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In this article, our technical specialist Michael B. shares his insights into liquid staking — how it works under the hood, how Liquid Staking Tokens function, and what technical nuances developers and crypto users should keep in mind when working with this rapidly evolving DeFi mechanism.
Staking is a way to earn money on cryptocurrency. Its essence is that the owner “freezes” their digital assets for a certain period of time and receives a reward for this. It is similar to a bank deposit. However, the beauty of blockchain is that it is constantly evolving and offering new ways to capture additional returns. Liquid staking is one of them.
Introduction to Liquid Staking
Liquid staking unlocks capital efficiency but it also requires reliable blockchain infrastructure. Any wallet, DeFi platform, or analytics service integrating LSTs must access smart-contract data, track staking rewards, monitor token supply changes, and broadcast transactions in real time. This is where NOWNodes becomes essential. Let’s connect.
Definition of Liquid Staking
Liquid staking works through smart contracts and involves holding funds in DeFi escrow accounts. This allows access to tokens at any time, as the funds are highly liquid.
With liquid staking, users can generate yield from crypto assets in several ways, as funds can be locked but still accessible. Participants in such staking can use liquid versions of their assets again in other DeFi protocols and earn more on their initial deposits.
How Liquid Staking Works
The starting point for the development and popularization of liquid staking is considered to be 2022 and Ethereum‘s transition from the Proof of Work consensus model to Proof of Stake.
This transition increased network throughput and reduced energy and gas costs for asset transactions. These improvements opened up new opportunities for developers and enthusiasts to use smart contracts, strengthened the role of staking in the Ethereum ecosystem and accelerated liquid staking adoption.
Mechanics of Liquid Staking Protocols
It all starts the same way as with regular staking — you deposit tokens, they are “frozen” and work to maintain consensus in the network while you receive a reward for this. But the differences start to appear immediately.
First, unlike solo staking, contributors do not need to have a large number of tokens and become validators to participate in staking. But this problem is solved not only by liquid staking, but also by staking pools, so we are more interested in the following difference.
Unlike staking in its classical understanding, liquid staking allows you to operate with “frozen” assets.
In liquid staking, you send tokens to a specialized protocol (smart contract). In return, you receive a liquid staking token (LST) — a digital asset that reflects your share in the total staking pool and accumulated rewards. This token can be freely moved and used within the DeFi ecosystem.
In practice, this means that you not only earn staking rewards on your initial deposit, but you can still manage that deposit and use it to generate additional yields. For example, if you send ETH to one of the liquid staking protocols, you can receive stETH (where st means that the original token has been staked) — a token tied to your ETH at a 1:1 ratio, also known as a wrapped token.
Understanding Liquid Staking Tokens (LSTs)
What are Liquid Staking Tokens?
Liquid staking tokens (LSTs) are derivative tokens representing staked assets in a liquid staking protocol.
Different liquid staking providers may issue different types of wrapped tokens to stakers.
Rebase token. Rebase tokens work on the basis of an algorithm that automatically issues or burns tokens, distributing them among users. Such tokens are designed in such a way that their supply in circulation is automatically adjusted in accordance with fluctuations in the token price. Rebase tokens are similar to algorithmic stablecoins in that they both have target prices.
For example, you staked 1 ETH at x% and were immediately issued 1 stETH. The next day, taking into account the reward, the balance in your wallet will increase and may already be 1.01 stETH. This happens automatically, without user intervention. The downside of rebase tokens is that not all DeFi platforms support them.
Reward token. This type of token does not increase in quantity, but grows in value proportionally to the reward received. Its value is also regulated automatically and depends on the size of the staking reward, but it can only be fixed when exchanged for the base asset.
Another example: you staked 1 ETH at x% and received a wrapped token in the form of yETH. Unlike a rebase token, the stETH balance in your wallet will not change, but if you want to exchange stETH back to ETH, you will see that the next day it is no longer worth 1 ETH, but 1.01 ETH. This is a more popular type of wrapped token because it is more compatible with DeFi services.
Risks and Challenges of Liquid Staking
Despite the advantages listed above, liquid staking remains a high—risk way to generate income. The most important risks are as follows:
- Vulnerability of the protocol’s smart contract. Poor—quality contract code may contain vulnerabilities that can be exploited by malicious actors. Even proven platforms carry some risk, as new vulnerabilities may be discovered after launch.
- Market risks. Your wrapped tokens should maintain a 1:1 value with the underlying asset, but prices on secondary markets depend on supply, demand, and arbitrage trading. This occurred on the Ethereum network, for example, where stETH traded at a price 4% lower than ETH.
- Systems risks. Due to the close interconnection of DeFi protocols, including through liquid staking, problems in securing one protocol can lead to problems in several projects at once. Also, platform failure, mismanagement, or regulatory issues may make it difficult or impossible to redeem your staked tokens.
Trends in Liquid Staking
The liquid staking market continues to grow rapidly. At the time of writing, $71 billion is staked on the Ethereum network, with nearly half of that amount — $29 billion — allocated to liquid staking solutions.
The development of liquid staking is confirmed by a number of significant innovations in the Ethereum ecosystem. The emergence of the restaking model, implemented in particular by the EigenLayer protocol, has made it possible to reuse wrapped assets to secure other services, thereby increasing capital efficiency. The expansion of the number of liquid staking providers has increased competition and reduced the risks of centralization.
However, the technology brings additional risks, including smart contract vulnerabilities, market volatility, and provider dependencies.
Liquid staking is indeed more effective than traditional, but it is important to understand the additional risks that its flexibility brings.
