Liquid Staking Derivatives: 4 Potential Risks You Should Watch Out For

What Is Liquid Staking?

Liquid staking is an alternative to traditional staking that offers greater flexibility and efficiency. Specifically, it allows bettors to access their assets while still enjoying the benefits of staking their tokens.

Token staking has traditionally had a high opportunity cost to token holders. By staking their tokens, they agree to lock their assets for a specific period of time. In doing so, they may miss out on the opportunity to profit by trading their tokens or using them in other ways. This opportunity cost may dissuade some token holders from participating in regular staking.

However, through liquid staking, networks enjoy the stability and security associated with staked tokens. At the same time, token holders have the ability to use their assets at will while still receiving staking rewards.

Why is Liquid Staking getting so much attention?

Staking their Ether prevents them from using it in other potentially more profitable ways. While stakingers will be compensated in Ether, transaction fees, and mineable value from miners, they can get a better return on their Ether by depositing it into protocols. DeFi APY is high.

Liquid bet derivatives offer the solution to that conundrum. Ether holders can pool their Ether in a protocol that runs validators on their behalf. Those holders are then assigned protocol tokens to represent their staked Ether, and those tokens can be used in other DeFi protocols as if it were Ether.

While the launch of The Merge does not allow existing bettors to withdraw their locked tokens, this will soon change with the Ethereum Shanghai upgrade scheduled to launch in March 2020. 2023.

The allure of being able to withdraw staked ETH early may attract new staking users, but not every investor has 32 ETH to stake. Since staking is a viable option for passive income, users may try to look for other ways they can staking ETH without compromising on liquidity. Thus, the increase in popularity of staking ETH on Beacon Chain also inadvertently led to the rise of liquidity staking protocols.

4 risks Liquid Staking Derivatives must watch out for

Limited options exist

There are a limited number of options for users who are looking to initiate liquid bets. Liquidity staking is a novel niche in the crypto economy and is still evolving. There are very few platforms that offer liquid staking and these platforms support not many cryptocurrencies.

Some platforms and projects have staking services and masternodes for users to earn recurring rewards in the regular staking market. However, not all of these platforms have liquid staking options. The same goes when one considers the tokens available for liquid and casual staking. Regular staking platforms support many tokens, but the number of tokens backed by liquid staking platforms is very limited.

The lack of options available in the liquid staking market can be attributed to the fact that the market is very new and small. As the liquidity staking market grows, more tokens will be supported by liquid staking platforms, and the number of liquid staking platforms will also increase.

Risk of market volatility

The problem with derivatives is that they are not automatically pegged to the original tokens through algorithmic means. Derivatives are freely traded in the market, and their prices are determined entirely by market forces. This means these derivatives can start selling for much less than their original token during a bear market or liquidity crisis.

This is not just a vision of the end of the world either. Derivatives in the Terra ecosystem drop in price almost simultaneously when the chain crashes, and this resulted in millions of dollars in losses for investors. In June 2022, the stEth token, a derivative of Eth, also fell about 7% against regular ETH due to market pressure.

When a significant drop occurs, one almost immediately loses access to their original tokens. Even if they were able to trade derivatives for their bet assets, the value of the original assets received would be significantly reduced. This is a huge risk that does not exist with normal betting.

Liquidity staking rewards are not standardized

Each staking platform has its own set of protocols on which it operates. This happens in regular staking operations, liquidity staking, and even DeFi operations. Likewise, liquid bettors experience various incentives within the crypto ecosystem.

Different platforms offering liquid staking have additional profit rewards, even for the same token. This means that specific liquidity staking platforms can offer higher returns when staking the same token, so choosing your liquidity staking platform wisely and carefully is very important.

Smart contract exploited

Liquidity staking is mainly done on smart contracts. This means that investors run the risk of being scammed into signing faulty smart contracts. That is why it is important to use reputable liquidity providers in the market or cross-check smart contracts where possible.

A centralized provider like an exchange holds custody of the assets, while a decentralized provider like Lido does not require custodial rights but instead requires tokens to be deposited into a smart contract.

Conclusion

The allure of being able to withdraw staked ETH early may attract new staking users, but only some investors have 32 ETH to stake. Since staking is a viable option for passive income, users may look for other ways to staking ETH without compromising on liquidity. Thus, the increase in popularity of staking ETH on Beacon Chain also inadvertently led to the rise of liquidity staking protocols. However, these risks can be minimized by taking careful steps in the betting process.

DISCLAIMER: The Information on this website is provided as general market commentary and does not constitute investment advice. We encourage you to do your own research before investing.

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