Exploring Liquid Staking Derivatives: Introduction, Benefits, and Strategies

@hacker9253814

Lead Engineer in Eonian Finance

Staking is a well-known strategy for earning yield among crypto users. In a nutshell, it is a process where you hold coins in a wallet to help the blockchain network keep it safe and running smoothly, and the best part is, you can get rewarded for it!

Unfortunally, there are some limitations to staking. For example, you can’t trade or use the coins you’ve staked until the staking period ends.

But what if I told you that it is possible to bypass these limitations and use the liquidity of staked coins to increase your income? This is where liquid staking derivatives (LSDs) come in.

LSDs are tokens that are issued to you by the liquid staking protocol in place of your native tokens of the current network. The price of a derivative token is pegged to its underlying asset and is usually valued at around a 1:1 ratio.

User interaction with the Liquid Staking protocol

Once you’ve got your hands on some LSDs, you’ll start earning staking rewards every day, which will increase your wallet balance over time. But there’s more! You can also use these tokens in the DeFi market to get some yield opportunities.

Examples of Liquid Staking Protocols

There are many different liquid staking protocols, allowing you to stake assets on different networks and receive LSDs in return, here are a few of them:

Lido

Lido is a liquid staking protocol for Proof of Stake (PoS) networks that provides staking solutions for crypto assets such as Ethereum (ETH), Solana (SOL), Polygon (MATIC), Polkadot (DOT), and Kusama (KSM). When staking, Lido users will receive stTokens (stETH, stMATIC, etc.) which represent their staked native assets (+ aggregated rewards).

Stader

Stader protocol is a non-custodial smart contract-based multichain staking platform. It currently supports the following assets: Polygon (MATIC), BNB, Terra 2.0 (LUNA), Fantom (FTM), NEAR Protocol (NEAR), Hedera (HBAR). After the user’s assets have been staked, Stader mints [Token]X derivatives (e.g.: BNBX, HBARX), which will be placed in the user’s wallet.

pSTAKE

pSTAKE is another liquid staking protocol that enables you to access liquidity for your staked assets. By using pSTAKE, you can safely stake your PoS assets and receive the protocol’s staking derivatives — stkASSETs (such as stkBNB, stkATOM, and stkETH).

Using LSDs in DeFi

After depositing your assets into any of the mentioned liquid staking protocols, such as Lido, Stader, or pSTAKE, you will receive liquid staking derivatives in return, let’s explore how we can make them work for us. There are several strategies we can use.

For example, we can deposit our LSDs into a lending protocol to receive constant rewards. Alternatively, we could borrow against them (by using the LSDs as collateral), allowing us to obtain more assets and continue to utilize the DeFi market. Moreover, we can borrow additional underlying assets, restake them, get LSDs, and lend them again to make a leverage staking with higher rewards.

Another option is to provide our LSD tokens to the liquidity pool (LP) of a decentralized exchange (DEX) and receive incentives through trading fees. By doing so, we contribute to the liquidity of the DEX and earn rewards for facilitating swaps and get income from staking at the same time.

Each of these strategies has its own pros and cons. Let’s examine them in more detail.

Supply liquidity pools

A liquidity pool is a collection of assets locked in a smart contract, used to provide liquidity for trading on a DEX. Usually, it’s a pair of two tokens that can be seamlessly exchanged with one another.

The strategy is to supply a pair of LSD tokens and an underlying token (such as ETH and Lido’s stETH) to the pool. Why this pair? As mentioned earlier, the value of the LSD token is pegged to the value of the underlying assets, which can lead to lower impermanent losses.

Liquidity pools yield logic

For Lido’s stETH/ETH pair, the most popular LP is Curve’s stETH-ETH liquidity pool that allows to simultaneously accrue trading fees, protocol incentives (CRV, LDO), as well as stETH staking reward.

This yield strategy is fairly easy to execute, as it requires only a few transactions: receiving LSD tokens via staking/exchange and supplying the pair to a liquid pool. As a result, we can pay a minimum amount of network fees.

However, there are some disadvantages to be aware of:

• Although impermanent losses are minimized compared to other conventional liquidity pools, they can still occur.
• Most exchanges require a 1:1 ratio of tokens to deposit them into liquidity pools. This means that you need to have almost 50% of your assets unstaked.

Leveraged staking

This strategy can be implemented using lending protocols. The basic idea is that lending protocols can accept LSDs as collateral, which allows users to borrow assets while still earning rewards from staking. By borrowing the underlying asset and staking it again, users can earn more LSDs. This cycle can be repeated as long as the loan health factor remains within an acceptable range.

Logic of leveraged staking strategy

The algorithm for this strategy looks like this:

1. Stake the underlying assets and receive LSDs.
2. Use the received LSDs as collateral for borrowing from the lending protocol.
3. Borrow as much of the underlying assets as the collateral factor allows.
4. Repeat the process from step 1.

By using this strategy, we can potentially earn more rewards than we normally get from staking. Why? And how can it be profitable, since we have to pay the loan (borrow interest)?

Our collateralized LSDs generate rewards. Besides dividends from staking, we also receive a part of the interest paid by borrowers, and some lending protocols may incentivize users with additional rewards. Furthermore, since the value of the borrowed assets is always less than the value of collateral we put up for the loan (as the DeFi loan is always overcollateralized), and the interest on the loan is usually lower than the cumulative yield earned on the collateral, we are able to achieve a better APY in the end.

Are there any pitfalls? Yes, there are a few things to keep in mind when using this strategy:

1. Although the values of LSDs and the underlying asset are pegged to each other, liquidation is still possible, and the health factor of the loan must be constantly monitored to avoid losing the collateral.

2. Borrow APY can suddenly rise, and in such cases, the strategy may become unprofitable. Then it may be necessary to withdraw funds and look for another profitable lending protocol or even another strategy.

3. The implementation of this strategy involves many steps, and each step is a separate transaction for which you have to pay fees. This can be very expensive, especially when it comes to a blockchain like Ethereum, where the transaction fees can be high. Therefore, it’s important to carefully consider the fees involved and make sure they don’t eat into your profits.

None of the LSDs strategies can be considered truly passive, as they require continuous monitoring of profitability dynamics, calculation of final earnings while taking into account impermanent losses and network fees, as well as keeping a close eye on the status of the protocols being used. However, there are options available to simplify this process such as protocols that support automated yield farming strategies. We also see potential in the automation of such strategies and are currently planning to add them to the Eonian protocol.

More related info

• Want to learn more about lending protocols and leveraged yield farming? Check out “The Ultimate Guide to Leveraged Yield Farming”.
• Curious about impermanent losses and how they can impact your yield? Read our recent article, “Why do half of Uniswap v3 users lose money?”.

Also published here.