By
Dimitar Bogdanov
July 5, 2023
4 Min Read
Liquid staking derivatives have been the talk of the town in DeFi in recent months and that’s not surprising.
The world of DeFi is fast moving and full of innovation and liquid staking derivatives are the latest example of that. A big part of what makes them interesting is the fact that they are not just an investment product, but they have significant utility for the Ethereum network. The accessibility and flexibility of liquid staking derivatives are expected to attract more users to staking and DeFi activities. And following the recent Shapella upgrade, LSDs are about to explode even more, as they are already attracting billions worth of previously inaccessible ETH. So let’s delve deeper into this exciting new product of DeFi and highlight why it’s taking the world by storm.
Liquid staking derivatives are new DeFi instruments that open up new investment opportunities for investors and, at the same time, help solve some limitations of Ethereum staking.
Ethereum’s transition from proof-of-work to a proof-of-stake consensus mechanism changed the way transactions are verified on the network. The change meant that validators were to take on verification duties, replacing PoW miners. And, anyone could become a validator by staking 32 ETH in the network and start accruing staking rewards. This turned Ethereum staking into an opportunity to generate income. But there are some caveats.
The first one is rather obvious - at nearly $1,900 per ETH, the 32 ETH stake requirement represents a significant financial barrier to entry - one that not many afford to make. This high minimum creates significant entry barriers for most users. The second issue is that all that substantial capital is essentially locked away and cannot easily be used to take advantage of other investment opportunities.
Here we have a classic example of a double whammy. On the one hand, the distinct lack of liquidity makes staking less attractive to experienced investors who often employ more active trading strategies. On the other hand, the steep financial barrier is likely to deter people who are simply looking for alternative ways to generate passive income. Fortunately, liquid staking derivatives offer an elegant solution to both of these problems.
So what exactly are liquid staking derivatives? Liquid staking work involves staking tokens in a protocol and receiving derivative tokens that can be used across DeFi applications, providing flexibility and liquidity. Simply put, they are tokenized IOUs (an IOU, stands or ‘I owe you’, is a document that acknowledges the existence of a debt) that are issued for staking ETH through a liquid staking platform. These tokens represent staked assets within DeFi protocols, allowing users to maintain liquidity and utilize their staked assets in various financial activities. So when you stake ETH through a liquid staking provider, you deposit some amount of ETH on the platform and in exchange receive special tokens—often referred to as receipt tokens—which act as digital representations of the staked ETH.
These tokens, referred to as liquid staking derivatives (LSDs), then start to automatically accrue yield that goes directly to your wallet, saving you the trouble and the cost (gas fees) of having to withdraw your rewards, as it is the case with regular staking. These receipt tokens are backed by the underlying asset, which is the staked ETH, ensuring their value and stability. A liquid staked derivative is a financial product that allows users to remain liquid while their assets are staked. Liquid staking derivatives are financial instruments that represent staked tokens in a DeFi protocol, enabling users to access liquidity and utilize their assets across various DeFi applications. Keep in mind, however, that the liquid staking providers typically take a 5-to-10% cut of the yield as a service fee.
So you can hold on to your liquid staking tokens and let them generate passive income for you, but you’re also free to use these derivative tokens in other DeFi protocols and take advantage of lucrative opportunities, such as using them as collateral or for other financial activities. In other words, LSDs allow you to retain your ability to generate passive income through staking, but you don’t have to sacrifice liquidity. LSDs play a crucial role in maintaining liquidity for stakers.
Perhaps most importantly, liquid staking derivatives remove the 32 ETH requirement, thus reducing the steep barrier to entry. This is because liquid staking providers allow users to stake any amount of ETH and earn rewards corresponding to the size of their investment. This means that even small investors can take advantage of the stable annual yield that staking offers. Staked assets are managed and utilized within DeFi applications through these derivatives, providing flexibility and utility. Traditional staking often locks up assets, restricting their use, whereas LSDs provide greater flexibility. Users continue to accrue staking rewards while holding LSDs, which can be traded or used in DeFi applications, allowing for ongoing yield generation and liquidity.
Demand for liquid staking derivatives has been on the rise following the ‘Shapella’ upgrade, also known as the Shanghai upgrade, which was activated on Ethereum in April. This upgrade enabled the withdrawal queue for staked ETH, allowing stakers to finally withdraw their stakes in the network. As a result, a significant portion of the circulating ETH supply, previously locked, could now be redirected towards liquid staking protocols. This has impacted staking yield, staking APR, and the broader staking ecosystem, as more users seek to earn yield and additional yield through DeFi activities. Many ETH stakers have been more than willing to switch to a more liquid form of staking, as users stake ETH by depositing it on liquid staking protocols, receiving receipt tokens, and earning yield while maintaining liquidity.
As a result, a number of prominent liquid staking platforms have risen to the forefront of the DeFi industry. Lido and Rocket Pool are leading providers, with Lido recognized as the first liquid staking provider. Lido is currently the largest DeFi protocol in terms of total value locked, having over $14 billion of TVL, according to data from Dapp Radar. Lido’s node operators are selected by LDO token holders, which centralizes node operator permissions compared to other protocols.
Other notable platforms include Rocket Pool ($1.93 billion TVL) and Frax Finance ($807 million TVL). Rocket Pool stands out for its decentralized approach, allowing anyone to become a rocket pool node operator with low entry requirements (16 ETH and RPL tokens), and supporting independent node operators to enhance decentralization. Frax Finance offers Frax's ETH LSD, where users can stake ETH to mint frxETH, provide liquidity with frxETH LP tokens, and benefit from the deep liquidity of Curve pools. ETH LSDs like stETH, rETH, and frxETH are gaining traction due to their integration with DeFi applications, increased liquidity, and the ability to participate in yield farming, lending platforms, and money markets for additional yield.
The market cap of liquid staking protocols continues to grow, and secondary markets provide liquidity and flexibility for these crypto assets. Providing liquidity to LSD pools enables users to participate in various DeFi activities, such as yield farming and lending protocols, further enhancing the DeFi ecosystem. LSD protocols are dominating DeFi by integrating with other protocols, increasing financial flexibility, and offering users more opportunities. Maintaining a constant quantity balance in liquidity pools is important, and wrapped tokens help address this issue. The integration of staking directly into wallets like MetaMask has lowered entry barriers and attracted more users. The SD token also plays a key role in incentivizing liquidity and supporting the overall growth of the liquid staking sector.
The meteoric rise of liquid staking derivatives is yet another example of DeFi's remarkable ability to rapidly grow and evolve in order to meet the growing needs of the community. Ethereum's transition to PoS may have brought us ETH staking, but it's LSDs that are now taking this concept to the next level.
