Understanding liquid Ethereum staking
To understand what liquid Ethereum staking is, we need to start where Ethereum is coming from. In the beginning Ethereum was a Proof of Work (POW) based blockchain, which means that you could run a mining rag with graphic cards to mine Ethereum, similar how Bitcoin is mined. But Ethereum was planned from the beginning to change this heavy energy consuming mechanism to a more environmental friendly mining method. This happened on September 15, 2022 with an Ethereum upgrade called "The Merge", which switched mining process of the blockchain from POW to Proof of Stake (POS). The transition changed the way how Ethereum is mined and users can now stake 32 Ethereum to participate as a validator and mine Ethereum. [Source]
Staking Ethereum
Now that graphic cards are obsolete for Ethereum mining, the interest shifted to participate as a validator on the network. But to run your own validator a user would need to stake 32 ETH, which would mean even at a price of $1,000 USD about $32,000 USD as starting capital. Anybody who is not willing or can't afford that much still has the option to join a staking poo. These pools will let users stake less and still earn fractions of the total rewards.
These staking pools does have a few benefits compared to solo staking.
- Can stake lower amounts than 32 ETH
- No hardware setup
- No node maintenance
- Partly Liquidity tokens - possibility for DeFi (Decentralized Finance)
Liquidity Tokens
One of the biggest difference between solo staking and pooled staking is, that some projects are offering liquid tokens in exchange when staking Ethereum with them. If you keep your liquid tokens, you can still accrue fees while staking your Ethereum but also can use the received liquid token to participate in other decentralized finance protocols to earn more fees, interest or rewards.
A very basic part is to create a "Liquid token / Ethereum" pair on an exchange like Curve. It is also the part which makes the liquid token actually liquid, as you can exchange the liquid token on a decentralized Exchange (DEX) back to Ethereum based on these liquidity pools. Liquidity providers offering liquid token / Ethereum pairs have the advantage that they can earn direct fees on every transaction.There are also incentivized pairs where users can further stake their created liquidity pairs (LP tokens) to receive as an example governance tokens from a project. Or a user can use his liquid token as collateral to get a loan from platforms like Oasis.
The Risk
In general there are several risks involved in general when using DeFi protocols. They mainly involve the circumstance that we are using a platform that is running mainly on the blockchain without a middleman.
- Token Risk
- Smartcontract Risk
- Regulatory Risk
- Impermanent Loss
- Counterparty Risk
So let's dive into each risk to see where they are coming from.
Token Risk
When using staking platforms based on DeFi, it does involve in some forms different kind of tokens. It could be the token that a user receive when staking on the platform as an example in form of stETH for the Lido.fi platform. In that case the stETH token accrues automatically staking rewards and should normally have a higher price than liquid ETH itself. But the financial mechanics for stETH and ETH are working based on stable liquidity pools, which are also at then end tokens, which have combined ETH and stETH to be able to swap them each other. Now risks like depegging of ETH and stETH could happen (and had happen before) when there are interested parties that are attacking the liquidity pool. Other token risks are when specific tokens from staking platforms are distributed as additional rewards, like $LDO from the Lido platform and used as leverage. Whenever a token is exposed to leverage there is always the risk of a liquidity attack. In these kind of attacks, a large amount of attack fund is used to depeg a specific pair and short it at the same time at another platform to gain based on the attack. These kind of architecture are also combined with leverage platforms to increase the attack effect.
Smartcontract Risk
When we are using decentralized platforms, we are eliminating the middleman with software based on a blockchain. The problem here is that at the end the software itself is normally also programmed from somebody in the beginning, which means that it could be vulnerable at some point. It happens sometime not directly at the platform, as they try to secure themselves as good as possible and open sourcing their code for a better protection. But when, as an example, an attacker choose a bridge to hack the code and mint more tokens than allowed, this would have a massive financial effect on every token that would be affected.
Regulatory Risk
The SEC and other institutions can have a massive effect on how DeFi protocols work or not. As an example Tornado Cash was even regulated based on a smartcontract level major Ethereum RPC's decided to follow the rules and block Tornado Cash. If any regulatory body would decide to either block or make a service not available in the US, it would have a direct effect on how somebody could use a staking service for Ethereum.
Impermanent Loss
Using a staking service and receiving a liquid token normally does not involve any impermanent loss. But if you are providing liquidity like a stETH-ETH pair, an impermanent loss could happen in the case of a depeg .
Counterparty Risk
When you are using staking protocols to earn liquid tokens and use them to give a loan and increase your potential interest rate, you are also involved in counter party risk. Counterparty risk means that you are loaning your assets to someone who does not repay you. When depositing liquid Ethereum tokens to a lending pool, you will have to ask yourself the basic questions to whom you are lending your assets and what risks are involved in return of the interests.
The Use cases
Liquidity Pools
Ethereum staking projects are giving in most cases a liquid token when staking Ethereum. This has the advantage, that you can accrue on the one side rewards for staking Ethereum and also still use your assets to participate in DeFi and increase your rewards. But to make liquid tokens actually liquid, you will need to create a liquidity pool for your token. If we take Lido, which is currently the biggest staking platform for Ethereum, as an example, investors can use their Ethereum and stETH to pair them on an AMM (automated market maker) DEX like Uniswap, Sushiswap or Curve. These liquidity pools allow users to swap their vanilla ETH directly to stETH and vice versa. Liquidity provider can earn fees on each transaction while providing liquidity for a pool. Providing liquidity in these pools is normally coming with lower risk, as they are in theory stable. (Look at Impermanent Loss above for further information)
Lending
Lending protocols are platforms where users can deposit their liquid Ethereum staking tokens and borrow assets while accruing still rewards for staking ETH. There are different platforms available like Aave, Maker, Compound, Cream and Alpha. Theoretically, a user could stake Ethereum to receive as an example stETH, deposit it on a lending platform to borrow Ethereum and stake it again, and so on.
The risk for these kind of strategies is, that while borrowing assets your deposit is always exposed to price fluctuations which could result in liquidation of your collateral.
Aggregators
Platforms like Yearn, Harvest or Badger allow to maximize the rewards, as they add an additional layer of rewards on top of the already existing staking rewards.
Summary
Investors now have different kind of options to stake their Ethereum and earn rewards based on staking. Diverse platforms are offering not only smaller amounts of Ethereum to stake, but also liquid tokens for every staked ETH, which allows to follow advanced strategies and earn more rewards on DeFi protocols.
It has to be considered that these strategies does come with their own risks, as DeFi and also ETH 2.0 staking itself is still very new compared to TradFi instruments.