Ethereum LSD: How Does It Work?

Today the amount of staked ETH is more than 16 million! And according to DeFi Llama, about 7 million ETH was staked through LSD providers. This means that about 40% of users blocked funds not directly in the Ethereum smart contract, but through intermediaries – liquid staking platforms.

What is LSD?

LSD stands for Liquid Staking Derivatives. The name itself perfectly describes the main mechanism of operation of such platforms: they produce derivatives (wrapped tokens) linked to a staked asset. Different providers decide on their own, what to do with the underlying tokens and what type of derivatives they issue to users.

Liquid staking provides that the user blocks the token on the DeFi platform, receiving in return a derivative – a wrapped token. Different liquid staking providers may issue different types of wrapped tokens. There are 3 most common models:

1. Rebase token. These tokens are based on an algorithm that releases or burns tokens automatically, distributing them among users. However, not all DeFi platforms support them. If you use wETH, for example, to provide liquidity on an incompatible DEX, you may not receive your reward.
2. Reward token. It does not increase in quantity, but increases in value, which depends on the size of the staking reward. You can fix its value when you make an exchange for another asset. This is the most popular type of wrapped tokens as it is compatible with DeFi services.
3. Rebase+Reward token. A derivatives model that issues one type of token by default and allows you to convert it to another if necessary. For example, Lido issues a stETH rebase token by default, but if necessary, the user can convert it to wstETH, which works on a reward model and is compatible with DeFi.

As for the use of the staked asset, it may differ depending on the principles of the chosen protocol. For example, Lido and Coinbase deploy validator nodes by themselves. Such protocols are the most user-friendly, but not the most secure. While Rocket Pool works in a decentralized manner, allowing any user to run a node through the platform. This is a more secure way that does not require trusting anyone, but it complicates the user experience.

The size of the fees and their distribution also depends on the business model of the protocol. Don’t forget to pay attention to that when choosing an LSD provider – it affects the final income of the staker.

Why is LSD needed?

The key requirement for a derivative on a staked asset is that it must be liquid, so you could exchange it for other assets. Otherwise the very concept of liquid staking wouldn’t make any sense. The liquidity of the wrapped tokens is provided by the protocol itself and third-party DEX sites through liquidity pools. For instance, it’s possible to swap stETH into regular ETH on some service like Curve. It gives us some benefits:

• Release of liquidity, which otherwise would simply be blocked on smart contracts and would not be involved in the market.
• The staker can manage his assets through the wrapped token, which gives more opportunities for risk management and earnings.
• The staker does not need to deploy a node on the network and become a full-fledged validator, he simply delegates his share of assets to existing validators.
• The entry point for stakers is lowered as LSD providers act as intermediaries, accumulating deposits of any size until they reach the minimum node requirement – 32 ETH.

Liquid staking is available for many blockchains using the PoS algorithm, but it has gained  popularity in the Ethereum network, which recently has switched to PoS.

The fact is that the deposit smart contract for Beacon Chain validators (the PoS version of Ethereum) was deployed back in 2020 with a minimum deposit requirement of 32 ETH and no withdrawal option. The Shanghai update was in the plans, but no one knew when it would be launched. So validators were offered to stake a large amount for an indefinite period. Many users considered it a risky deal, for others the entry threshold was too high. Liquid staking protocols have helped solve this problem by issuing liquid wrapped tokens in exchange for an indefinitely locked ETH deposit and allowing even small amounts to be staked.

Conclusion

The popularity of LSD providers is growing, which may be due to the upcoming Shanghai update, which should unlock deposits of ETH stakers. About 40% of ETH was staked through LSD providers, like Lido, Coinbase, Frax and Rocket Pool. Liquid staking is known as a more profitable and affordable alternative to direct smart contract staking, as it allows staked assets to be used to earn money in DeFi. However, it also comes with additional risks, such as price cuts and hacking of LSD providers.