In September 2022, the crypto staking domain broke new ground when Ethereum through a groundbreaking update transited from the Proof-of-Work (PoW) consensus mechanism to that of Proof-of-Stake (Pos). Dubbed The Merge, the update entailed the merging of the original Ethereum Mainnet with a new blockchain known as Beacon Chain which is a PoS consensus layer. With this, Ethereum has become much more environmentally friendly as the switch to PoS would reduce the network's energy consumption by ~99.95%. Fast forward half a year, The Merge has catalyzed another new frontier in the crypto staking domain through the advent of liquid staking.
With this, let’s explore some of the key features, economic and financial aspects as well as industry examples of liquid staking. We will cover some industry examples and notable projects in our second part so please stay tuned!
Unlike conventional staking where owners of staked cryptocurrencies are unable to use them for other purposes, liquid staking is a game-changer as it allows owners of staked cryptocurrencies to use them for other purposes in the DeFi ecosystem. This is made possible by the use of the wrapping mechanism which entails the creation of wrapped tokens of the original cryptocurrencies. In essence, the wrapped token whose value is pegged to the original cryptocurrency serves as a functional representation of the original version. Whilst the original cryptocurrency is staked i.e. locked, the wrapped token can be used for other purposes in the DeFi ecosystem including for yield generation activities. Some of the pros and cons of liquid staking vis-a-vis conventional staking are as follows:
(i) Double yield generation is possible as the wrapped tokens can be used for yield generations, whereby these yield would be in addition to the rewards from the staking of the original cryptocurrencies.
(ii) The absence of a lock-up period means that liquid staking offers unparalleled flexibility as the staked original cryptocurrencies can be unstaked at any time.
(i) The wrapping of the original cryptocurrencies to create wrapped tokens entails the use of an additional layer of smart contracts which leads to increased security risks due to the possibility of the exploits of these contracts.
(ii) In times of high market fluctuations, there may be a great divergence between the value of the original cryptocurrencies and the wrapped tokens. This could affect the pegging mechanism of the wrapped tokens leading to a need to depeg which could potentially result in a significant reduction in the value of the tokens.
Economic and Financial Benefits
The element of double yield generation and absence of lock-up period in liquid staking renders it to bring about a host of economic and financial benefits as follows:
(a) Minimization of Opportunity Costs
Opportunity costs can be defined as "the potential benefits that an individual, investor, or business misses out on when choosing one alternative over another." Thanks to the use of wrapped tokens, owners of the staked original cryptocurrencies no longer have to miss out on other potential benefits in the DeFi ecosystem as they can use their wrapped tokens to capitalize on these benefits. This helps minimize the opportunity costs arising from the staking of the owners’ original cryptocurrencies.
(b) Transcending the Liquidity Preference Theory
The Liquidity Preference Theory posits that "an investor should demand a higher interest rate or premium on securities with long-term maturities." The absence of any lock-up period coupled with the element of double yield generation means that liquid staking is able to offer high interest rates without the requirement of a long term maturity period. This renders liquid staking to be transcending the Liquidity Preference Theory.
(c) Dispensation with Liquidity Premium
Liquidity premium refers to "an incremental return that compensates an investor for owning an asset that is not highly liquid". The absence of any lock-up period coupled with the pegging of the wrapped tokens to the value of the staked original cryptocurrencies means that the assets under liquid staking frameworks would be highly liquid. This renders the element of liquidity premium to be almost non-existent particularly in times of low market volatility.
Stay tuned for our part 2 where we cover industry examples and notable liquid staking projects!