Why Liquid Staking on Ethereum Is So Attractive

Early November 2022 saw the market capitalisation of the crypto staking industry closing in on US$100 billion. Ethereum ranked top for registering the highest net staking inflow, followed by Polygon, Stacks, Cosmos, PancakeSwap, etc. However, the margin by which Ethereum led over its competitors seemed unbridgeable, at least soon. 

While Ethereum’s net staking inflow was hovering near US$337 million, Polygon was near US$21 million, Stacks was a little above US$11 million, and Cosmos and PancakeSwap were near US$10 million. 

Why is staking on Ethereum so enticing? And why is the demand for liquid Ethereum staking surging at such a fast pace? Before tackling those questions, let us have an overview of what staking is. 

What is Staking?

In short, staking is a way of earning rewards for holding specific cryptocurrencies. Such cryptocurrencies may include Ethereum, Tezos, Cosmos, Solana, Cardano, etc. Staking these cryptocurrencies imply allowing the blockchain to put these assets into work for the original owner of these currencies to earn some rewards at a percentage rate over time.

For cryptocurrencies to allow the provision of staking, they must adhere to a consensus mechanism known as the Proof of Stake. Since cryptocurrencies and the world of blockchain is a decentralised realm, no central bank or pivot financial institution is looking after the operations. And that’s where the consensus mechanism – Proof-of-Stake – has a role to play.  

The Proof-of-Stake consensus mechanism ensures that the transactions are verified and secured without help from any bank or centralised payment processor. 

Ethereum’s Shift to Proof of Stake

In 2022, Ethereum made a significant shift from its earlier “Proof-of-Work” (PoW) consensus mechanism to the “Proof of Stake” (PoS) consensus mechanism. Several reasons drove this decision for Ethereum, including better energy efficiency, low entry barriers, reduced centralisation risk, low energy requirement, and better protection from breaches or cyber vulnerabilities. 

PoW computations use a lot of energy. Unlike PoW, PoS uses less energy, and less ETH issuance is required to incentivise participation. Since the computation requirements on PoS are less, it does not require energy-intensive, high-grade hardware to create new blocks. Reduced hardware requirement makes PoS a more inclusive arrangement than PoW. Decentralisation is also a strong point for PoS. It has more nodes to secure the network, leading to enhanced efficacy. 

Because of a higher degree of decentralisation and a robust penalising structure for fraudulent behavior on the chain, 51%-style attacks prove more costly on PoS than PoW. 

The advantages of shifting from the PoW to PoS get compounded when we bring Liquid Staking to the scene. 

Why is Liquid Staking Better?

A gold ethereum coin in the middle of other buried ethereum coins

One of the relative drawbacks of the traditional staking process is that it makes the ‘staked’ assets illiquid. Currently, while staking your assets, you need to lock your currencies for a fixed or variable period. It is only after this period is over will you earn rewards as a yield to locking your currencies. Another type of staking known as liquid staking takes this aspect of asset immobility away from the mechanism. 

In Liquid Staking, once you stake your assets, which are the native tokens of a chain, you receive a staking token in exchange. These staking tokens represent the staked tokens on a 1:1 basis. For instance, if you have staked two Ethers (ETH), you will receive 2stETH tokens. Not only do these st Tokens keep your assets mobile, but they also help you earn additional yield. 

The Advantages of Liquid Staking on Ethereum

When Ethereum shifted to the PoS consensus from the PoW, validators required a mandatory deposit of 32 ETH into the deposit contract. Those who deposited 32 ETH could then run an execution client, a consensus client, and a validator – three separate pieces of software. However, users who do not want to deposit such a substantial amount of ETH can participate in pooled staking. Pooled staking also implied mobility as pool participants could withdraw staked ETH at any time. 

According to studies on the topic, these liquid staking holdings were skewed toward long-term holders. However, pool protocols have come up that are attracting new deposits faster than established services. Lido Finance and Rocket Pool are examples of such services. These decentralised applications offer liquid staking services on Ethereum and some other selected currencies. 

These services play a key role in facilitating smooth and seamless liquid staking on Ethereum. When it comes to the relative share of staked ETH by the entity, Lido finance leads the race by occupying nearly 31% of nearly 13.4 million staked ETH, followed by Coinbase (15%), Kraken (8.5%), and Binance (around 7%).

There are reasons why people are opting to go for these liquid staking pools. They imply utility and security for ETH holders as well as decentralised finance applications. Since Ethereum shifted to the PoS consensus mechanism, stETH has seen a 127% surge in average daily trading volume. Every investor wants to have their fair share of this growth. And liquid staking protocols are allowing people to leverage this growth. 

For instance, the Coinbase liquid staking pool (cbETH) has offered more than 43% growth over the past three months. In a remarkable performance, cbETH surpassed all other assets besides stETH in supply, although it was launched only in August 2022. Rocket pool is another successful performer when it comes to offering returns on staked Ethereum. It has seen more than 52% growth over the past three months. 

Few Challenges to Address

While growth is evident, liquid staking of ETH is also facing some challenges. And one of the core challenges is the over-centralisation of some of the protocols. The ownership of Lido’s native governance token LDO, for instance, is highly concentrated. 

Excluding treasury, the top 9 addresses control nearly 46% of its governance power. Even LIDO understands this bottleneck and is making attempts to solve it through initiatives like dual governance and a set of legally and physically distributed set of validators. 

The overall staked ETH landscape also points towards centralisation, with a blockchain analytics platform showing that only five entities held nearly 64% of staked ETH. Although there were more than 425,000 validators and around 80,000 depositors, it was a concern that a small group of depositors could have their command over a significant share of staked ETH. 

However, many investors also prefer centralised entities as many decentralised applications ask for deploying complex, on-chain yield-bearing strategies. 

Liquid Staking on Ethereum Has Picked Up 

With its fair share of advantages and disadvantages, the liquid staking on Ethereum has gained major traction in a short span. According to the latest report, 11% of the total circulating ETH is staked. But liquid staking already dominates with a 65% share to 35% for traditional staking. 

Ethereum is one of the most well-known assets in the crypto world. In terms of total market capitalisation, Ethereum’s presence is nearly one-fifth of the entire crypto market. Its importance stems from the fact that it helps expand the ecosystem by helping developers create decentralised applications, exchanges, lending and borrowing protocols, and more. The provisions of liquid staking add an extra layer of advantage to Ethereum’s benefits as a chain.

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