Liquid Staking Derivatives: Supercharged Staking

July 11, 2023 - 8 min read

LSD tokens are issued as receipts for staked funds, giving users newfound flexibility and liquidity while still enjoying the rewards of staking crypto.

Introduction

Proof of Stake is a relatively new consensus model for blockchains, aiming to increase the speed and efficiency of validating new transactions added to the blockchain in cost effective ways. PoS reduces transaction costs and energy expenditure compared with proof of work protocols by not requiring nodes to “mine” new coins by computing hash functions, which is rather energy intensive. Transactions are instead validated by participants who stake their tokens, risking their tokens to slashing for any dishonest, Byzantine behavior.

‘Staking’ is the process of locking up some assets in order to participate in the validation process in return for token rewards. While staking is not a new concept, it has long been understood that staking often involves a sort of ‘lock-up’ period during which the staked funds can’t be withdrawn. “Liquid staking” breaks from this framework, enabling users to earn staking rewards while still maintaining the flexibility to use their staked assets for things like collateral for loans or arbitrage trading, for instance.

This is possible by issuing tokens which represent those staked assets, which can subsequently be traded and used like any other on-chain asset. Since these new tokens derive their value from the underlying staked tokens, we can call these ‘derivative’ tokens, or more precisely, liquid staking derivative (LSD) tokens. LSD tokens can be traded on secondary markets or loaned out, restaked, or used for arbitrage trading.

Competition Heating Up for Liquid Staking TVL

First off, Lido Finance is the clear leader in the Liquid Staking market on Ethereum, capturing roughly 75% of market share to date. Coinbase takes the number two spot in terms of market share with just under 15%. Some worry that a centralized entity like Coinbase could more easily be targeted by the SEC, especially following the recent actions taken against Kraken’s stakings services.

Lido Finance is credited with popularizing the idea of liquid staking, and was the first to successfully implement it at scale on Ethereum. Having said that, this sort of market dominance is unlikely to be sustained very long, and as we have seen in the past, competitors often rise up with better technology after the early movers have worked out many of the early problems of a given tech.

Interestingly, Coinbase’s ETH peg was deviating the most at the time of writing this article, making it tempting to declare DeFi to be more effective at maintaining stability via the decentralized, invisible hands of the market.

Aside from the more centralized Coinbase, Rocket Pool offers a convenient solution for Liquid Staking Derivative tokens, and provides most of the technical assistance and expertise as well. Unlike Lido, node operators must stake ETH and LDO tokens, running a node with Rocket Pool necessitates staking both ETH and RPL, their native governance token.

It appears that Rocket Pool is focused on adding more decentralization to their node network via individual validators as opposed to many delegators joining a few validator staking pools. If not kept in check, a large percentage of staked assets could become too concentrated, forming an oligarchy amongst a network’s validators. This would undermine the decentralization of the network, and compromise the security of their assets.

By staking assets with Rocket Pool, full node operators enjoy a higher ROI with both RPL and ETH staking rewards, though 16 ETH is required the minimum stake to operate an ETH node within their network.This stands in contrast to the 32 ETH typically required to run a full node on Ethereum’s Beacon Chain.

In addition, individual stakers can delegate their ETH to one of Rocket Pool’s nodes and receive the liquid rETH token in return. However, the APR is only 4.31% for delegators, compared to the estimated 7.14% for full node operators. Therefore, stakers must ask themselves if staking additional ETH is worth the additional return for them.

How Liquid Staking Works on Lido

Normally, once crypto has been delegated as proof of stake in a protocol, users must lock their tokens, sacrificing both liquidity and optionality. LSD protocols issue a fungible, transferable token with a prefix attached to the staked assets name after the stake is delegated, which represents the staked crypto. Issuing an LSD token for underlying assets could theoretically be done for any crypto, like stETH, stMATIC, or stSUPRA, for instance.

To explain how it works, we’ll use the model used by Lido Finance, but readers should understand that there are certainly alternatives out there. When users stake ETH on Lido, they are issued stETH tokens which correspond to their ETH, and are also issued staking rewards as they accrue or slashed due to penalties associated with their validator key on Ethereum’s Beacon Chain. As seen below, node operators stake their ETH in a smart contract on the current version of the Ethereum blockchain, with those funds then staked to the beacon chain. The LSD tokens remain tradable on Ethereum 1.0 as stETH.

Lido users are simultaneously able to generate yield and trade stETH tokens, giving them both active and passive income opportunities on a single, decentralized platform.

Users can then freely trade their LSD tokens in secondary markets if there is sufficient liquidity on the respective LSD pools. For instance, Lido Finance offers users the LSD token stETH after providing liquidity to the stETH-ETH pool. Lido further allows users to take their stETH onto Layer 2s like Arbitrum and Optimism by wrapping the LSD token and issuing wstETH tokens. In addition to having no lock-ups, Lido also doesn’t require minimum deposits for staking either.

On Lido, users mint stETH tokens by staking ETH and may be burned once users are ready to redeem their stake. The circulating supply of stETH tokens are to match 1:1 to the ether staked on Lido. The price of the stETH token’ is pegged to the price of ETH, and is updated via an oracle which tracks the peg. The minting and burning mechanism which maintains the fidelity of the price peg is called rebasing.

Lido retains 10% of the fees for minting stETH to reward both node operators and the DAO’s treasury.

LidoOracle tracks the ETH balances for the DAO’s validators on Ethereum’s beacon chain. Balances often increase as rewards accumulate, and decrease if slashing occurs or some other penalties are incurred. Oracle daemons push their reports once per day after receiving enough data to satisfy the quorum value for that round, which means that balances are updated roughly every 24 hours.

At times, the stETH derivative will deviate from the peg of its corresponding asset. As mentioned, traders can leverage this premium by exiting their positions, but this requires active monitoring and the free time to do it. Tracking the ETH peg allows arbitrage traders to take profits on the spreads, effectively helping to return the peg to its equilibrium.

Of course, users can simply hold their LSD tokens instead of redeeming them as an arb trade, since their tokens appreciate along with the pegged asset and its staking APR. Node operators and the Lido treasury are able to step in and defend their stETH to ETH peg if it remains deviated from par for too long.

The Future of Staking is LSD

Overall, liquid staking is an attractive option for those looking to maximize their returns on their staked assets. This is most obvious to users that will be actively trading or making use of their funds, since users simply seeking passive incomes should be happy to receive the rewards for their originally staked assets without incurring any additional slashing risks, hacks, or even user errors.

It’s also incredibly bullish for the Ethereum ecosystem as it frees up previously-illiquid tokens that had been locked in staking contracts. This increases the amount of useful capital that can be effectively deployed to run Web3 services for related applications, which should accelerate growth substantially. Other ecosystems which adopt liquid staking mechanisms should enjoy similar boosts in terms of capital efficiency, each depending on their own unique contexts, limitations, and challenges to overcome.

It is also an opportunity for arbitrage traders to make money while providing price stability via the balancing of supply and demand for stETH tokens. It isn’t obvious that node operators as well as the Lido Treasury could utilize these arbitrage opportunities to build up capital at opportune moments and then deploy it wisely in order to optimize the protocol’s operations.

While this article has used Lido Finance as an example for explaining the concepts of liquid staking, readers interested in finding out more about LSD tokens and protocols might find alternatives like Stakewise, Stakehound, or Ankr Protocol more suitable for their purposes. Though bigger is not always better, safety is often found in higher numbers when it comes to financial assets, meaning that smaller protocols are more likely to be overrun by attackers since they have fewer resources with which to defend their ecosystems and fewer nodes to override Byzantine behaviors.

Alas, it seems inevitable that any protocols with significant lockup periods for staking will begin to make use of liquid staking derivatives for the aforementioned reasons. We expect to see more and more LSD tokens trading hands as time goes on, and hope to further innovate on this concept ourselves in terms of making the security of LSD tokens more robust and interoperable before potentially offering a novel version further along our roadmap.

References

Hooper, A. (2023, 7 Feb.). DeFi’s next big thing: Liquid staking derivatives. Cointelegraph.
Lido. (2021, 1 Feb.). Lido’s stETH: The mechanics of stETH. Lido Blog.
Lido. (2023). LidoOracle. Lido Docs.
Shapovalov, V. (2020, 6 Nov.). How Lido works. Lido Docs.

SupraOracles

By leveraging the power of entropy and zero knowledge cryptography, SupraOracles will soon offer the most robust set of decentralized price and data feeds in the world- along with a host of other automated solutions to complement each other in the ultimate Web3 stack. Users and their digital assets rely heavily on the fidelity of the ledgers as much as the automation of their smart contract agreements.

That means that lapses in oracle security are unacceptable due to the important juncture at which oracles are positioned. With this in mind, every aspect of security has been designed to withstand every sort of malicious attack and prevent any “gaming” of the system by potential rogue, colluding node operators. To learn more about how exactly this works, check out Supra’s most current product offerings by reading up on our litepapers and whitepapers.