Staking is the cornerstone of proof-of-stake blockchains. Validators provide, say, ETH to the Ethereum blockchain for a chance of winning the right to process transactions, plus newly-issued ETH.
The economic model presents a neat and environmentally friendly alternative to proof-of-work, the consensus mechanism that PoS replaced.
Until recently, however, it also presented a novel problem: staked funds lay dormant in the protocol.
Indeed, before a critical upgrade known as Shanghai came to the rescue on April 12 (more on this below), anyone who had staked 32 ETH on the Ethereum network could not withdraw their funds. The funds instead just sat there, accruing returns but otherwise inert.
Investors had a seemingly stark choice: stake funds in ETH and earn a return of about 5%, or try and eke out better returns in the volatile DeFi market.
Developers, however, ignored this binary. Instead, they created a solution to sidestep the long wait: liquid staking, which allowed investors to stake funds in blockchains like Ethereum and receive trade-able liquid staking tokens in return.
With liquid staking, users could make use of their staked tokens for other purposes, for instance as collateral for loans on DeFi protocols, or even trading on secondary markets. Their liquid staking tokens would ideally increase in value over time, representing the benefit accrued to your staked tokens.
In other words, liquid staking meant that funds weren’t just locked in users’ staking accounts. For a non-crypto example, imagine that you could hold cash in your Chase interest account while simultaneously investing that money in the stock market.
The rise of liquid staking on Ethereum
In crypto, liquid staking became incredibly popular as investors awaited the Ethereum upgrade known as Shanghai, which in mid-April eventually let stakers withdraw their funds from the Beacon Chain, where they had locked up funds since December 2020. (It’s also occasionally referred to as Shapella, a portmanteau of Shanghai and another upgrade that launched alongside it called Capella).
Among the most popular of the liquid staking platforms is Lido. On April 4, about a week before the launch of Shanghai, Lido had a TVL (Total Value Locked) of $11.21 billion, according to DefiLlama. Commanding about 22% of the entire TVL of DeFi, it is the most popular DeFi protocol by about $4 billion.
Lido, which remains popular, issues a derivative token known as stETH in exchange for ETH staked on its platform. The ETH locked up in Lido earns daily staking rewards, while the user is free to do whatever they like with stETH. If the user wants to withdraw their ETH, they can unstake the funds by exchanging their ETH for stETH.
The same problem exists on other blockchains: if you’re validating funds on one blockchain, you can’t do anything else with your funds unless you invest via a liquid staking protocol. Competitors to Lido include Parallel Finance, Marinade Finance and Yield Yak.
Risks to liquid staking
Of course, the liquid staking model presents a few risks. The most obvious is that the user might lose their staked tokens to a dodgy or mistimed trade, in which case they would not be able to retrieve their original tokens from the liquid staking platform.
The other risk is that the protocol might mess up. The liquidity pool that holds all the original crypto might break due to a bug, the market for the staking token could collapse and no longer maintain parity with the original asset, or the protocol could be operated by a scammer that steals all the staked funds.
Liquid staking on Ethereum after Shanghai
Liquid staking on Ethereum made sense when users couldn’t withdraw their staked funds. But what happens to liquid staking markets now Shanghai has been implemented? It’s not impossible that investors will try to both stake their ETH on Ethereum as validators and eke out returns elsewhere to boost their profits. The early signs are indeed good: tokens for liquid staking platforms, including LIDO, have shot up since the upgrade.