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Liquid staking derivatives explained

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. 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.

What are liquid staking derivatives?

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. 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 staling derivatives offer an elegant solution to both of these problems.

So what exactly are liquid staking derivatives? Simply put, they are tokenized IOUs (an IOU, stands or ‘I owe you’, is a documents that acknowledges the existence of a debt) that are issued for staking ETH through a liquid staking platform. 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 that match the value of your deposit.

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. 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 tokens in other DeFi protocols and take advantage of lucrative opportunities. In other words, LSDs allow you to retain your ability to generate passive income through staking, but you don’t have to sacrifice liquidity.

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.

Demand surges after Shapella upgrade

Demand for liquid staking derivatives has been on the rise following the ‘Shapella’ upgrade which was activated on Ethereum in April. Among other things, the upgrade enabled stakers to finally withdraw their stakes in the network. This meant that a lot of previously unavailable ETH could now be redirected towards liquid staking platforms. And many ETH stakers have been more than willing to switch to a more liquid form of staking.

As a result, a number of prominent liquid staking platforms have risen to the forefront of the DeFi industry. Chief among them is Lido, which is currently the largest DeFi protocol in terms of total value locked, having over $14 billion of TVL, according to data from Dapp Radar. 

Other notable platforms include Rocket Pool ($1.93 billion TVL) and Frax Finance ($807 million TVL).

Conclusion

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.

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