Understanding Liquid Staking

Liquid staking is the biggest DeFi narrative in terms of TVL.

Let’s break down this concept from its root ELI5.

(Explain Like I’m 5)

We’ll cover:

  1. Understanding Blockchain Transactions

  2. The Dinner Party Analogy

  3. The Liquid Staking Era

  4. Staking vs Liquid Staking

  5. Risks Associated w/ Liquid Staking

Let’s goo.

1. Understanding Blockchain transactions

Before introducing the notion of staking, we need to come back to the basics first.

How a transaction operates on the blockchain.

It’s actually pretty simple:

Consider this scenario:

Bob wants to send Marie some crypto:

He initiates a transaction (tx).

Tx is placed in a block, sent to validators.

Validators inspect it.

One, the 'champion', confirms it.

Peers validate the champion's decision.

Champion gets their reward.

Confirmed tx in its block, joins the blockchain.

Marie gets her crypto!

2. The Fancy Dinner Party & Staking


I forgot to tell you something important about the tx validation process.

The 2 most popular methods are Proof-of-Work (PoW) & Proof-of-Stake (PoS).

Hmmm, how to explain…

💡 Let’s use this metaphor:

Imagine a dinner party where guests need to validate activities to do and the one who chooses an activity that benefits all earns a reward.

  • In a PoW scenario:

It's like having guests compete in a physical challenge.

And the winner gets to decide the evening's activities.

Guests put in the "work" to earn the right to decide.

  • In a PoS scenario,

It’s like giving decision power to guests who have invested in the party.

One guest is chosen randomly or based on some criteria like the amount of their investment in the party.

All guests have something "at stake" in the dinner.

In both scenarios, guests are incentivized to make choices that benefit all because if they make poor choices that ruin the party, they stand to lose their reward.

In this metaphor:

  • Fancy dinner party = Blockchain

  • Guests = Validators

  • Investment = Staked crypto

Translating to Blockchain:

🔨 PoW Validators = Miners using specialized equipment 🔐

PoS Validators = Stakers locking crypto on the blockchain

You got it right!

Staking means locking up a certain amount of crypto on a blockchain to validate and secure network transactions in exchange for rewards.

Here, the main differences between the 2 methods:

Now that we understand how staking works, let’s dive into Ethereum staking.

Here’s how it works:

Ethereum traditional staking can be challenging.

Due to the high minimum staking requirement (32 ETH worth $50k at this time) and management complexities, it is hardly accessible to regular retail investors.

And that’s the moment where liquid staking enters the stage.

3. Liquid Staking (LS)

Lido offers a prime example of liquid staking platform and it’s currently the biggest DeFi protocol (all categories included) in terms of TVL.

So… here’s how liquid staking works:

  • Liquid staking platforms like Lido simplify staking for users and allow them to earn rewards.

  • Once you delegue your crypto on such platforms so they can stake them on your behalf, you get a token representing your staking position (stETH in this example)

  • Previously illiquid crypto staked in traditional staking, becomes liquid with this “proof of staking” token and can be reutilized in other DeFi platforms.

4. Traditional Staking vs Liquid Staking

5. Risks Associated w/ Liquid Staking

Every silver lining has a cloud.

As appealing as it can be, liquid staking just like any other DeFi product comes with its own risks:

1) Smart Contract Vulnerabilities

Liquid staking often relies on complex smart contracts. Any vulnerability or bug in these contracts can lead to the loss of staked assets or other unforeseen consequences.

2) Platform Centralization

Some liquid staking platforms might control a significant portion of a network's staked assets, leading to centralization concerns and potentially making the underlying blockchain less secure.

3) Token Value Fluctuation

The value of the staked token representation (e.g., stETH) might not always align perfectly with the staked asset's value, leading to pricing discrepancies.

4) Regulatory Concerns

Depending on jurisdiction, the issuance and trading of tokenized staked assets might come under regulatory scrutiny, potentially impacting their utility or tradability.

5) Dependence on 3rd Parties

Many liquid staking solutions rely on third-party validators or platforms. The mismanagement or malicious behavior of these entities could impact users' staked assets.

6) Operational Risks

Downtime, system failures, or other operational issues with the liquid staking platform can impact users' ability to stake, unstake, or trade their tokens.

7) Liquidity Concerns

In some cases, the secondary market for the staking tokens might not be very liquid, making it challenging to sell or trade them.

That’s a wrap!

I hope you now have a better understanding of the basics of liquid staking.

If you need DeFi content for your project, let’s discuss:

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