodes on their behalf. When you participate in pooled liquid staking, you generally exchange your ETH for a receipt liquid staking token distributed by the staking pool. This liquid staking token represents the ETH you have staked in the pool and becomes your key to redeeming your original funds and tracking cumulative staking rewards that the pool assigns to you.
The primary benefit of liquid staking is that, while other forms of staking force you to completely lock your coins and their associated capital, it instead allows you to participate in providing security via staking while still having access to some form of capital. Liquid staking tokens are tradable and therefore offer far more flexibility in accessing capital as opposed to directly staking as an individual Ethereum validator. If a solo staking validator wishes to access their capital, they must wait in an algorithmic queue based on the amount they need to withdraw from the network. Furthermore, for many members of the Ethereum community, liquid staking represents an opportunity to have their voice heard in the act of on-chain security and governance by deciding which liquid staking providers they want to utilize.
At the moment, liquid staking represents 33% of all staking on the Ethereum network. It not only offers convenience, cost-effectiveness, and liquidity, but also “smoothed rewards” when compared to an individual Ethereum validator. While individual validators may vastly outperform (or underperform) average staking rewards based on the potential to capture exceptionally valuable block rewards, this will not be the case for users that participate in pools. The pool itself will likely win blocks that are more valuable than average, but it will be balanced by lower-value blocks as well. Pool operators will then even out these fluctuations in value when distributing rewards to all members.
Of course, there are also drawbacks to consider when utilizing liquid staking. All liquid staking pool solutions take a margin of the staking rewards that they manage as a form of compensation for their services. On average, this commission ranges from 10% - 20% of the ETH rewards that a staker would otherwise receive. The nature of liquid staking, where a central provider can manage funds for outside users, also creates friction with the overall goal of any robust cryptocurrency staking system - to have a decentralized network that is resistant to centralized failure points.
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Additionally, there is a price paid for the convenience afforded by liquid staking. For example, should the individual pool operators mismanage users’ funds, holders of liquid staking tokens could find themselves in a situation where their assets are no longer backed by the corresponding ETH. Another risk to consider is the “correlation penalty”. The rules for calculating Ethereum’s slashing fees have a calculation multiplier in place to discourage collusion between dishonest validators. This is known as the “correlation penalty”. This penalty reflects the number of other validators slashed over the same time period. The maximum applicable amount can be as high as the total effective balance of the offender(s).
At the moment, there are a variety of reputable liquid staking options to choose from. For example, Lido is not only the largest liquid staking operation on Ethereum, they are the network's largest staking operation of all. Their website states that Lido “attempts to solve the problems associated with initial ETH staking - illiquidity, immovability and accessibility - making staked ETH liquid and allowing for participation with any amount of ETH to improve performance of the Ethereum network.” The protocol was one of the first movers in liquid staking, publishing their first outline document in October 2020 and launching in December 2020 alongside Ethereum’s Beacon Chain. Other options include Rocket Pool and Coinbase.?
Whether you're a solo-staker or you have funds locked in a staking pool, if you're looking to increase your validator's profit it is important that your validator nodes are connected to as many MEV-Boost relays as possible, with as much relay code diversity as possible. This will ensure you maintain highly-available MEV-Boost connections and have exposure to the highest-value blocks available.?
What excites you about liquid staking? What worries you? Are you planning to participate?