An Explainer to Liquidity Staking Solution (2024)

Digital investors often find liquidity staking confusing, but the technology is easy to understand. It is one of the fintech blockchain solutions that enable users to stake on a proof-of-stake (PoS) network. Users get liquidity provider (LP) tokens in return. In this article, we will explore more about this staking solution.

What is Liquidity Staking

Liquidity staking refers to a process in decentralized finance (DeFi) where users can lock their tokens in a liquidity pool. In return, they will earn more tokens as rewards. Liquidity pools are smart contracts that hold a combination of two or more tokens and typically facilitate trading on decentralized exchanges (DEXs).

When users contribute their tokens to a liquidity pool, they receive liquidity provider (LP) tokens in return. LP tokens represent their share of the total liquidity in the pool. Users can stake LP tokens in other platforms or protocols that offer additional incentives, such as yield farming or staking rewards.

By staking LP tokens, users provide liquidity to the underlying DEX and, at the same time, earn rewards for their participation. These rewards can come from various sources, including transaction fees generated by the DEX, token distributions, or incentives provided by the platform or protocol.

Liquidity staking allows token holders to earn passive income on their holdings. Simultaneously, it supports the liquidity and trading activity of a DEX or other DeFi protocols.

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How Liquidity Staking is Different from Traditional Staking

Liquidity staking and traditional staking are two different mechanisms with distinct purposes and characteristics:

Purpose

Traditional staking typically involves locking up a specific cryptocurrency or token to support the network's security, consensus, or governance processes. It often serves to incentivize participation and secure the blockchain network.

On the other hand, liquidity staking focuses on providing liquidity to DEXs or other DeFi protocols. It allows users to earn rewards by supplying their tokens to liquidity pools.

Rewards

In traditional staking, participants get additional tokens or fees generated by the network as their rewards. The network's consensus mechanism determines these rewards.

In liquidity staking, users get rewards as additional tokens from the protocol or platform. Rewards may also include transaction fees by a DEX or other incentives specific to the DeFi platform.

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Risk and Exposure

Traditional staking involves a lower degree of risk since participants are exposed to the performance and security of the underlying network.

In liquidity staking, participants face additional risks such as impermanent loss. It may occur when the value of tokens in the liquidity pool fluctuates in relation to each other. It may potentially result in a loss compared to holding the tokens separately.

Moreover, liquidity staking exposes participants to the risks associated with the specific DeFi protocol, including smart contract vulnerabilities and market volatility.

Flexibility

Traditional staking often requires participants to lock their tokens for a predetermined period. They may not have immediate access to their funds during this period.

Liquidity staking, on the other hand, provides more flexibility as participants can withdraw their tokens and stop staking at any time. However, specific lock-up periods or requirements may vary depending on the protocol or platform.

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The Working of Liquidity Staking

The working of liquidity staking involves several steps and interactions between different participants and protocols. Here's a general overview of how liquidity staking typically operates:

1. Liquidity Pool Creation

A DEX or DeFi protocol creates a liquidity pool by deploying a smart contract. The liquidity pool typically consists of two or more tokens. Users can utilize these tokens to facilitate trading on the platform.

For example, a common type of liquidity pool is an automated market maker (AMM) pool that holds token pairs.

2. Token Contribution

Users who want to provide liquidity to the pool can deposit an equal value of each token in the desired ratio into the liquidity pool. They receive liquidity provider (LP) tokens for their contributions. LP tokens represent users' share of the total liquidity in the pool.

LP tokens act as proof of ownership and enable participants to redeem their share of the pool's assets.

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3. Staking LP Tokens

Participants can then stake their LP tokens in other platforms or protocols that offer liquidity staking opportunities. These platforms or protocols provide rewards or incentives for staking LP tokens. Incentives can be in the form of additional tokens, transaction fees, or other benefits.

4. Reward Distribution

The platform or protocol calculates and distributes rewards to participants based on their share of staked LP tokens. The specific mechanism and frequency of reward distribution can vary depending on the protocol. Users get their rewards periodically or in real time.

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5. Monitoring and Managing Stakes

Participants can monitor and manage their staked LP tokens through the platform or protocol's interface. They can see their accumulated rewards, the total value of their stakes, and any available options to withdraw or reinvest their rewards.

6. Withdrawal and Exit

Participants can withdraw their staked LP tokens and earn rewards at any time, subject to applicable lock-up periods or requirements. They can choose to exit the liquidity staking program entirely or reinvest their rewards to compound their earnings.

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Advantages of Liquid Staking

Liquidity staking solutions have the following benefits:

Immediate Liquidity

Liquidity staking solution gives an advantage of immediate liquidity. This advantage varies with the type of blockchain network and liquidity staking token.

For instance, the Polkadot blockchain has an 'unbounding period' of 28 days. Users wishing to unstake their tokens need to wait for this period to unstake.

Composability

Liquidity staking solution enables composability of yield strategies. Users can represent their receipts for staked assets as tokens. They can utilize liquidity staking as collateral across various protocols, such as centralized or decentralized exchanges, prediction markets, or lending pools.

Continued Access to Assets

ETH or other staked token holders do not need to lock their assets to receive staking rewards. They receive liquid staking derivatives that may double as collateral in decentralized finance yields farming protocols.

Tokens holders can generate passive income with staking rewards and simultaneously benefit from liquid assets.

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Liquid Staking Platforms

Here is a list of liquid staking platforms:

Lido

Lido is one of the largest liquid staking protocols. Users need not lock their tokens or maintain their infrastructure for staking. The platform offers staked ETH (stETH) LSTs on Ethereum, stSOL on Solana, and stMatic on Polygon.

Hubble

Hubble is a liquid staking platform built on Solana. Users can borrow USDH, the stablecoin of Hubble, against their assets. It enables more liquidity in their long-term holdings.

Rocket Pool

Another popular liquid staking protocol on Ethereum is Rocket Pool. This platform doesn't require any minimum deposit to access its rETH LSTs. But it requires a minimum deposit to operate a mini pool validator.

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Liquidity Staking Platform Development

Investors are opting for platforms offering liquidity staking to diversify their assets. This protocol gives immediate liquidity to users. If you are interested in developing a similar platform, then connect with our developers today.