Liquid Staking Derivatives ("LSD")

This week we focus on Liquid Staking Derivatives, what they are, the pros and cons, and whether to go Centralized or Decentralized with them.

Author

P Z
May 12, 2023

Liquid Staking Derivatives

Liquid Staking Derivatives (“LSD”) offer a unique value proposition to the Decentralized Finance (“DeFi”) ecosystem and its users. DeFi can be complicated, and a term like Liquid Staking Derivatives (”LSD”) can get confusing for those that are unfamiliar with the jargon.

Before we jump into what this narrative is about and what LSD’s are in the Web3 ecosystem, let’s define some terms:

Definitions

Staking

Staking is a financial term specific to the crypto industry.

Staking involves supporting a blockchain network's operations by locking up some cryptocurrency in a wallet. This allows users (?) to participate in the proof-of-stake (PoS) consensus mechanism. Validators (also called stakers) are chosen to create new blocks and validate transactions based on how much cryptocurrency they hold and are willing to "stake" as collateral in PoS-based blockchain networks. Validators will get rewarded for being chosen in this instance.

For our purposes, it involves locking up crypto assets in a protocol to earn rewards over a period of time which the user usually decides upon.

Liquidity

Liquidity means how easy it is to buy or sell something in a market without changing its price much.

A market with lots of buyers and sellers is highly liquid because assets can be easily turned into cash or other assets without affecting prices much.

In a market with few participants, prices can swing a lot when assets are bought or sold because there aren't many people involved. This is because with fewer buyers and sellers, the spread between the bid and ask prices becomes greater, making it more expensive to trade.

Derivatives

Derivatives are financial tools that get (or ‘derive’) their value from something else. People use them to do different things like protect themselves from price changes, make bets on price changes, or invest in different types of assets. Some common examples of derivatives are options, futures, and swaps.

For our purposes, a liquid staking token is a derivative because it represents the underlying staked asset.

What are Liquid Staking Derivatives?

Staking involves locking up tokens in a smart contract within a protocol, which requires you to reclaim your tokens before utilizing them. This isn’t ideal because you effectively lock up your funds.

Liquid staking enhances this process of staking by minting a new token that represents your locked-up tokens along with any associated rewards or penalties. This liquid staking token is tradable within the DeFi ecosystem and can be redeemed at any time through the native protocol to unlock the original stake's rewards or penalties.

Essentially, liquid staking offers the same benefits as traditional staking while providing greater flexibility, as you can use the value of your liquid staked assets as collateral in DeFi ecosystems without needing to reclaim them first.

The liquid staking token is a representation of the staked tokens and can be traded or used as collateral elsewhere. For this reason, liquid staking tokens are sometimes referred to as liquid staking derivatives.

Centralized vs Decentralized

This is crypto’s classic debate. In the context of LSDs, you basically pick your poison.

Centralized exchanges (CEX) provide custodial services and manage your assets on your behalf. CEX’s are also regulated and thus have been forced to be regulatory compliant, which adds an extra layer of security, and legitimacy if you will. This can be a benefit, but in the world of crypto, it can also be a major drawback, as we saw with the FTX incident where funds were locked and people were unable to withdraw them.

With decentralized protocols, you are in control of your assets. They are non-custodial, but this freedom comes with risks. Smart contracts operate these protocols, and they are susceptible to hacks and exploits, historically more so than a CEX.

The choice between CEXs and decentralized protocols will depend on your preference, risk tolerance, and the level of control and trust you want in the staking process.

LSD Pros and Cons

Pros

  • Enhanced yield
    LSD’s allow users to enhance their earning potential because their staked assets are liquid. This means that users can interact with other DeFi protocols which offer lending or yield farming products, whilst still earning staking rewards.

  • Liquidity
    The main benefit is that users have access to the value of staked assets immediately without needing to unstake those assets and forfeit their staking rewards.

  • Technical advantages
    When staking normally, you delegate your stake to a single validator. This comes with a small risk of your tokens being "slashed" by the blockchain if the validator misconfigures their hardware or experiences significant downtime. However, when staking into an LSD pool, the pool's tokens are staked across many different validators. In the event of a "slashing," the penalties are socialized across the entire pool. | -

Cons

  • Complexity 
    LSDs add another layer of complexity to the staking process which might be confusing for newer users in particular. With LSDs other smart contracts can get involved, and if those are hacked or exploited, the LSDs can be stolen and the value of those staked assets would be gone.

  • Secondary market risk
    LSD’s are tradable assets, hence their value can be affected by market volatility. Furthermore, the price of the LSD is not pegged to its underlying asset, and price fluctuations of the LSD do not directly correlate with the staked asset. This means users need to be careful if they intend on using LSDs as collateral in DeFi lending protocols.

  • Reduced overall liquidity

    The immediate liquidity of an LSD comes at the price of reduced overall liquidity. For instance, ETH trades between $10b-$30b of volume per day whilst the largest LSD, stETH, trades less than $5m-$20m per day. If you’re a small fish it may not matter so much, but whales should carefully consider which LSD market they’re entering. |

Conclusion

LSDs offer a unique opportunity for investors to benefit from a double-whammy in their investment strategies. They can earn rewards by staking the original asset and use the LSDs that come from locking those assets to earn yield, lend, or use as collateral in another DeFi protocol. It’s important to be careful, as with any new DeFi trend, but it’s promising to see that a few cons of LSDs can be overcome with careful consideration and research, particularly by looking into the secondary market for the LSD you decide to enter and understand the smart contracts involved with these LSDs.

LSDs are not a new concept, but they have gained traction in DeFi over the last month. With the recent Ethereum Shapella upgrade in April 2023, 1.1 million ETH tokens became instantly withdrawable for the first time in three years, suddenly making about $2 billion USD available. This upgrade has been a serious catalyst for the growth of liquid staking protocols generally, especially as they have become increasingly more common in the DeFi ecosystem. On April 26 for the first time, liquid staking became the leading category in DeFi for total value locked (TVL) with 17.87bn, overcoming DEX’s at $17.3bn. The opportunities presented by the use of LSDs could mean more freedom for investors and greater transaction volume in the DeFi ecosystem as fewer funds are locked up.

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