A Liquid staking token is a receipt issued by a protocol to resemble the underlying asset, which maintains liquidity and can be traded, borrowed, lent, or staked again, on supported dapps. It represents the ownership of staked digital assets. LSTs are issued by protocols based on deposited tokens. Liquid staking tokens are typically generated through tokenization and can represent staked assets on other networks or layer-2 solutions, enabling stakers to utilize their capital in a broad DeFi ecosystem, not being limited to a single chain. LSTs can be obtained through minting directly on liquid staking protocols or swapping on centralized and decentralized exchanges.

Liquid staking tokens come in various types, each with distinct reward distribution mechanisms, which is worthwhile for users to understand before depositing assets. These token types include:

Rebase Tokens - they automatically adjust balances based on deposits and rewards. Rebasing takes place at regular intervals, typically once per day, without any visible transactional activity for token holders. This user-friendly form of liquid staking allows your LST balance to increase as you continue to stake your assets.

Reward-bearing Tokens - their value increases over time based on exchange rates between the derivative and the staked asset. The ratio dictates LST pricing and earned rewards. The ​​LST balance remains constant, while the rate increases.

Wrapped Tokens - this mechanism describes the transition from rebase tokens to reward-bearing tokens. After wrapping, they stop automatic balance recalculations and transition into reward-bearing tokens where the exchange ratio between underlying assets changes. Wrapped LSTs often garner more popularity in DeFi because they are easier to integrate into protocols.

Dual-token Model - design where one token maintains a 1:1 ratio with the staked asset, while the other represents rewards, aiming to mitigate risks associated with blockchain technology and exploits.

stETH is designed as a rebase token, which automatically adjusts balances. To improve stETH use cases and utilization in DeFi, holders should wrap it for wstETH to unlock more yield opportunities.

Lido is a liquid staking solution for PoS networks. Lido lets users stake any amount of tokens for daily staking rewards. Lido is a liquid staking protocol backed by industry-leading staking providers that supports staking for Ethereum and Polygon. Lido lets users stake their tokens without locking assets or maintaining infrastructure, whilst participating in on-chain activities, e.g. lending, farming, and more.

When using Lido to stake your ETH on the Ethereum beacon chain, users will receive a token - stETH, which represents their ETH on the Ethereum beacon chain on a 1:1 basis. It effectively acts as a bridge bringing ETH 2.0’s staking rewards to ETH 1.0.

Liquid staking presents exciting opportunities for users to unlock the liquidity of their assets and increase yield, but it also comes with risks that must be carefully managed. Liquid staking is the largest DeFi category regarding the total value locked and users must navigate the diverse range of protocols and LSTs.

Smart Contract Risk: Smart contract vulnerabilities pose a significant risk in liquid staking. Since LSTs are created and managed through smart contracts, any bugs or errors in the code could be exploited by malicious actors, leading to the loss of funds. It is essential to mitigate this risk by selecting well-audited and reputable smart contracts. However, with open-sourced code, audits, and bug bounty programs, the inherent risk remains. When engaging in liquid staking, remember that your assets are held by a third party, introducing counterparty risk.

Slashing Risk: Validator slashing is a significant concern in Proof-of-Stake networks, where validators failing to meet network requirements may face penalties, potentially losing part of their staked assets. Users of liquid staking services delegate their validation duties, exposing themselves to slashing risks if service providers fail to comply with network rules. To mitigate this risk, protocols can distribute stakes across diverse and reputable node operators and offer additional protection such as insurance against slashing penalties. Liquid staking providers are accountable for maintaining infrastructure and technology, and any operational issues may jeopardize staked assets.

Price Depegging Risk: Price disparity in liquid staking occurs when LSTs and the underlying asset prices diverge, especially in turbulent markets, potentially resulting in losses for users upon withdrawal of staked assets. This discrepancy undermines arbitrage opportunities and market-making strategies, making it impossible to maintain a risk-free market. Additionally, low liquidity in liquidity pools can lead to the depegging of LSTs, causing high slippage during asset swaps and making it difficult for investors to sell staked assets when needed. While arbitrage mechanisms in decentralized exchanges typically help maintain pegs, a dramatic drop in total value locked can disrupt these incentives.