Just seeing the topic of this article, it calls for questions in the mind like, what is Liquid staking? What does PoS mean? Not to worry, it’s going to be critically analysed in this article. However before then, let’s take a peep at the prerequisites to this study and follow up closely.
While mainstream still perceives cryptocurrency as a synonym of bitcoin, the last couple of years has seen the height of two innovative trends in the crypto world. The First is an earthshaking transfer from proof of work to proof of stake is earsplitting, with the most visible case being how the an implementation of Ethereum, named Casper, which will eventually convert it into a Proof of Stake (PoS) blockchain from its current Proof of Work (PoW) state. However, the Second is the rise of DeFi (decentralized finance) applications has dominated discussions about investments in the crypto space. According to DeFi Pulse, who keeps track of the money flowing towards those new DeFi apps, the total value of assets locked into DeFi smart contracts has grown from just $900 million in 2019 to nearly $10.8 billion at the time of writing.
However, PoS and DeFi weren’t kind of created to be conformable to each other. In fact, staking requires users to commit their assets to earn rewards for protecting the rudimentary network, thereby making them unable to get access the DeFi ecosystem. In addition, protocols enforce waiting periods for users wanting to withdraw their stake, which makes readily investing these tokens close to impossible. This by implication becomes a loss of income for validators who cannot invest their stakes in more profitable opportunities.
Now, what is Liquid Staking and how does it work?
Liquid Staking can be described as the next step in the growth of the proof of stake market where Users can earn passive income by staking funds. However, The returns can be more than 15% — depending on the protocol. Unfortunately, there are some restrictions: these are;
¶ locked-up funds
¶ different locked-up periods
¶ minimum amount to take part in the proof of stake mechanism
Also, In times of high volatility, this can lead to a loss. You cannot move the funds due to illiquidity and If you want to take part in the switch towards Ethereum 2.0 and stake your ETH, you have to deal with these challenges.
How does Liquid Staking work?
Liquid Staking brings flexibility and liquidity to your staked funds. You know, You deposit f.e. ETH via a third-party application into a smart contract (deposit contract). And In return, you receive an issued tokenized version of your funds — a sort of derivative or wrapped token. This minted token represents your ETH. Now it can be transferred, stored, spent, or traded like a regular token.
However, You can also use this wrapped token for:
collateralization, lending And for much more
You know, Everything is possible while you are still earning your Ethereum staking rewards. You can also unstake your derivative token at any time. This is possible through the use of stETH-ETH liquidity pools.
Bottom line is this, Liquid Staking makes interacting with DeFi more flexible.
Infact, As it stands, DeFi is still much smaller than the PoS space, but it has the potential to become a tail-wagging-the-dog situation: DeFi, being designed around investment and profit, might entice even those who are foreign to cryptoassets and, as a result, might ultimately influence proof of stake.
what is Proof of stake and how does it work?
Proof of stake is a type of consensus mechanism used to validate cryptocurrency transactions. With this system, owners of the cryptocurrency can stake their coins, which gives them the right to check new blocks of transactions and add them to the blockchain.
This method is an alternative to proof of work, the first consensus mechanism developed for cryptocurrencies. Since proof of stake is much more energy-efficient, it has gotten more popular as attention has turned to how crypto mining affects the planet. Understanding proof of stake is important for those investing in cryptocurrency.
How does proof of stake work?
The proof-of-stake model allows owners of a cryptocurrency to stake coins and create their own validator nodes. Staking is when you pledge your coins to be used for verifying transactions. Your coins are locked up while you stake them, but you can unstake them if you want to trade them. When a block of transactions is ready to be processed, the cryptocurrency’s proof-of-stake protocol will choose a validator node to review the block. The validator checks if the transactions in the block are accurate. If so, they add the block to the blockchain and receive crypto rewards for their contribution. However, if a validator proposes adding a block with inaccurate information, they lose some of their staked holdings as a penalty.
As an example, let’s look at how this works with Cardano (CRYPTO:ADA), a major cryptocurrency that uses proof of stake.
Moving forward, why is Liquid staking important in relation to PoS?Absolutely, One of the primary arguments in favor of liquid staking is the ability to use staked assets as collateral in other financial applications. Such that, it opens up so much possibility in the design space. For example, instead of having lock staked assets on a blockchain, tokenized staking positions could be integrated in other protocols that enable stakers to manage their risk exposure and to earn additional returns on their staked assets. Tokens will be able to move freely across different users, locations or even chains. Collectively managed by a DAO (decentralized autonomous organization), the rights associated with tokens can be separated and owned by different entities. Be that as it may, Such composability is an essential feature of DeFi and has been proven to foster innovation in the Ethereum ecosystem. For instance, MakerDAO’s stablecoin DAI can be borrowed and lent using the Compound protocol. Hence, This ability in turn led to other applications automating interactions between the two protocols to optimize yields and to reduce risks for token holders engaging in these transactions.