How Liquid Staking Can Improve DeFi

Decentralized finance (DeFi) created a marketable shift in the history of crypto assets. Unlike conventional finance, it avoids centralized intermediaries, offers tremendous potential to lower the bar for entry into financial markets, and enables a seamless exchange of value.

Looking at the growth of DeFi, it is evident that this new, open financial economy is growing at a tremendous pace. In July 2020, the DeFi platforms’ locked value was estimated at $3.6 billion, which has now surpassed $100 billion.

With the introduction of liquid staking, there is going to be further potential for highly liquid and interoperable financial services.

What is Liquid Staking?

Traditionally, staking in PoS protocol-based projects has mainly sought to lock in one’s assets in a single network for a long time and allows expecting a fixed, predetermined staking income in return. While it guarantees the investment return on staked assets, as does a bond, it also limits token owners’ opportunities of generating higher returns on those assets from the DeFi ecosystem.

Liquid Staking and Its Benefits: A Deep Dive by Lido | Alexandria
Image via Coin Market Cap

How is Liquid Staking Different From Normal Staking?

If you’ve staked your crypto holdings, you’re essentially in what’s called a liquidity crisis.

As its name suggests, as with liquid staking, this allows you to utilise the staked crypto assets in several available trading or investing opportunities to enable getting the best of both worlds – the reward you expect on your staked assets, as well as the APR, returns from new trading/investing opportunities that you spot.

What Is Liquid Staking? Staking Yields Are Not Enough, Yield-Hungry  Investors Turn To 'Liquid Staking' To Juice Yield

This mechanism works by tokenising the stakes so that the token holders can use them as collateral in other financial applications. Tokenised stakes, also called staking derivatives, work very much like derivatives where they can trade them freely among users, locations, and even blockchains. 

That’s one of the main reasons liquid staking has become so popular. Several new projects featuring liquid staking are popping up in the DeFi ecosystem, and crypto token holders are interested in earning more on their stakes.

What Are the Challenges of Liquid Staking?

In theory, liquid staking is another form of derivatives that could help investors instantly increase liquidity. Still, those staking derivatives are not necessarily fungible, and the health of underlying risk is not considered.

In practice, speculation, appreciation, network adoption, and reliability all come into play when evaluating a staking derivative. Due to this, it may be difficult to aggregate them efficiently since it is much more complicated than a simple sum.

Hypothetically speaking, a validator could also short its own derivative token and profit from decreases in its price. When borrowing large amounts, a validator entity could profit from this decrease since it can pay back the borrowed tokens at a lower price.

How This Is Relevant to DeFi

DeFi is an innovation in that it allows you to simultaneously hold on to your crypto assets and earn from their liquidity – whether it is to earn interest, borrow money, or yield farming. This is substantially different from traditional finance, where once you have invested in a stock or some other investment vehicle, you can only make gains as the price of the asset rises or falls.

Liquid staking is essentially an extension of that innovation, and the primary argument in favour of it is that idle assets should have the ability to be used as collateral in other financial applications. As such, it opens up greater possibilities for investing and thus the connection to DeFi. For instance, you can take most staked assets on a blockchain, tokenise your asset’s staking positions, and integrate them into other protocols.

This enables investors to manage their risk exposure and earn additional returns on staked crypto assets. Moreover, the flexibility of use in assets is an essential feature of DeFi and has been proven to lead to more innovation in the Ethereum ecosystem.

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