What is liquid staking and why does it matter?

Liquid staking refers to obtaining a tradable asset in exchange for staking a cryptocurrency in a proof-of-stake blockchain. 

Unlike traditional staking, which locks up a user's tokens until they're unstaked, liquid staking lets users retain access to the value of their staked assets for use across decentralized finance applications or other web3 protocols.

How liquid staking works

Users must first lock up their cryptocurrency tokens (e.g., ether or solana) in a smart contract or platform that supports staking. By doing so, they contribute to the security and consensus mechanism of the blockchain network and earn staking rewards in the form of additional tokens.

In return for staking their tokens with a liquid staking provider, users receive a staked asset or staking derivative called a liquid staking token (LST). LSTs represent staked tokens and can be used as collateral in lending protocols or traded on various DeFi platforms.

Example of liquid staking

Decentralized platform Lido Finance lets users stake their ether and receive a staked asset called stETH, or staked ETH, in return. These stETH tokens represent users' staked ETH on Ethereum. This LST can be used across various DeFi applications while the user still accrues staking rewards. 

Lido is one of the most popular protocols for this type of staking and maintains a high lead in total value locked, according to The Block's Data Dashboard.

Centralized versus decentralized

Crypto exchanges like Coinbase and Binance provide popular centralized methods of liquid staking. Users delegate their cryptocurrency assets to a centralized platform, which acts as a custodian and staking operator on behalf of the users.

Centralized liquid staking platforms offer convenience for users who may lack the technical expertise for getting started with liquid staking, but it also exposes users to counterparty risks associated with centralized platforms such as insolvency, mismanagement or regulatory issues. 

Decentralized liquid staking protocols, like Lido Finance and Rocket Pool, eliminate single points of failure. Users maintain sovereignty over their assets and do not need to trust centralized intermediaries. However, decentralized liquid staking may require users to have web3 technical expertise like familiarity with decentralized protocols or smart contracts. Users must also consider factors such as gas fees, smart contract risks and network congestion when participating in decentralized staking.

Drawbacks

Here are a few things to consider: 

1. Smart contract risks: Liquid staking platforms rely on smart contracts to issue staked assets or staking derivatives. Users are exposed to smart contract risks, including vulnerabilities, bugs and exploits, which could result in the loss of their staked tokens.
2. Reduced governance rights: When users stake their tokens on liquid staking platforms, they may relinquish certain governance rights associated with their tokens, such as voting rights in on-chain governance protocols. This could limit users' ability to participate in network governance decisions.