Liquid Staking: The Most Complete Guide on the Internet
The problem with traditional staking is that it locks up your tokens, so you can’t trade or use them elsewhere. And that’s where liquid staking comes in.
With liquid staking, you can stake your tokens and still use them. Platforms give you liquid staking tokens (LSTs), like stETH, which represent your staked assets and the rewards they earn. You can trade, lend, or invest these LSTs in DeFi while continuing to earn staking rewards.
Of course, it’s not all perfect. Risks like centralization, platform fees, and smart contract issues exist. But for many, the benefits of liquidity and flexibility outweigh the downsides.
This guide will help you explore the benefits and risks of liquid staking so you can decide if it’s right for you.
What is Liquid Staking?
Liquid staking is a way to stake your tokens in Proof of Stake (PoS) systems without locking them up. Unlike traditional staking, it keeps your tokens liquid, so you can use them in other activities while still earning staking rewards.
Here’s how it works: when you stake through a liquid staking platform, you get liquid staking tokens (LSTs) like stETH or rETH. These tokens represent your staked assets and the rewards they earn. You can trade them, lend them, or even use them in DeFi liquidity pools.
Take Michael, for example. He wants to stake 10 ETH but doesn’t want to lock it up. He uses a platform like Lido and gets 10 stETH in return. Michael can now use his stETH in a liquidity pool to earn extra through transaction fees, while still earning staking rewards on his staked ETH.
The benefits?
Flexibility, liquidity, and more simultaneous ways to earn. It’s a smart move for anyone looking to make the most of their crypto investments.
How Does it Work?
Liquid staking lets you stake your tokens while keeping them usable. When you stake through a liquid staking platform, your tokens are locked on the blockchain to secure the network. In return, you get liquid staking tokens (LSTs), like stETH or rETH. These represent your staked tokens and rewards.
Learn more about how proof-of-stake blockchains work here.
Here’s where it gets interesting.
You can use these LSTs in other ways. Michael, who staked 10 ETH and got 10 stETH, decides to use his stETH as collateral on Aave to borrow stablecoins. He reinvests these stablecoins in another DeFi protocol to grow his portfolio. And don’t forget, his staking rewards also grow over time, compounding automatically. Some platforms, like pSTAKE, even allow cross-chain liquidity. Michael could move his staking derivatives to another blockchain and explore more DeFi options.
Instead of sitting idle, liquid staking allows your digital assets to stay productive, helping you earn staking rewards and take advantage of other opportunities in DeFi.
Liquid Staking Vs Traditional Staking Explained
| Features | Traditional Staking | Liquid Staking |
| Lock-Up Period | Tokens are locked and inaccessible. | Tokens remain accessible via liquid tokens (LSTs). |
| Flexibility | No flexibility; funds are tied up. | High flexibility; LSTs can be traded, lent, or used in DeFi. |
| Use of Asset | Cannot use staked tokens for other purposes. | LSTs enable participation in DeFi activities like lending and yield farming. |
| Capital Efficiency | Limited; assets are idle during staking. | Maximized; assets generate rewards and can be reinvested. |
| Risk | Low; focused on staking rewards. | Moderate; involves DeFi risks like smart contract vulnerabilities. |
While we’re at it, let’s clear up any confusion between liquid staking vs liquidity pools since both involve locking assets, but they serve different purposes. Liquid staking secures Proof of Stake (PoS) networks and earns you staking rewards. Liquidity pools, on the other hand, help enable token swaps by providing trading pairs. In return, liquidity providers earn a part of the transaction fees that traders pay to liquidity pools.
With liquid staking, you usually stake a single asset, like ETH. Liquidity pools often require two assets, like ETH and USDC, to create a trading pair for decentralized exchanges.
Another important difference is how assets are represented. In liquidity pools, getting a token back (like an LP token) is the standard. These tokens show your share of the pool and any fees you earn. In traditional staking, this isn’t the case—you usually don’t receive any token as proof of your stake.
But with liquid staking, things are changing. While it’s not the norm yet, it’s quickly becoming a popular way to maximize flexibility in DeFi.
Best Liquid Staking Platforms
Here are some of the top liquid staking platforms out there:
1. Lido Finance: Lido is a top choice for Ethereum staking. It gives you liquid staking tokens (LSTs) like stETH, which can be used across DeFi platforms. It supports both Ethereum and Matic staking, making it super versatile.
2. Rocket Pool: Rocket Pool stands out for its decentralized model. You can stake as little as 0.01 ETH and get rETH as your LST. It offers staking liquidity while helping maintain a decentralized network.
3. pSTAKE: pSTAKE is all about cross-chain liquid staking. It supports assets like ATOM and BTC and offers high yields with auto-compounding rewards. You can stake through their validator set and use your liquid tokens in DeFi.
4. Ankr Staking: Ankr supports Ethereum, Binance Smart Chain, and more. Its LSTs work well with DeFi protocols, giving you flexibility and capital efficiency while earning staking rewards.
Risks and Limitations of Liquid Staking
Liquid staking is exciting, but it’s not without risks. Before diving in, it’s important to understand what could go wrong and how to manage those risks.
1. Smart Contract Vulnerabilities: Liquid staking platforms rely on smart contracts to manage your staked tokens and issue liquid staking tokens (LSTs). While these contracts are often audited, they aren’t immune to bugs or hacks. For example, if the smart contract managing Michael’s stETH is exploited, his funds could be at risk.
How to avoid: Choose platforms with strong security, multiple audits, and a good track record. Diversify your staking across different platforms to avoid a single point of failure.
2. Impermanent Loss: If you use LSTs like stETH in a liquidity pool, you risk impermanent loss. This happens when one token in the pair changes value faster than the other. Check out our in-depth guide on impermanent loss and how to avoid it here.
How to avoid: Stick to stable pools, monitor market conditions, or avoid risky pools entirely.
3. Liquidity Risks and Depegging: LSTs should ideally maintain a 1:1 peg with the staked asset. However, during market crashes, tokens like stETH can lose their peg, making them harder to trade.
How to avoid: Check trading volume and market depth of LSTs before staking. Use platforms with a strong ecosystem supporting LST liquidity.
Quick Tips to Stay Safe:
- Use well-audited platforms like Lido or Rocket Pool.
- Diversify across platforms and tokens.
- Keep some assets unstaked for flexibility.
- Regularly review market conditions.
Liquid Staking Regulations
Regulations around liquid staking are still unclear in many parts of the world. Some countries lump it under general crypto rules, while others haven’t addressed it yet, leaving users and platforms guessing.
In the U.S., the SEC has been strict about staking services. It says some staking programs are unregistered securities. For example, Kraken had to pay a $30 million fine in 2023 and shut down its staking services in the U.S. Coinbase and Consensys (with MetaMask Staking) have also faced similar actions. The SEC’s focus is on protecting investors, but it creates challenges for platforms offering liquid staking.
Elsewhere, the EU is working on its MiCA framework, though it doesn’t offer much clarity on liquid staking yet. In Asia, countries like Japan and South Korea are starting to create specific rules, but progress is slow.
Future regulations may include stricter rules for staking derivatives, which may raise further complications. For instance, we discussed how the U.S. Infrastructure Investment and Jobs Act could extend broker reporting requirements to staking and the challenges of actually applying these rules to decentralized platforms here.
Liquid Staking Taxes
Liquid staking rewards are generally treated as taxable income in most countries. When you earn rewards, their fair market value (FMV) at that time is used to calculate taxes. This works for traditional staking, but liquid staking introduces extra layers of complexity.
But why?
Well, swapping one cryptocurrency for another is usually considered a taxable event. Let’s say Michael bought 0.5 BTC for $25,000. Later, when it’s worth $30,000, he decides to swap it for Ethereum. At the time, ETH is priced at $2,000 per token.
This swap counts as a taxable event. Michael needs to report the $5,000 profit he made from the increase in BTC’s value (from $25,000 to $30,000). Even though he didn’t cash out to fiat, swapping Bitcoin for Ethereum triggers a tax obligation. Depending on his local rules, he may owe taxes on that $5,000 gain.
So, does that mean when Michael stakes his ETH and receives stETH (a liquid staking token), it’s a taxable event? In some places, tax authorities might treat receiving stETH as a trade, meaning Michael could owe taxes based on its FMV. This happens even though his original ETH is still locked.
Things get more complicated if he frequently uses stETH in liquidity pools or yield farming. Each action might trigger a taxable event, requiring him to track the cost basis and calculate gains or losses. This could lead to a cascading tax burden. This can lead to a cascading tax burden, especially if he’s frequently moving LSTs around in different protocols.
The lack of clear rules makes it harder to stay compliant. Michael would need to keep detailed records and possibly rely on tax software like Bitcoin.Tax to calculate gains and generate reports. Seeking advice from a local expert is also smart to avoid audits or penalties.
Final Thoughts
Liquid staking is a flexible way to earn staking rewards while keeping your tokens usable, but it’s important to be smart about it. Start by checking the fees on liquid staking platforms and understanding the risks, like smart contract issues or depegging.
If you’re new, start small. Learn the basics by following experienced community members and exploring strategies like leveraged yield farming. This way, you can test what works without risking too much.
Set realistic expectations. Liquid staking isn’t a get-rich-quick scheme. Building passive income takes time and patience. Yields can be lower because of platform fees, and there are always risks, especially in DeFi. Keep some tokens unstaked for emergencies and stay on top of market trends.