What is staking?

Staking is the process of actively participating in transaction validation (similar to mining) on a Proof-of-Stake blockchain. On these blockchains, anyone with a minimum-required balance of a specific cryptocurrency can validate transactions and earn staking rewards.

What is Ethereum 2?

Ethereum 2 (ETH2) is an upgrade to the Ethereum network that aims to improve the network’s security and scalability. This upgrade involves a shift in Ethereum’s mining model (“Proof-of-Work”) to a staking model (“Proof-of-Stake”).

Advantages to liquid staking

The most obvious advantage to liquid staking is the immediate liquidity. Exactly how large of an advantage this is depends on the blockchain and liquid staking token in question. On the Polkadot blockchain for example, stakers wishing to unstake are subject to a so-called “unbonding period” of 28 days. If a staker wished to react to a sudden market movement, they would be better off selling a liquid staking token than waiting to unstake.

The immediate liquidity of a liquid staking token comes at the price of reduced overall liquidity: Ethereum’s native token ETH trades between $10b-$30b of volume per day, while the largest liquid staking token stETH trades less than $5m-$20m per day. Large market participants must carefully consider whether the size of their position is appropriate for the liquid staking token they will receive.

An additional advantage of liquid staking is the “composability” of the yield strategies that it enables. Liquid staking tokens can be used as collateral on centralized or decentralized exchanges or lending pools, for example: the staker can lend out their liquid staking token and receive the loan’s interest on top of the staking yield. This generally applies to all of the yield strategies in decentralized finance (DeFi). On centralized platforms, staked tokens may be used as collateral for loans, margin and derivative trading, depending on the platform.

There are also advantages to liquid staking on a technical level: when staking the usual way, a token holder would delegate their stake to a single validator, who keeps a share of the reward in return for running the required infrastructure. Note that the validator usually does not need to take custody of the tokens, the tokens are merely delegated to the validator.

The risk typically associated with staking is that tokens can be taken away (“slashed”) by the blockchain if the validator misconfigures their hardware or has significant downtime. When staking into a liquid staking pool, though, the pool’s tokens are staked across many validators and slashing penalties are usually socialized across the pool. This decreases the risk of significant loss from slashing. Stakers may also consider whether staking with a certain liquid staking provider earns a higher yield due to the collection of Miner Extractible Value (MEV).