Does liquid staking as liquid as it sounds
Liquid staking is an invention to increase the capital efficiency of Proof-of-Stake (PoS) staking. PoS staking usually requires locking up the staked coins. When unstaking, there is a freeze period until the coins are liberated. The constraint with staking is that you cannot use the staked coins when higher earning opportunities appear or when the market dumps and you want to cash out. Liquid staking creates a derivative of the staked coins, for example, stETH for ETH. The product is a liquid asset you can use just as any other fungible token. Liquid staking allows stakers to represent their staking position by using the staked token (i.g stETH) in various scenarios in defi: trading, lending, liquidity providing, collaterals, etc.
You may have heard that liquid staking lets you “use your staked assets to gain yield on top of yield”. It is good copywriting, but the reality is far from ideal. Now I break down the risks and unfortunate outcomes of liquid staking.
For simplicity, I will take stETH as an example. Other liquid staking assets assume similar characteristics as stETH, be it another version of ETH staking or the staked token for other blockchains’ cryptocurrencies such as AVAX, FTM, MATIC…
stETH is a token representing staked ETH in Lido Finance, combining the value of initial deposit+staking rewards-penalties. StETH tokens are minted upon deposit and burned when redeemed, which will be possible when Ethereum completes its merge to PoS. The Merge may come as early as this September and as unpredictable as…
You cannot get your staked ETH back until then. The liquidity pool stETH-ETH gives a solution if you need to abandon the ETH staking ship. But the exchange rate between stETH and ETH is not always satisfying. If selling at a bad rate, you will lose the realized staking rewards or, worse, get less ETH compared to the beginning of staking! ETH staking has a 3.9% APR at the time of writing. The staking APR should be the benchmark for evaluating whether it is profitable to sell stET. At this rate, I should get 1.039 ETH after one-year staking. If I sell for less than 1.039 ETH after a year, I’d better not sell it if there is no urgent reason.
But here is a much worse situation, 1 stETH can be worth less than 1 ETH. This is the case at the time of writing. And it has happened several times. Now the market rate is 1 stETH = 0.978 ETH.
In the market, stETH price is determined by the ratio of stETH and ETH in the liquidity pool. In other words, by supply and demand. stETH market price does not link to the intrinsic value of staking. When there are more stETH than ETH, the price of stETH to ETH drops. Now the pool consists of 69% stETH and 30% ETH, which is very unbalanced. To understand how the liquidity pool works, you can read this article.
Many reasons can lead stETH to depeg:
Uncertainty about the Ethereum Merge. People need cash before it happens or do not want to hold the asset for a prolonged time.
ETH price dump. People sell ETH (voluntarily or involuntarily) to rebalance their portfolio or need cash. Before getting to ETH, stakers need to convert stETH to ETH first.
Liquidation from stETH leverage positions. AAVE offers the opportunity to collateralize stETH for borrowing ETH. Leverage yield chasers use the borrowed ETH to acquire more stETH and loop the process multiple times (I despise this behaviour!). This creates multi-loop leverage on stETH. When stETH’s price deviates, the liquidation cascade is triggered.
All reasons can trace back to one common motivation: the need to get rid of stETH.
But don’t get panic. stETH does not have the death spiral to go to zero, provided that ETH Merge will happen one day. Regardless of what FUD is saying, the depeg of stETH is nothing like UST (about UST collapse, read here). stETH’s market price is a temporary reflection of its supply and demand, it will eventually redeem 1:1 in ETH when the Merge is completed. Arbitrageurs can trade the discounted stETH for profits. The deciding factor for success is the completion of ETH Merge. So if you are staking ETH, you’d be better in it for the tech.
What about “gain yield on top of yield”? Does the double gain offset the potential loss from an unfavourable conversion rate? The most usual way to earn yields on the staked token is providing liquidity of the staked token and its underlying asset, aka stETH and ETH, in an AMM liquidity pool. Providing liquidity can earn trading fees, and some exchanges (DEX) give extra yields on top of that. However, providing liquidity has an impermanent loss (more about this in this article). In the event of stETH depegs, the liquidity provider suffers the loss, making the whole position less profitable than simple staking.
The strength of liquid staking is providing flexibility for staking, giving a quick way out when unstake. The correct mindset for staking should be that you are natively bullish about the coin and the blockchain it represents. And you are in for a long time. I would consider liquid staking a backup plan for any black swan event of the coin in staking rather than a yield-chasing activity.
From the blockchain perspective, liquid staking protocols can threaten the network’s security and decentralization when they obtain a significant stake. Power will be concentrated in a few’s hands. You don’t want this to happen, right?
Good news at the end.
A big market cap cryptocurrency in the market has by-default liquid staking. Which one? Cardano!
ADA staking is non-custodial, has no lock-up, no slash, and you can use the staked ADA without restriction during staking. Staked ADA can be transferred to another wallet or be used in defi, just as tokens sitting in the wallet. These characteristics make liquid staking solutions obsolete. Staking is fundamental for the functioning of the Cardano network. Cardano has 3000+ stake pools, aka validators. Cardano’s consensus protocol Ouroboros ensures a secured and fair way to select the validators as block producers, and distribute network control across validators. It enjoys a pretty high level of decentralization among layer 1s.
Unlike other blockchains where it is possible to select the number of coins to delegate in staking, all ADA in the wallet are delegated on Cardano. Stakers can change the stake pool whenever they want. An edgy advantage is that even when ADA is used in liquidity providing with another token in a liquidity pool, it can keep earning staking rewards. The staking rewards in ADA will return to the pool and increase the value of the LP token. Thus, a liquidity provider’s LP token rises in value from the trading fees and staking rewards. This is a true double yield.
Stake if you are natively bullish about the coin and the blockchain it represents.
Liquid staking provides flexibility for locked staking, giving an instant way out.
ADA is by-default liquid staking, feeless staking.