Liquid Staking: What It Is and How It Works

Liquid staking is an innovative mechanism in the cryptocurrency world that enhances the traditional process of staking. It allows participants to earn staking rewards without locking up their assets, thus providing liquidity that was previously unavailable in standard staking methods. This article explores the fundamentals of liquid staking, how it operates, compares it with traditional staking, and discusses its advantages and disadvantages.

What is Staking? 

Staking is a critical component of the Proof-of-Stake (PoS) blockchain ecosystems, whose primary purpose is to ensure the security and efficiency of a blockchain network. In PoS systems, unlike their Proof-of-Work (PoW) counterparts such as Bitcoin, blocks are not mined but rather forged or minted. Holders of the cryptocurrency can "stake" their coins in a network’s wallet to become validators. Validators are chosen to create new blocks and verify transactions based on the amount of cryptocurrency they hold and are willing to "lock up" as stake.

Beyond transaction validation, staking often involves participation in the blockchain's governance. Stakeholders may have the right to vote on key issues such as network upgrades and changes in protocol, reflecting their stake in the network's well-being and future. This not only decentralizes the management of the blockchain but also incentivizes stakeholders to act in the network's best interest.

The incentive for staking is the potential to earn rewards, typically in the form of additional coins or tokens. These rewards are distributed either through new blocks created in the blockchain, transaction fees, or a combination of both. The reward mechanism encourages holders to stake their coins rather than leaving them idle, thereby enhancing the network's security.

However, staking is not without risks. The staked coins are often locked for a period, during which they cannot be traded or sold. During this period, if the market price of the staked cryptocurrency falls, the staker might incur a notional loss, despite earning staking rewards. Additionally, there's the risk associated with the security of the staking platform or wallet, which, if compromised, could lead to a loss of staked assets.

What is Liquid Staking?

Liquid staking represents a significant evolution in the staking landscape, providing cryptocurrency holders with enhanced flexibility and utility for their staked assets. This innovative approach allows participants to support the network through staking while also maintaining access to their capital for other uses.

At its core, liquid staking addresses one of the main drawbacks of traditional staking: the lack of liquidity. In traditional staking models, users must lock up their cryptocurrency assets for a set period, during which they cannot access or use these assets in any other form. This can deter potential stakers concerned about losing trading opportunities or needing quick access to their funds in a volatile market.

Liquid staking offers a solution by allowing stakers to receive representative tokens, often referred to as staking derivatives, in exchange for the cryptocurrencies they stake. These tokens accurately represent the staked assets and include the rights to any staking rewards earned from the assets.

How Does Liquid Staking Work?

When a user engages in liquid staking, they send their tokens to a staking contract and, in return, receive an equivalent amount of liquid staking tokens. These tokens serve multiple purposes:

• Liquidity: They can be traded or used as collateral in various decentralized finance (DeFi) applications, allowing users to participate in additional investment opportunities without sacrificing their staking rewards.
• Flexibility: Users can potentially unstake their assets more quickly or adjust their staking positions in response to market changes.
• Compound Returns: Holders of liquid staking tokens can use these tokens in other yield-generating activities, potentially compounding their returns by earning multiple streams of income simultaneously.

Liquid staking relies heavily on the integration of smart contracts and decentralized protocols, which automate the tokens’ issuance, management, and redemption. These contracts ensure that the staking process and the allocation of staking rewards remain transparent, secure, and in line with the underlying blockchain's governance rules.

Several blockchain networks and protocols have developed their own versions of liquid staking, each with unique features tailored to their specific ecosystem. For instance, Ethereum's implementation might focus on enhancing scalability and reducing transaction fees, while another network might prioritize cross-chain functionality to appeal to a broader range of DeFi applications.

Advantages of Liquid Staking

Liquid staking introduces several benefits over traditional staking methods, primarily centered around liquidity, utility, and financial efficiency. These advantages make it an attractive option for cryptocurrency holders who wish to maximize the potential of their assets while contributing to the security and functionality of blockchain networks.

Enhanced Liquidity

One of the most significant advantages of liquid staking is the enhanced liquidity it offers compared to traditional staking. In a conventional staking setup, assets are locked up for a period, during which they cannot be accessed or sold, even if the market conditions change or the holder needs immediate liquidity. Liquid staking circumvents this by issuing liquid staking tokens that represent the staked assets. These tokens can be freely traded, sold, or used as collateral in other decentralized finance (DeFi) operations, providing stakers with much-needed flexibility.

Increased Capital Efficiency

Liquid staking enhances the capital efficiency for stakeholders. In traditional staking, the capital is dormant; it generates staking rewards but cannot be used for any other purpose. With liquid staking, the issued staking derivatives allow holders to engage in additional investment opportunities such as yield farming, lending, or even providing liquidity to trading pools. This dual functionality enables stakers to potentially earn multiple streams of income from the same initial capital investment.

Risk Mitigation

Staking in traditional formats exposes holders to significant market risk, primarily due to the immobility of their assets. If the market drops significantly, stakers cannot unstake and sell their assets without entering a potentially lengthy unbonding period, during which losses could mount. Liquid staking derivatives provide a buffer against this risk by allowing stakeholders to react more swiftly to market changes through the tradeability of the derivative tokens.

Operational Flexibility

Liquid staking also offers operational flexibility that is absent in traditional staking. For example, in many staking models, there is an unbonding period during which assets cannot be moved or traded. Liquid tokens, on the other hand, can typically be redeemed or swapped for the underlying assets with minimal delay, allowing stakers to adjust their positions in response to changing network conditions or personal financial needs.

Participation Thresholds

Traditional staking often comes with high minimum thresholds, which can be a barrier for smaller investors. For example,  Ethereum requires a minimum of 32 ETH (roughly $100,000 as of mid-April 2024) to participate in staking as a validator. Liquid staking, on the other hand, often allows for lower entry points, making it more accessible to a broader audience. This inclusivity strengthens the network by increasing the number of participating validators, which can lead to a more robust and secure blockchain.

Cryptocurrencies Supporting Liquid Staking

Liquid staking is supported by several major blockchain networks, each of them having its unique characteristics and requirements for staking.

Ethereum, a leading blockchain network, has embraced liquid staking with its shift to a PoS consensus mechanism in 2022. Participants can stake their ETH to receive liquid staking tokens like stETH, which are usable across various DeFi protocols and can be traded on supported exchanges.

Similarly, other prominent blockchains such as Polkadot, Cardano, Avalanche, and Cosmos have also adopted liquid staking. Each of these networks provides its distinct liquid staking solutions, enhancing flexibility and liquidity for their users.

Adding to the landscape of liquid staking, Stroom Network introduces a novel approach for Bitcoin, a cryptocurrency traditionally not associated with staking due to its PoW consensus mechanism. Stroom Network's protocol, currently in the testnet mode, enables Bitcoin holders to participate in liquid staking by issuing representative tokens against their Bitcoin holdings. These tokens (stBTC and bstBTC) can be used similarly to those issued in Ethereum's liquid staking model, allowing Bitcoin holders to engage in DeFi activities without relinquishing control of their underlying assets. 

This innovation not only broadens the utility of Bitcoin but also integrates it more deeply with the burgeoning DeFi sector, potentially increasing its value proposition and appeal to a wider range of investors and users. Stroom Network's protocol, therefore, represents a significant step forward in bridging traditional cryptocurrencies with modern financial mechanisms, enhancing liquidity and functional diversity across the blockchain ecosystem.

Conclusion

Liquid staking emerges as a compelling advancement within the cryptocurrency domain, addressing the traditional limitations of staking by enhancing liquidity and flexibility for asset holders. This innovative method allows stakeholders to remain actively involved in the market, offering them the freedom to trade, leverage, and optimize their assets without foregoing participation in the vital network support activities that staking entails. By providing liquid staking tokens as a representative of the staked assets, participants gain access to instant liquidity and the potential for diversified income streams, further enhancing the capital efficiency of their investments.

Moreover, liquid staking reduces the entry barrier for smaller investors, fostering broader participation and consequently strengthening the security and robustness of blockchain networks. As more blockchains adopt and refine liquid staking solutions, the potential for increased integration with decentralized finance activities and the broader financial ecosystem grows. This not only enriches the blockchain's utility and appeal but also propels the entire cryptocurrency market toward more mature and sophisticated financial mechanisms, one of which is being built by us at Stroom Network. 

To learn more about Stroom, access detailed information about our technology, or explore how you can join the ecosystem, visit the following resources:

Official website: https://stroom.network/ 
Whitepaper: https://stroom.network/Primer.pdf 
Twitter (X): https://twitter.com/StroomNetwork 
Discord: https://discord.gg/DZ53WjDXz9 
Telegram: https://t.me/stroomnetwork