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What are Liquid Staking Tokens (LSTs)?

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Liquid staking token (LST) is a crypto-specific term that can be hard to grasp at the first sight. But it is an expression of a fundamental DeFi ecosystem building block. In brief, the following describes the LST characteristics:

  1. Liquid staking tokens are utility tokens issued upon the network’s cryptocurrency staking, i.e., stETH is an LST issued by Lido software upon ETH staking on the Ethereum network.
  2. The fundamental purpose of LST is to unlock the liquidity of funds in a staking system. Investors can simultaneously earn staking yield and maintain LSTs’ tradeability.
  3. LST finance (LSTfi) exploded after Ethereum’s Shanghai upgrade (12th April 2023), which enabled staked ETH withdrawals. LSTfi is nothing else than LSTs’ use in DeFi.
  4. LSTfi amassed an enormous Total Value Locked (TVL). Beyond the demand from decentralized protocols, both institutions and CEXes demonstrate a significant interest in regular and liquid staking.

Before we delve into LSTfi, let’s make a short liquid staking introduction. The concept emerged when DeFi contributors and users realized staking alone comes with capital inefficiencies. Proof-of-stake blockchains (PoS) operate on validators who hold a certain amount of native tokens and ensure security. They must lock collateral. Some blockchains, such as Cosmos-SDK chains, offer individual investors the option to stake via delegated proof-of-stake (DPoS). Although validators and delegators benefit from obtained rewards, their capital is frozen out temporarily. Hence, projects started working on solutions to solve resource inefficiency problems. It is how liquid staking came about.

Ethereum’s switch from proof-of-work to proof-of-stake, called The Merge, concluded on 15 September 2022. That transformation process consisted of a few stages and initiated the innovation spiral. The Ethereum Beacon Chain launch was a major step. It introduced staking to the Ethereum network, and people could start locking their ETH. Initially, staked ETH was not subjected to withdrawals. Users’ funds were inaccessible until the Beacon Chain merged with the mainnet, The Merge, and later Shapella upgrade. The chart below shows deposited and withdrawn ETH from a staking contract. As observed, the total value increases constantly. Over 28 million ETH staked currently corresponds to 23% of the total supply.

Deposited and withdrawn ETH from staking contracts (Source: Nansen)

The process of liquid staking addresses obstacles regarding individual staking requirements. Initially, to become a validator, i.e., on the Ethereum network, participants must provide 32 ETH (about $57k at the time of writing). It is a substantial investment threshold, not to mention the operational costs of hardware and cloud services required to run a validator node. Thanks to LSTs, people can share staking rewards without committing thousands of dollars in capital. They can contribute as little as they wish (within protocols’ limits). It is what made liquid staking so successful.

In the meantime, protocols wanted to enable ETH liquidity. The first to do it successfully at scale was Lido. Since then, liquid staking has grown to be the decentralized finance leading sector with a combined TVL of $22.4B (based on DefiLlama data). Nowadays, liquid staking is a standard in the crypto space. Networks and tokens offering solely locked staking or illiquid solutions without derivatives will not cut it in the competitive market. The lack of additional utility hinders DeFi usability and projects’ growth.

Liquid staking tokens, which used to be inadequately called liquid staking derivatives (LSD), enable earning yield on native tokens while ensuring tradeablity. A receipt is a well-known comparison for LST. It represents the ownership of staked digital assets. In addition, LST and its issuing protocols allow anyone to partake in ETH (or different PoS blockchain) staking. In the traditional approach, profiting from staking involves securing a spot in the validation pool, running a node, which requires managing both hardware and software operations, and providing collateral in the network’s currency. Liquid staking protocols take all of the responsibilities for the end user. Users’ tokens secure the network, earn them rewards, and they still have liquid cryptocurrencies that can be utilized in DeFi. It is a win-win-win situation, as long as all the systems work properly (more on risks further in the report).

LST protocols took DeFi by storm. Liquid staking is accountable for 32.5% of decentralized finance TVL. The top DeFi application by TVL is Lido, overtaking the second MakerDAO by $8B. It shows the scale and popularity of liquid staking tokens. The chart below presents the growth of the liquid staking industry compared to other categories. Since 2022, decentralized exchanges and lending have taken a massive hit regarding the accumulated value. In 2023, while different sections of the DeFi landscape have decreased in TVL, liquid staking has sustained its expansion.

DeFi Categories by TVL (Source: DeFiLlama)

The scene of liquid staking tokens is very rich. LST includes decentralized and centralized approaches. DeFi solution leaders incorporate protocols such as Lido, Rocket Pool, Frax, StakeWise, and Stader. Their operations revolve mainly around ETH. Liquid staking on the second-largest blockchain in terms of market capitalization (following Bitcoin) has no close competition so far. The largest CEX players, whose users are big ETH holders, also do not want to miss the occasion and prepare centralized alternatives. For example, Coinbase and Binance introduced their own LST versions. The TVL breakdown of the top protocols is displayed below. The dominance of Lido looks overwhelming. The project achieved it by the first mover advantage and continuous protocol’s resilience in the turbulent market. The same applies to Uniswap in DEXs or Aave in lending.

Market share of particular LSTs (Source: DeFiLlama)

The crypto market offers multiple staking solutions. The main categories include liquid staking, CEX staking, solo staking, and staking pools. For ETH, liquid staking leads the charge with a 42.4% market share. Its dominance has been growing at the expense of centralized exchanges.

ETH staked distribution by category (Source: Dune)

Disclaimer: This post is not a financial advise. It was created for informational purposes only. Remember to always do your own research.