What are Liquid Staking Derivatives? Working Mechanisms and Case Studies

If you are familiar with staking in the Web3 ecosystem, Liquid Staking Derivatives, also known as LSDs, are a relatively new dynamic aspect of staking worth exploring.

LSDs provide a way for staked assets to become fluid instead of being locked. In their most basic form, they enable those who stake to gain liquidity on the value of their staked crypto while still earning their staking rewards.

These derivatives broaden staking access and free up capital stuck in lock-up periods. They do this by issuing tokens representing the underlying staked assets. The derivative tokens can then be traded freely, moved across blockchains, used in DeFi protocols for lending/borrowing, and more that you can think of, thus bringing liquidity to the illiquid staked tokens.

Interesting right? Oh yes, let’s get into more details!

Background and Context of Liquid Staking Derivatives

Staking derivatives are still in their early stages, with rapid evolution happening as platforms compete to offer the most innovative and useful products. One of the first staking derivative implementations was initiated in 2020 through a project called Lido for Ethereum's proof-of-stake Beacon chain. Lido enabled users to stake Ethereum while receiving liquid stETH tokens that could be freely used, like regular tokens. This demonstrated an early model allowing staked asset yields without rigid locking periods. From there, the staking derivatives concept has expanded into more diversified offerings catering to multiple staking networks.

In 2021, Stader Labs introduced liquid staking across multiple blockchains, allowing staking on chains like Ethereum, Terra, Polygon and others using a native token, SDER, to represent staked assets. Similarly, StakeDAO also focused on multi-chain staking, targeting high-yield proof-of-stake blockchains.

Moving into 2022, staking derivatives grew even more versatile, with options to stake across various DeFi protocols in addition to main blockchain networks. Ankr protocol introduced its liquid staking solution that brings utility features like staking tokens and lending markets.

This expansion of staking derivatives is likely to continue evolving with more bridges across chains, integration with DeFi money markets, and user-friendly wrapping/unwrapping mechanisms. The growth is propelled by the need to open illiquid capital in what could become one of the largest staked asset markets in crypto, on pace to exceed $50 billion soon. The innovation wave in liquid staking has only just begun, with the derivatives space promising to be a key area powering the next generation of staking products.

Working Mechanism of Liquid Staking Derivatives

The key mechanism that powers Liquid Staking Derivatives involves token staking by a validated third party, while the issuance of derivative tokens provides liquidity for users.

Let’s examine the process in more detail:

Step 1: Staking

A user decides to stake their token to earn rewards by depositing their native staking tokens, in this case, Ether (ETH), to a smart contract provided by a liquid staking service, like Lido.

The LSD platform then accumulates deposits from multiple users to stake on users' behalf on the official network validator nodes.

Step 2: Issuance of the Derivative Token

Upon receiving the ETH, the smart contract automatically mints new derivative tokens known as vTokens, i.e. stETH tokens to the user representing each user's staked deposit. This issuance is typically done on a 1:1 basis, meaning 1 stETH is issued for each ETH staked, although this ratio can change over time based on rewards earned.

Step 3: Utility of the Derivative Token

The user can now use the vTokens, i.e. stETH, just like any other token. They can trade it, use it in DeFi protocols, use it as collateral for loans, etc.

Step 4: Earning Rewards

The staked ETH continues to earn rewards as part of the Ethereum network's staking process.

These rewards increase the value of the stETH token. So, over time, the ratio of ETH to stETH may become more favourable (e.g., 1 ETH = 1.05 stETH).

Step 5: Redeeming the Derivative Tokens

When the user decides to redeem their staked ETH, they return their vTokens to the liquid staking platform. The platform then processes the unstaking (which might involve a waiting period) and returns ETH to the user, including any staking rewards earned.

Market Dynamics

vTokens like stETH trade independently and may have price variations compared to ETH due to market conditions and liquidity.

Thus, LSD platforms act as custodians that stake tokens on users' behalf while providing derivative vTokens giving comparable benefits plus transferability before unlocking. The relationship between the underlying staked asset and LSD derivative is defined by the following:

vTokens are backed 1:1 by the actual staked native tokens.
vTokens accrue the yields from staking, allowing holders to redeem interest/rewards.
The price of a vToken is pegged to the staked asset, adjusting for accrued yields.
Users burn vTokens when withdrawing to receive the native tokens back.

So, while the native tokens bring hard-locked rewards over a fixed staking period, vTokens offer flexibility for users to gain transferable liquidity on those staking yields.

Benefits of Liquid Staking Derivatives

Having discussed the concept of LSDs and understanding their functioning, you likely already have an idea of some key benefits, which will be highlighted shortly. LSDs open up several advantages compared to direct staking, including:

Liquidity

Instead of having staked assets locked, holders of LSDs can participate in various DeFi protocols, using their vTokens for lending, borrowing, or as collateral for other investments while earning rewards which brings flexibility to enter/exit positions.

Composability and Diversification

vTokens can integrate across DeFi apps for activities like lending markets, liquidity pools, token wrapping, etc., expanding what users (investors) can achieve.

Yield Optimization

LSD platforms distribute rewards from an optimized basket of validators, allowing potentially higher yields compared to individual stakers.

Reduced Custody

LSD platforms may undergo rigorous audits and decentralize operations to reduce asset custody risks compared to exchanges.

Challenges of Liquid Staking Derivatives

While promising, LSD adoption faces hurdles like:

Smart Contract Risks

Bugs or hacks of the complex tokenization mechanisms could jeopardize user funds. Because of this, proper audits are important.

Sustained Collateralization

Platforms need to maintain a good over-collateralization ratio between staked assets and issued derivatives to prevent losses.

Liquidity and Redemption Risks

If the market for a particular LSD is not sufficiently liquid, it might be difficult to buy or sell the derivative without significant price impact. Depending on the specific LSD platform's design, there might be delays or periods of illiquidity when redeeming the LSDs for the underlying asset.

Regulatory Uncertainty

The regulatory status of LSDs is still unfolding across jurisdictions, which might affect their adoption, functionality, and future legal standing.

Slashing Risk

If the validator nodes that the LSD platform has staked on behave maliciously or incompetently, the staked assets might be slashed, leading to a loss of value for the derivative token holders as well.

Comparison with Traditional Staking

Here are some of the key differentiators in terms of how LSDs compare to traditional staking.

Advantages	Challenges
Traditional staking typically locks assets, making them illiquid. LSDs resolve this by providing a tradeable token, and unlike traditional staking, LSDs allow users to exit their staking position without waiting for long unbinding periods.	LSDs are more complex than traditional staking, requiring a deeper understanding of the underlying mechanisms and complex contracts.
	Traditional staking often involves directly staking with a network, while LSDs introduce an additional layer with the LSD platform, potentially increasing counterparty risk.

LSDs involve intermediaries introducing smart contract/platform risks. However, they allow users to gain liquidity without needing to have the full technical expertise or funds for node operation. LSDs also potentially optimize yields by pooling validator rewards for users. Hence, by balancing tradeoffs, they can enhance traditional staking with flexibility and composability.

Market Impact and Adoption

Liquid Staking Derivatives have recently seen surging growth, adoption, and impact across cryptocurrency markets as they open wider functionality for the rapidly expanding staking economy.

Current adoption metrics highlight the traction gaining momentum:

Over $20 billion worth of crypto assets were staked via Lido alone on Ethereum as of 2023, commanding ~30% of all ETH staked.

The total value deposited on LSD protocols exceeds $20 billion, reflecting nearly 15% of the total estimated amount staked in crypto.

The growth of LSD solutions is catalyzing broader impact across crypto markets in noticeable ways, including enhanced liquidity, mainstream reach, and others mentioned earlier.

As the future of crypto heads towards widespread adoption, Liquid Staking Derivatives are sitting at an exciting intersection promising to enhance flexibility, interoperability and accessibility for existing networks into new models.

Case Studies and Real-world Applications

Along with Lido mentioned above, the following are some other pioneering platforms demonstrating interesting case studies for LSD adoption.

Stader Labs

Stader Labs is a leading multi-chain LSD provider with its native SDER token representing staked value across nets like Terra, Polygon, etc. It has attracted around $235M TVL, indicating strong traction for its interoperable model.

Ankr

Ankr’s solution brings innovations across staking liquidity pools, token wrapping features and staking derivatives for optimized yield generation. Partnerships with chains like Binance and Polygon showcase range.

Real-world traction through these platforms validates that investors and networks stand to mutually benefit from flexible staking options. For users, temporary liquidity on staked holdings allows fuller utilization of their assets while still earning yield. For networks, LSDs attract a wider base of adopters to participate in consensus building through validator staking.

Conclusion

Liquid Staking Derivatives are changing how staking works, making it more flexible and decentralized. In the future, LSDs will likely spread to different blockchains, work more with DeFi, and bring in new features. Predictions suggest over $100 billion will be staked by 2025, and LSDs will provide users with more choices.

To sum up, LSDs show that staking is growing up. They make staking more open to everyone and add something new to Web3. Watching how they grow is important for understanding their impact on money and banking in the future.