Liquid Staking Explained: How LSTs Work

Liquid staking is a way to stake cryptocurrency without locking up your assets. When you stake normally, your coins are locked and you can’t use them until you unstake. With liquid staking, you receive a token that represents your staked coins. That token, called a liquid staking token (LST), can be traded or used in other crypto applications while your original coins keep earning staking rewards.

How Liquid Staking Works

Here’s the basic process:

1. You deposit crypto into a liquid staking protocol. This could be on Ethereum, Solana, or another proof-of-stake network.
2. The protocol stakes your crypto with validators. Validators are the computers that secure the network and earn rewards.
3. You receive an LST in return. This token is pegged to the value of your staked crypto plus any rewards earned.
4. You can use the LST in decentralized finance (DeFi) — for example, as collateral for a loan or to provide liquidity — while your original stake continues to earn rewards.

The LST’s value grows over time as staking rewards accumulate. For example, on Ethereum, if you stake 1 ETH through a liquid staking protocol, you might get 1 stETH (or a similar token). As rewards are earned, the amount of ETH that 1 stETH can be redeemed for increases. The exact mechanism varies: some LSTs use a rebasing model where your token balance increases, while others use a value-accrual model where the token’s price in ETH rises.

Why Liquid Staking Matters

Traditional staking has a trade-off: you earn rewards, but your assets are illiquid. You can’t sell them, lend them, or use them elsewhere. Liquid staking solves that by giving you a tradable receipt. This unlocks several benefits:

• Capital efficiency: You can earn staking rewards and DeFi yields at the same time.
• Flexibility: You can sell your LST if you need liquidity, without waiting for an unstaking period.
• Lower barriers: Many liquid staking protocols accept small deposits, so you don’t need 32 ETH to stake on Ethereum.

Practical Examples

Suppose you hold 5 ETH. You want to earn staking rewards but also want to keep some liquidity. You deposit your 5 ETH into a liquid staking protocol and receive 5 stETH. Now you can:

• Hold stETH and watch it accrue rewards.
• Lend your stETH on a lending platform to earn interest.
• Use stETH as collateral to borrow stablecoins, which you can then use for other investments.

All while your original 5 ETH is staked and earning rewards. The same idea applies to other networks: you can liquid-stake SOL on Solana, ATOM on Cosmos, and so on.

Risks and Common Mistakes

Liquid staking is not risk-free. Here are the main risks and mistakes to avoid:

Smart Contract Risk

Liquid staking protocols are software. Bugs or exploits can lead to loss of funds. Always use well-audited protocols with a strong track record.

Slashing Risk

If a validator misbehaves, part of the staked crypto can be slashed (burned). Most liquid staking protocols diversify across many validators to reduce this risk, but it’s not zero.

Depegging Risk

An LST is supposed to trade at a value close to the underlying staked crypto. But in stressed markets, it can trade at a discount. If you sell at a discount, you realize a loss. This happened with some LSTs during market turmoil.

Liquidity Risk

While LSTs are tradable, there may not always be enough buyers. If you need to exit a large position quickly, you might face slippage.

Centralization Risk

If one liquid staking protocol dominates, it could pose a risk to the network’s decentralization. Some networks have limits or incentives to avoid this.

Common Mistakes

• Not checking fees: Liquid staking protocols take a cut of rewards. Compare fee structures.
• Ignoring tax implications: Staking rewards and DeFi activities may be taxable events. Consult a tax professional.
• Overleveraging: Using LSTs as collateral to borrow and then re-staking can amplify losses if prices drop.
• Assuming 1:1 peg: LSTs can trade slightly above or below the underlying asset. Don’t assume you can always redeem for exactly 1:1.

How to Get Started

If you want to try liquid staking, follow these steps:

1. Choose a network: Ethereum, Solana, and Cosmos are popular for liquid staking.
2. Research protocols: Look for audited, widely used protocols with transparent fees.
3. Set up a wallet: Use a non-custodial wallet that supports the network and the LST.
4. Deposit and stake: Follow the protocol’s instructions to deposit your crypto and receive the LST.
5. Decide what to do with the LST: You can hold it, trade it, or use it in DeFi. Start small to understand the risks.

Summary

Liquid staking solves the illiquidity problem of traditional staking. By issuing a tradable token that represents your staked assets, it lets you earn rewards while keeping your capital active. But it comes with risks: smart contract bugs, slashing, depegging, and more. If you understand these risks and choose reputable protocols, liquid staking can be a powerful tool in your crypto toolkit.

Disclaimer: This article is for information only and is not investment, financial or trading advice. Cryptocurrency prices are highly volatile. Always do your own research.