liquid staking derivatives (LSDs)

This article aims to provide an overview of liquid staking derivatives (LSDs) and how they work. If you are unfamiliar with decentralized finance, do consider reading our introduction to DeFi and cryptocurrency. You might also want to read our article introducing the concept of staking and liquid staking.

Introduction to Liquid Staking Derivatives (LSDs)

What Are LSDs?

Liquid staking derivatives (LSDs) are tokens issued by liquid staking protocols or platforms, enabling users to unlock their illiquid staked assets to earn higher yields. The price of the derivative token could either be pegged to its underlying asset which is locked when staked on a Proof-of-Stake (PoS) network, or it could accrue rewards and increase in value over time.

In both traditional finance and crypto, derivatives are contracts that derive value from an underlying asset, primarily used for hedging and speculating. The difference in crypto is that the underlying asset is a token. The LSD mechanism was pioneered by Lido in December 2020 and was built for the Ethereum chain. Lido remains the largest liquid staking protocol by total value locked (TVL).

Why LSDs?

With regular staking, users help to secure PoS networks by locking their assets through a protocol or platform, receiving staking rewards in return. However, this brings about the problem of capital inefficiency as stakers lose out on the opportunity to earn additional yield when their assets are illiquid and locked up. 

Solves Capital Inefficiency

LSDs solve this problem by providing users with a liquid and usable token representing their staked asset. This way, stakers can use their LSDs to further participate in DeFi, such as through liquidity provision or using them as collateral, while still receiving network staking rewards. 

Lowers Barriers to Entry for Staking

LSDs also use pooled staking, which lowers the barriers to entry for users to stake on a network as it is usually costly to run a validator node. This is especially useful for Ethereum, where 32 Ether (ETH) is the minimum amount needed to run a validator node to stake on the network.  

Increases Network Security and Stability

By lowering the barriers to entry for staking and incentivizing staking by mitigating capital inefficiencies, LSDs encourage user staking on the network. The stability and security of PoS networks increase with the number of stakers on the network because greater decentralization is achieved. 

Drawbacks of LSDs

Despite its benefits, there are also disadvantages and risks associated with LSDs. 

Small Market Size 

Compared to their underlying assets, LSDs might be limited by their small market size and thus, may not always have deep liquidity. This makes it more difficult for users to enter or exit their positions, resulting in risks of wider bid-ask spreads and slippages, which can cause significant losses. 

Counterparty Risks 

LSDs are typically traded on centralized exchanges (CEXs) or decentralized protocols involving a counterparty. This comes with counterparty risks, such as the counterparty’s potential insolvency or inability to fulfill its obligations. Further, there has been a recent crackdown on staking by the SEC on platforms such as Kraken. This may impact the liquid staking space in the future, contributing to uncertainties around the future of LSDs on CEXs. 

Depegging Risks 

The price of LSDs is typically pegged to that of the underlying token. However, most LSD prices are dependent on their secondary market. There have been instances where the price of the LSD token fell below that of the underlying token, creating a liquidity crunch. During the 2022 crypto contagion, there was a stETH/ETH depeg with stETH trading at around 0.93 ETH at its bottom in June 2022. As a result, liquidity providers started withdrawing their funds and draining market liquidity. The resultant volatility could be a risk faced by any LSD.

A Rise in Popularity  

Although there are risks associated with LSDs, they have been growing in traction and could emerge as one of the main 2023 crypto narratives, as mentioned in our Insights piece, “Treehouse’s 2022 Wrap-up and 2023 Outlook”. There was a significant increase in interest in liquid staking, especially after Ethereum’s successful Merge as it shifted from Proof-of-Work (PoW) to PoS. 

liquid staking pre-merge and post-merge

Staking rewards are probably the key driving factor for user adoption. The table below shows some decentralized liquid staking platforms’ Annual Percentage Rates (APRs).

liquid staking platforms

Despite the rise in LSDs, up till the end of 2022, Ethereum’s stake rate was only 13%, compared to the average stake rate of other PoS networks at 60%. Stake rate refers to the total percentage of an asset staked out of the total supply of the underlying asset.

Ethereum Shanghai Upgrade

There is also anticipation for Ethereum’s Shanghai network upgrade, slated for March 2023. The upgrade will finally allow users to withdraw their staked ETH on the Beacon Chain, de-risking staking and potentially encouraging more users to stake ETH on the network. This could mean greater liquidity for the Ethereum LSD market, contributing to a flywheel for the adoption of LSDs. 

It is important to note that there might be a spike in volatility once the Shanghai upgrade happens. A sudden wave of user withdrawals could occur, especially with stakers who have had their ETH locked since late 2020.

How Do LSDs Work?

LSDs allow individuals to gain exposure to DeFi yield in addition to staking rewards by retaining the liquidity of their assets. These liquid tokens represent a claim on the underlying, illiquid staking position. They can be used in various ways, such as for lending, trading, and as collateral, within DeFi. 

Examples of LSDs 

There are two types of liquid staking platforms or service providers—centralized and decentralized. The main difference between the two is that of custody, where centralized platforms such as CEXs like Coinbase hold on to users’ assets, while DeFi protocols such as Lido, Rocket Pool, Frax Finance, and BENQI allow for self-custody. Each liquid staking platform has its own unique LSD mechanism. Although there is a huge focus on Ethereum LSDs, other PoS chains, such as Avalanche and BNB Chain, also have a significant liquid staking market. 

Lido 

Lido is currently the largest liquid staking protocol with 29.2% of the staked ETH market share and a TVL of US$8.86B (as of 16 February 2023). Apart from Ethereum, it supports liquid staking on other chains, including Solana, Polygon, Polkadot, and Kusama.

distribution of staked ETH

Users can deposit any amount of the supported tokens, such as ETH, SOL, and MATIC, to receive the respective staked derivative tokens or LSDs, such as stETH, stSOL, and stMATIC. These LSDs can be used to participate in other DeFi protocols or accrued as staking rewards directly in the wallet. In exchange, Lido takes 10% of the staking rewards, a percentage decided by its decentralized autonomous organization (DAO), and splits it between node operators and the DAO treasury. Despite Lido’s success, there have been concerns regarding centralization due to Lido’s market share of staked ETH. 

Track your Lido assets with Treehouse APIs which provide DeFi analytics data. Also, check out our integration with CryptoSheets, an Excel and Google Sheets plug-in for crypto data.

Rocket Pool 

Rocket Pool is the second largest liquid staking protocol with 2.38% of the liquid staked ETH market share and a TVL of US$1.06B (as of 16 February 2023). It aims to solve the centralization problem that Lido faces. 

Rocket Pool lowers the barrier for users to run their own nodes. Instead of 32 ETH, an operator only requires a minimum of 16 ETH and 1.6 ETH worth of RPL, Rocket Pool’s governance token. The remaining 16 ETH is matched by other stakers. Regular stakers receive rETH from staking their ETH, while node operators receive additional RPL rewards from the network on top of their staking rewards. Rocket Pool takes a fee of 5% to 20% from the rewards to distribute to its node operators. 

BENQI

BENQI liquid staking (BLS) is built on Avalanche, and it is the second largest protocol on Avalanche with a TVL of US$251.59M (as of 16 February 2023). Users receive sAVAX when they stake AVAX on BENQI.

The minimum staking requirement (MSR) for delegators on Avalanche is 25 AVAX. BENQI lowers the barriers to entry by bypassing this MSR so a less AVAX is needed for staking. BENQI also allows users to stake and unstake at any time, apart from a cooling period of 15 days, with no deposit or withdrawal fees. This is otherwise not possible on Avalanche. 

Coinbase 

Ahead of the Merge in September 2022, Coinbase started offering its own LSD, the Coinbase Wrapped Staked ETH (cbETH), with a TVL of US$1.85B (as of 16 February 2023). It is currently the first and only centralized liquid staking platform.

The price of cbETH is not pegged or maintained by Coinbase. Rather, it is determined by the market, where users can buy, sell, wrap, and unwrap cbETH. It is currently primarily used as collateral in crypto borrowing and swapped for liquid assets while staked ETH is locked on the Beacon Chain. Despite cbETH’s success, custody and counterparty risks are considerations since Coinbase is a centralized platform.

Conclusion

As the world of crypto continues to evolve, we foresee LSDs’ pivotal role in the future of staking, especially since they solve problems faced in traditional staking. An increasing number of protocols and platforms are beginning to accept LSDs as a currency for DeFi participation, which promotes growth in the LSD markets. There is still much room for growth within the liquid staking sector, and it will be exciting to see the innovations arising out of this untapped market.

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.


Hyperion by Treehouse reimagines workflows for digital asset traders and investors looking for actionable market and portfolio data. Contact us if you are interested! Otherwise, check out Treehouse Academy, Insights, and Treehouse Daily for in-depth research.