Liquid staking has emerged as an innovative mechanism on Ethereum that gives users a way to participate in securing the network through staking while retaining liquidity of their assets. Traditionally, staking Ethereum requires users to lock up their ETH tokens in specialized validator contracts to serve the purpose of block production and verification. In return, stakers receive block rewards and fees. However, the locked tokens lose all liquidity during this process, meaning they cannot be transferred, traded, or utilized elsewhere. Liquid staking protocols solve this by issuing derivative tokens that represent staked ETH and allow stakers to regain liquidity.

Liquid staking protocols accept deposits of ETH from users and issue tokens that track the value of each user’s share of the staked ETH plus accrued block rewards over time. The key innovation is that these tokens are designed as freely transferable ERC20 tokens that can be traded on exchanges, lent or borrowed from DeFi applications, or provided as liquidity to AMMs. This unlocks the liquidity of staked ETH while still allowing stakers to earn from securing Ethereum through their share of validator rewards represented by the derivative token. The recent Blast protocol offers 4% on Eth deposits provided to the network via bridging assets via liquid staking, and has gained over 569 million-USD Eth(27, Nov, 2023) locked in their contract along with both claps and critics. This makes liquid staking as the hot topic again after the PoS merge since 2022.

In this post, we take an in-depth look at how liquid staking works technically, analyze the risks and benefits liquid staking introduces for both Ethereum and users, and explore the protocol-level implications it has on factors like network security, decentralization, and systemic risks arising from wider adoption of staking derivatives.

What is Liquid Staking

Liquid staking protocols facilitate the ability for ETH holders to stake their funds and participate in securing Ethereum without losing flexibility or access to their assets. These protocols accept deposits of ETH from regular users who may not have the 32 ETH minimum or the ability to set up and maintain validator infrastructure 24x7, which is required in normal staking.

In return for users’ deposits, liquid staking protocols issue derivative tokens that represent each depositor’s fractional share of the rewards-earning staked ETH pool held by that protocol. These tokens retain liquidity for the users, allowing them to transfer, trade or utilize them for other DeFi activities while still earning pro rata staking yields on their share of ETH.

Popular liquid staking protocols on Ethereum include Lido, Rocket Pool and Coinbase amongst others. For example, when users deposit ETH tokens into the Lido protocol, they receive stETH tokens in return. The stETH tokens track the value of the staked ETH deposits along with accrued block rewards over time. Users can hold stETH, trade it on exchanges or utilize these derivative tokens in other DeFi protocols to earn additional yields.

Mechanics of Liquid Staking Protocols

Under the hood, liquid staking protocols aggregate ETH deposits from various individual users into pools large enough to meet the 32 ETH threshold required for operating validator nodes on Ethereum.

The pooled ETH deposits are then leveraged by the protocols to set up and maintain validator nodes that run the infrastructure for tasks critical to staking on Ethereum - like participating in PoS consensus, block production, reward distribution and governance of the staked deposits.

These validator nodes are typically operated by professional node operators contracted by the protocols rather than the end users themselves. Users who deposit ETH into these protocols do not need to have the technical expertise or ability required for tasks like infrastructure management, key generation or security of validator nodes associated with staking.

In return for each unit of ETH deposited by a user, the liquid staking protocols mint and distribute ERC20 derivative tokens that represent fractional ownership of the rewards-earning staked ETH pool. For example, 1 stETH token issued by Lido would represent 1 unit of ETH deposited by a user into the Lido staking pool plus accrued block rewards over time.

When users want to retrieve their funds later, they return (burn) their share of derivative tokens to the smart contract in exchange for the underlying share of the staked ETH deposit plus any rewards earned while they were deposited.

Benefits of Liquid Staking to Users

Liquid staking offers several advantages to users compared to regular Ethereum staking around factors like accessibility, liquidity, delegation and capital efficiency:

1. Reduced barriers with no minimum ETH amount: Liquid staking protocols allow token holders to participate in staking even if they held less than 32 ETH. Smaller token holders can pool together funds while still earning pro rata block rewards and fees.

2. Liquidity of staked assets: Users can seamlessly transfer, trade or utilize liquid staking derivative tokens for other DeFi activities while still earning staking yields rather than having tokens locked. The derivatives provide better capital efficiency.

3. Delegation of staking responsibilities: Protocols appoint professional node operators to handle technical complexities around infrastructure, security, key management rather than regular token holders.

4. Capital efficiency via simultaneous rewards: Users can put their ETH to productive use earning staking yields even while using their liquid derivative tokens elsewhere like in AMMs to further increase yields.

Risks Associated with Liquid Staking

While liquid staking opens up new opportunities, it also introduces risks from aspects like smart contract vulnerabilities, excessive centralization among operators, and market volatility:

1. Smart contracts bugs and vulnerabilities: The smart contracts powering the staking pools and derivative token issuance in liquid staking protocols can have vulnerabilities that may be exploited to drain funds. Such incidents can lead to loss of pooled staked ETH given the value they hold. Preventing incidents requires high auditing standards and vigorous testing. Protocols like Lido have undertaken several audit rounds but risks cannot be fully eliminated.

2. Centralization tendency: As liquid staking via a protocol like Lido gets very popular, it raises centralization risks for Ethereum. Network effects arise with growing usage of a dominant staking derivative concentrating stake under it. For example, Lido has ~30% of total staked ETH supply presently. Very high penetration beyond 33% raises possibilities of transaction censorship, security risks and regulators exploiting central points of control. Maintaining an equilibrium of stakeholders is critical to prevent systemic imbalance.

3. Governance token domination: Many liquid staking protocols have issued governance tokens that allow holders to direct protocol actions. For example, Lido has the LDO token which allows voting on updates. High concentration of tokens with specific entities allows them overriding influence over decisions by staked ETH holders on factors like commission rates and risk policies. Preventing plutocratic control requires governance innovations and decentralization.

4. Opacity and principal-agent risks: In liquid staking systems, users deposit ETH but delegate actual validator operations to node operators contracted by protocols. This separation can pose risks like misalignments, fund misuse, opaque reward sharing affecting users. Protocols need transparent reward distribution, insurance and delegator control to prevent exacerbating risks. In many liquid staking designs, holders of governance tokens have overriding powers to control membership of the node operators running infrastructure. This creates a principal-agent problem where node operators interests may not fully align with those providing the economic stake i.e. LST holders. For example, both may collude to extract MEV or partake in censorship if incentivized sufficiently while bearing little economic risk - creating a centralized point of control. Appropriate checks and balances are needed to address this asymmetry.

5. Technical risks abound: Liquid staking relies on running validator nodes to earn staking rewards which is still based on experimental Ethereum technology that needs to stand the test of time. Any vulnerabilities in key management, consensus participation or blockchain history management can expose node operators to slashing.

6. Adoption risks: The long-term value proposition of liquid staking derivative tokens relies heavily on continuing adoption growth, network security and expected yields from Ethereum staking through validator nodes. Any technical failures or weakness in expected staking reward rates would undermine both adoption and market value of tokens.

7. Slashing risks: Validators in Ethereum PoS face penalties if they fail to follow protocol or suffer security lapses that can result in slashing of staked ETH.Though protocols like Lido distribute this risk through professional node operators, possibility of incidents persist along with need for insurance mechanisms to prevent impacts on users.

8. Derivative token volatility risks: Liquid staking derivative tokens can suffer from price divergence or instability during periods of speculation, poor market sentiment or mass unstaking pressures due to ETH price declines. These tokens are inherently volatile owing to complex factors driving risks and returns. Managing stability requires mature governance, monetary policy tools and capital controls.

9. Higher leverage increases attack risks: The high liquidity and composability of liquid staking derivatives allows them to be used in DeFi protocols for activities like getting loans/leverage or margin trading. For example, lending protocols allow depositing stETH as collateral to borrow ETH which can then be redeposited into Lido for compounding leverage. Though such looping strategies are capital efficient for users, at a systemic level they allow pooling potentially dangerous amounts of economic stake in validators while backed by little actual capital. This expands possibilities of exploit.

Case Study I: Risks from Excessive Lending and Leverage

To effectively secure a proof-of-stake network like Ethereum over the long run, a majority of the base assets need to be durably locked and staked to validate transactions. However, excessive lending and leverage provided on liquid staking tokens and their derivatives can undermine the collateral guarantees backing the security of validated chains.

For instance, a user can deposit 1 ETH on Lido to receive 1 stETH, use this stETH as collateral to borrow 0.8 ETH on a lending platform, and reuse this 0.8 ETH again to stake/get stETH as collateral to borrow 0.64 ETH and so on. Eventually, the total staked assets providing security arise from very low collateral, with the margin between borrowed amounts towering over the actual durable capital staked and locked. At a systemic level, this financialization poses risks of sudden deleveraging events severely impacting staked token values. Via different ways, an attacker with much lower capital may gain enough leverage to control stETH or LSTs to control the staking power of Ethereum to censor transactions or even override the protocol’s consensus to hard fork.

Hence, managing risks requires keeping the debt-based derivatives of liquid staking tokens within prudent collateral limits to maintain durable security capital and prevent excessive hidden leverage. Actions may involve governance measures to curb lending risks, maintaining diversified lending sources, monitoring stable redemption expectations on liquid tokens and preventing ecosystem contagion from deleveraging cascades.

Case Study II: Blast Yield Relies on Bridge Deposits, Raising Liquidity Risks

Liquid staking and yield generation protocols at Layer 2 are an innovative way to offer high returns on crypto assets like Ether. However, over-dependence on deposit bridging in these sorts of protocols can concentrate liquidity risks.

For example, the recently launched Blast protocol offers 4% on Ether deposits provided to the network via bridging assets in from Layer 1 (Lido ETH liquid staking derivatives) along with 5% yields on bridged stablecoins from MakerDAO - effectively offering a yield generation engine at L2.

This bridged ETH liquidity forms a key baseline for enabling yields as the tokens supply collateral value and establish staking positions. , infusing this liquidity by exclusively relying on a bridge deposit pathway means that withdrawal events on L1, sudden losses of market confidence or ambiguity in withdrawal rights can create an acute liquidity crunch on such L2s.

If doubts emerge on easy redemption into native assets or market crashes trigger deleveraging, the incentive to bridging in more external liquidity rapidly diminishes creating a runway risk. With everyone headed to the withdrawal exit in a short period of time, smooth processing may get compromised and capital losses could result in extreme scenarios.

Reliable liquidity access and risk mitigation on such protocols requires diversified liquidity channels, multiple bridges, alternate yield sources and prudent leverage caps to prevent a sudden evaporation of deposits or collateral value. Enabling direct fiat on and off-ramps can add more durability. In essence, dependency solely on bridges and staking derivatives requires protocols to dynamically account for inherent stability risks.

Conclusion

In conclusion, liquid staking introduces a novel form of derivative instrument that unlocks new opportunities in Ethereum around capital efficiency for users, accessibility of staking yields, and building liquid markets for ETH locked in validators. However, their implications span beyond users, creating a complex web of outcomes impacting factors like network decentralization, security, correlations and risk interlinkages that must be carefully measured and governed to fully unlock advantages while minimizing systemic risks.