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This article aims to provide an overview of liquid staking, its advantages, risks, and some useful strategies. It references blockchains, staking, Proof-of-Stake (PoS), delta neutral strategies, and liquid staking derivatives (LSDs). If you are unfamiliar with decentralized finance, check out our articles introducing DeFi and cryptocurrency first.

An Introduction to Liquid Staking

What Is Liquid Staking?

Liquid staking is a form of staking, a mechanism involving users in the process of securing a PoS network. Liquid staking was first introduced by Lido as a solution to the above problem.

Why Use Liquid Staking? How Does It Work?

In conventional staking, although users can accrue some interest by locking up their crypto in the network, these assets cannot be accessed when locked up. This means that users lose out on the opportunity to gain more yield and risk losing money in the event of a price dip.

Liquid staking involves users delegating their crypto to a validator node on a delegated PoS (DPoS) network by pooling tokens in a staking pool via a third-party liquid staking service provider — either platforms specializing in liquid staking or projects native to the network. In exchange for the tokens locked in the network, users will receive a derivative token to the underlying asset. This grants the user liquid funds following the staking of crypto. LSDs generally use two different mechanisms in the market: rebasable and exchange rate-based tokens.

Rebasable LSDs

For rebasable LSDs, the value of the underlying asset and the LSD will remain at a ratio of 1:1. The balance of the LSD is recalculated daily when the oracle reports the balance update for the underlying token. For instance, users will receive 1 stETH when they stake 1 Ether (ETH) on Lido. Once withdrawals from the Beacon Chain are allowed, users can redeem ETH by burning stETH at the same 1:1 ratio as when minting.

Exchange Rate-Based LSDs

For exchange rate-based LSDs, the value of the LSD changes over time to reflect accrued rewards and fees, but the balance remains unchanged. This means that the exchange rate between the LSD and its underlying asset changes constantly, usually on a 24-hour basis, depending on the protocol. For instance, users will receive 1 rETH when they stake 1 ETH on Rocket Pool. However, the rETH/ETH exchange rate is updated daily, based on the rewards earned by Rocker Pool’s Beacon Chain node operators, and the value of rETH increases daily. pSTAKE also makes use of this exchange rate-based model for its stkASSETs.

Learn more about LSDs here!

Liquid Staking vs. Regular Staking

Instead of having their crypto locked up in the protocol or network in the case of regular staking, liquid staking users can use their derivative tokens to further participate in DeFi activities to stack their yield on top of regular staking annual percentage returns (APRs).

Liquid staking also ensures greater decentralization in securing the network by lowering the barriers of entry to stake. The more validators present on the network, the more robust and secure the PoS network will be. In the case of post-Merge Ethereum, the minimum stake for a validator node is 32 ETH, which could be a significant sum of money for many retail users. With liquid staking, users can take part in the securing of Ethereum and receive the rewards without having to fork out the entire minimum amount of 32 ETH.

Liquid Staking Risks

Counterparty Risk

The involvement of a third party adds counterparty risk to users’ staking activity. This could present itself in smart contract risks and protocol legitimacy issues. Always remember to do your own research (DYOR)!

Centralization Risk

In the staking-as-a-service landscape, centralization risk remains a consideration. At the time of writing, Lido alone holds 29.28% of the market share for staked ETH across both centralized and decentralized players in the space. Although Lido is heavily audited, any form of disruption in the protocol would probably lead to network-wide disruptions.

However, although Lido has 29 whitelisted node operators voted in by the Lido Decentralized Autonomous Organization (DAO) and a total of 144,408 validators, no single entity controls more than 5.14% of the stETH (or 7,422 validators), as shown in the figure below. This means that the chances of manipulation or attacks on the network should be low since there is diversification of control among the node operators.

Breakdown of Lido Ethereum Node Operators

Examples of Liquid Staking Protocols

Although liquid staking is most commonly associated with Ethereum, liquid staking is also present on other PoS networks, such as BENQI on Avalanche and pSTAKE on Ethereum, Cosmos, and BNB Chain.

Lido

Established in December 2020, Lido is a decentralized liquid staking protocol on Ethereum 2.0’s Beacon Chain governed by the Lido DAO. It pioneered the mechanism of liquid staking, a solution to the high amount of capital and the technical competency needed to stake ETH. Currently, Lido is interoperable among the Ethereum, Solana, Polygon, Polkadot, and Kusama blockchains. Users receive stTokens (e.g., stETH) upon staking their crypto.

BENQI

Through BENQI Liquid Staking (BLS), users can stake AVAX on the Avalanche C-Chain without staking on the Avalanche P-Chain, earning validating rewards from the P-Chain without needing to run a full node or locking up AVAX on a node. Users receive sAVAX tokens for their staked AVAX, which can be used to participate in other decentralized applications (dApps) to stack yield.

pSTAKE

Established in 2020, pSTAKE is a liquid staking protocol that is the first in-house application on Persistence, a Tendermint-based Layer-1 that powers an ecosystem of dApps focused on unlocking the liquidity of staked assets. pSTAKE is interoperable among multiple chains, namely, its native Persistence chain on Cosmos, Ethereum, and BNB Chain. Liquid staking on Cosmos is the newest addition to pSTAKE, offering the highest annual percentage yield (APY) at 22.12% at the time of writing.

By staking underlying assets, such as ATOM, ETH, and BNB, users will receive stkASSETs in return: stkATOM, stkETH, and stkBNB, respectively. pSTAKE uses the cToken model adapted from Compound, where the value of a stkASSET increases over time as it accrues rewards. In other words, a stkASSET will increase in value after every reward epoch, which lasts for 24 hours. PSTAKE is the native token used for governance and incentivizing user participation. For some transactions related to ATOM or stkATOM, users may need XPRT, the native token of the Persistence chain.

Interestingly, there are ways in which liquid staking can be used to perform delta neutral strategies to hedge against risks. In the next section, we highlight how users can liquid stake ATOM on pSTAKE to optimize the stability of their portfolio.

Delta Neutral Liquid Staking

A delta neutral strategy involves balancing your portfolio to have zero delta or neutral market exposure. In relation to crypto staking, this means that you hold equal long and short positions in assets that are positively and negatively correlated with the price of your staked tokens. By doing so, you can reduce your overall risk and increase the stability of your portfolio. If the price of your staked assets decreases, the loss derived from spot volatility will be offset by the corresponding short position due to the correlation of the assets.

In the case of liquid staking, users can hedge against the underlying asset by shorting the corresponding perpetuals to achieve delta neutral yield. Users can also choose to, instead, deploy options for this strategy if the instrument exists.

pSTAKE Delta Neutral Liquid Staking Strategy Case Study:

Assuming a starting capital of 1K USDC to invest in ATOM, specifically stkATOM.

The structure of the trade is as follows:

#1: Swap USDC for US$500 worth of ATOM. If leverage is employed, you can swap for more ATOM, depending on the maximum leverage you are willing to take on.

#2: Stake ATOM on pSTAKE to receive stkATOM, which yields 23.79% APY (as of 23 February 2023). Note that the yield is auto-compounded through the increase of the stkATOM/ATOM exchange rate.

#3: Use the remaining 500 USDC to short the equivalent amount of ATOM staked on any exchange offering ATOM perp. Your ATOM exposure will increase over time as stkATOM accrues rewards. This structure will ensure that your initial capital will stay above 1K USDC, but the APY rewards earned will vary depending on ATOM price performance. Perp funding rate will have to be taken into account as well.

If leverage is employed (e.g., 3× leverage ATOM perp), you can convert up to 750 USDC to ATOM.
The remaining 250 USDC can then be used to leverage short ATOM perp to ensure zero delta exposure on your capital.
Note that with higher leverage employed, your shorts are more prone to liquidation risks, leaving your principal amount exposed to volatility.

Assuming zero transactions and gas fees, the estimated yield from this strategy can be calculated as follows:

Estimated Yield = (% of Principal Used to Buy ATOM × Liquid Staking Yield) + (% of Principal Left in USDC × Perp Funding Rate)

Following this example:

Estimated Yield = (50% × 23.79%) + (50% × 22.95%) = 23.37% APY

If the funding rate for ATOM perp is negative, you will end up reducing the yield earned from liquid staking in order to protect your principal amount.

Most perp exchanges’ funding rates change every one to eight hours. Hence, the estimated yield will likely vary based on the duration of the strategy.

Below is an example of all the different borrowing rates from exchanges offering ATOM perp. Depending on your capital size, liquidity and trading volume will be important factors to consider for minimal slippage.

ATOM Perp Borrowing Rates on Various Platforms

On top of that, users can choose to provide liquidity into the stkATOM/ATOM liquidty pools (LP) on Osmosis and Crescent.

liquidity provision of stkATOM/ATOM on Osmosis and Crescent

At the time of writing, these users will be able to earn an additional projected return of 16.65% to 20% based on the trading volume of the liquidity pools, pSTAKE ATOM external incentives, and internal emissions of OSMO and CRE.

To deploy this strategy, users can liquid stake half of their ATOM holdings mint stkATOM and use the remaining ATOM holdings to provide liquidity in stkATOM/ATOM pool.

Following the earlier example, the portfolio will consist of:

stkATOM: 25% of total capital
ATOM: 25% of total capital
Short ATOM Perp: 50% of total capital

Estimated Yield = (% of Principal Used to Mint stkATOM × Liquid Staking Yield) + (% of Principal in stkATOM/ATOM LP× LP Yield) + (% of Principal Left in USDC × Perp Funding Rate)

As for this example:

Estimated Yield = (25% × 23.79%) + (50% × 20%) + (50% × 22.95%) = 27.42% APY

In addition, the pSTAKE team is also working to integrate stkATOM with multiple lending and borrowing DeFi protocols such as Umee, Mars Protocol, Nitron, and Nolus. When that happens, other strategies, such as using stkATOM as collateral to borrow stablecoins to short ATOM perps, can be deployed. These strategies allow you to swap your full principal into ATOM and stake it as stkATOM or provide liquidity on stkATOM/ATOM pools. The estimated yield from these strategies can be calculated as follows:

Estimated Yield = (% of Principal Used to Mint stkATOM × Liquid Staking Yield) + (% of Principal in stkATOM/ATOM LP × LP Yield) + Deposit Reward Yield + Perp Funding Rate – Borrowing Rate

Liquid staking has blown up in recent weeks as ETH LSD governance tokens rally massively ahead of the Shanghai upgrade. Other PoS networks have also started coming up with LSDs, as liquid staking offers multiple benefits to stakers, the biggest being unlocking liquidity while earning staking rewards.

Disclaimer

This publication is provided for informational and entertainment purposes only. Nothing contained in this publication constitutes financial advice, trading advice, or any other advice, nor does it constitute an offer to buy or sell securities or any other assets or participate in any particular trading strategy. This publication does not take into account your personal investment objectives, financial situation, or needs. Treehouse does not warrant that the information provided in this publication is up-to-date or accurate.

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An Introduction to Liquid Staking and Its Strategies

Authors: @Web3Geee and @0xxxxxin

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