What are Liquid Staking Derivatives? Why Are They Important For Ethereum?

PIRIL MADASOGLU
6 min readApr 11, 2023

Liquid Staking is a process that allows users to stake their PoS tokens without having to lock them up for an extended period of time. In return, users receive liquid staking derivatives (LSDs) that represent their staked assets and allow them to participate in other DeFi activities, thereby enhancing their yield.

Last year, Ethereum transitioned to a proof of stake consensus, and the network’s security is now maintained by validators who stake their ether to operate block-producing nodes, validate transactions, and earn staking rewards.

However, there is a drawback to staking ether: it cannot be used to generate returns in other high-yield DeFi protocols. Despite stakers receiving moderate returns for transaction fees and minor extractable value, staking is not the most lucrative approach for utilizing tokens in DeFi.

LSDs are a solution to this problem, as they enable ETH holders to utilize staking derivatives. By using LSDs, users can deposit their tokens in a protocol that stakes on their behalf and entrusts the responsibility of securing Ethereum to node operators.

Once ETH holders use LSDs, they are issued protocol tokens that symbolize their staked ETH = LSDs.

Liquid Staking is a novel solution that allows users to stake their PoS tokens without having to lock them up for an extended period of time. This method allows users to receive a receipt token called a Liquid Staked Derivative (LSD) in return for staking their ETH with a liquid staking provider. LSDs are liquid tokens that are fully fungible, transferable, and fractional, similar to other crypto tokens.

By using LSDs, investors can unlock the liquidity of their staked ETH and utilize it in other DeFi activities such as selling, providing liquidity, lending, using it as collateral, and more, thereby earning additional yield on top of their staking rewards.

The value of an LSD is equivalent to the underlying staked ETH that is temporarily locked, allowing users to indirectly benefit from staking rewards while enjoying the flexibility and liquidity offered by these derivatives.

The Ethereum Shanghai upgrade is expected to enable the withdrawal of all staked ETH, offering liquidity to those who have staked their tokens. This upcoming hard fork will allow validators to withdraw their staked assets that were utilized to secure the Ethereum network. As a result, approximately 18 million ETH, equivalent to 15% of the total supply, will become available for withdrawal.

Based on data from StakingRewards, the current staked ETH supply represents only 15.64% of the total circulating ETH supply.

Staking derivatives have the potential to significantly increase the percentage of staked ETH, which could be as low as 15 to 30 percent without them. With the availability of staking derivatives, this percentage could increase to 80 to 100 percent, as there is no additional cost involved in staking as compared to not staking.

The upcoming Shanghai upgrade for Ethereum has raised concerns among some experts that a ‘sell the news’ event could occur due to individuals previously staking ETH potentially unlocking and selling their tokens, leading to a drop in prices and overall market sentiment in the short term.

However, recent data suggests that most people who staked their ETH are currently at a loss, which could encourage them to continue holding their tokens and support a bullish outlook for ETH.

Liquid staking providers provide a means to access the liquidity of staked assets through liquid staking services. In exchange for these services, the majority of providers take a commission of 5–10% from the staking rewards as their revenue.

  1. Lido Finance

The staking protocol offered by LidoFinance, known as stETH, is a leading liquidity staking solution in the cryptocurrency market. Moreover, LidoFinance has established its dominance as the largest DeFi protocol by market share, currently holding approximately 16.03% of the total value locked (TVL) in the DeFi market.

Lido’s staking page allows you to deposit ETH, and in return, you receive stETH, which serves as a receipt token representing your staked ETH (Liquidity Staking Deposit (LSD).

Lido has an impressive amount of over 5.9 million ETH staked per Dune Analytics. The staking return rate of approximately 5% coupled with the 10% commission earned would generate an estimated $50.81 million in annual revenue.

2. Rocket Pool

Rocket Pool operates differently from solo stakers in that it only requires 16 ETH per validator deposit, unlike the 32 ETH required for solo stakers to create a new validator. The 16 ETH is combined with an additional 16 ETH from the staking pool, which was deposited by stakers in exchange for rETH, to create a new Ethereum validator, referred to as a minipool.

Although minipools appear identical to normal validators on the Beacon chain, the creation, withdrawal, and rewards delegation processes are all managed by Rocket Pool’s smart contracts on the Execution layer, making the system entirely decentralized. The only difference between minipools and regular validators is the process of their creation and how they handle withdrawals when node operators opt to exit voluntarily or get slashed.

When you become a Rocket Pool staker, your primary task is to deposit ETH into the deposit pool, allowing a node operator to generate a new Beacon Chain validator. The minimum stake you can make is 0.01 ETH, and in exchange for your deposit, you’ll receive a token known as rETH. This token serves as a record of the amount and timing of your ETH deposit.

Risks: Rocket Pool is a permissionless network, which means that anyone can become a part of it. However, this also opens up the possibility of malicious actors attempting to exploit the network. To protect against such threats, node operators are required to deposit a minimum of 10% and a maximum of 150% of their bonded ETH amount in RPL tokens. This serves as an insurance policy against any potential slashing or penalties.

3. Frax Finance

The Frax protocol consists of two tokens, namely the stablecoin Frax (FRAX) and the governance token Frax Shares (FXS), along with a pool contract that holds USDC collateral.

Within the Frax ecosystem, there are two types of ETH tokens: frxETH (Frax Ether) and sfrxETH (Staked Frax Ether). frxETH is a stablecoin that is loosely pegged to ETH, with 1 frxETH always representing 1 ETH, and the total amount of frxETH in circulation matching the amount of ETH in the Frax ETH system.

When ETH is sent to the frxETHMinter, an equivalent amount of frxETH is minted. Holding frxETH alone does not qualify for staking yield, and it should be considered similar to holding ETH.

On the other hand, sfrxETH is an ERC-4626 vault designed to earn the staking yield of the Frax ETH validators. Users can deposit their frxETH into the sfrxETH vault at any time, converting it into sfrxETH and earning staking yield on their frxETH holdings.

Frax’s liquid staked ETH operates by minting frxETH when users stake their ETH with Frax.

In order to earn yield with frxETH, users must stake it with Frax to receive sfrxETH, which currently offers an annual growth rate of approximately 6.63%.

The reason why sfrxETH offers a higher APR than other ETH LSDs is that frxETH does not need to be staked in the validator nodes. All the yield from un-staked frxETH is given to sfrxETH. Thus, the less frxETH is staked, the higher the APR for sfrxETH.

Conclusion

Liquid Staking Derivatives (LSDs) offer a solution to the drawback of staking ETH, allowing users to utilize their staked assets while earning additional yield on top of their staking rewards. The availability of LSDs has the potential to significantly increase the percentage of staked ETH, which is currently low at around 15.64% of the total circulating ETH supply.

Leading providers such as Lido Finance, Rocket Pool, and Frax Finance offer liquidity staking services with varying features and benefits. With the upcoming Ethereum Shanghai upgrade expected to offer more liquidity to staked ETH, the use of LSDs may become even more popular in the future.

Please note that this article is for informational purposes only and should not be considered financial advice. This story was originally publised here.

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PIRIL MADASOGLU

This is Pırıl, I’m based in Turkey & I’m the content & social media manager for Ninja Squad. Follow me for content marketing, NFTs, and NFT marketing tips!