Nov 03 2023
Liquid staking tokens (LSTs) are a technological innovation taking the web3 ecosystem by storm. Representing a participant’s ownership of staked ETH plus network rewards earned, the total value locked (TVL) in ETH liquid staking tokens has increased by over 100% in the last year alone.
But the potential for LSTs is still nascent. LSTs like LsETH are not just a testament to the evolution of staking technology; they're a gateway to the development of innovative decentralized finance (DeFi) strategies and applications.
LSTs have a number of key characteristics that unlock the potential to build DeFi innovations on top of them.
Liquidity
One of the primary advantages of LSTs is that they provide liquidity to tokens that are otherwise locked in staking contracts. This means that while your tokens are staked and earning network rewards, you can still trade, sell, or use the LSTs in other DeFi activities, which isn't possible with traditional staking.
Interoperability
LSTs, especially those based on popular standards like the cToken model that LsETH follows, can easily integrate with existing DeFi platforms, tools, and services. This composability allows them to be used in a wide range of DeFi strategies, from being collateral in lending platforms to being part of yield farming pools.
Fungibility
LSTs are fungible tokens, meaning each token is identical and interchangeable. This is similar to the fungibility of grain in commodity warehouses. This characteristic ensures that LSTs can be easily traded on exchanges, used in smart contracts, or pooled together in DeFi protocols—even though they also represent direct ownership of a staked token (and, in the case of LSTs based on the cToken model, network rewards as well).
Staking’s durable reward rate
ETH network staking rewards are incentives for participants who lock up their tokens to support Ethereum’s security. LSTs, like LsETH, represent ownership of these staking rewards as they accrue. The consistent nature of staking rewards is often compared to a durable rate, akin to holding a dividend-paying stock or investing in an internet bond. Together, this potential for a steady accrual of value thanks to Ethereum’s historically durable reward rate, the ability to quickly adapt to market conditions due to the liquidity of LSTs, and LSTs’ onchain composability, unlock potential DeFi innovations that use ETH staking’s historically-predictable rewards as the base for applications requiring liquidity, such as self-repaying loans that don’t require staking pool operation.
LsETH’s regulatory-minded design
Liquid Collective’s LsETH is the only LST built to meet the compliance needs of businesses building staking products for their customers, including mandatory KYC/AML for operators, strict security standards, and enterprise-grade infrastructure. This unlocks an even larger world of potential innovation in the growing compliant-DeFi ecosystem, as products that must meet regulatory requirements can be built on top of LsETH.
Let’s unpack just a few examples of the potential use cases that could be built on top of LSTs.
Options-enabled liquid staking strategies
In traditional finance, options are contracts that grant the right, but not an obligation, to buy or sell an asset at a predetermined price on or before a certain date. In the context of LSTs, options strategies could be built that weren’t possible with traditional staking participation.
In theory, a product that integrates options with LSTs could be used to hedge against potential price declines (using put options) or earn premiums by agreeing to sell at a certain price (using call options). This innovation could allow participants to maintain their staking position while simultaneously earning a yield from option premiums. In volatile market conditions, where ETH prices can swing dramatically, options can act as a buffer, providing additional income or protection against adverse price movements.
For example, a participant holding an LST could sell call options, agreeing to sell the LST at a predetermined price. If the market price remains below this agreed price, the participant retains the option premium, effectively boosting their overall yield. On the flip side, buying put options could serve as a protective measure against potential market price declines for the LST. While this kind of options strategy could be built on top of many different token models, because LSTs also represent ownership of a staking position they could offer the potential of a higher return on the strategy due to any ETH network rewards that simultaneously accrue to the LST.
ETPs and ETFs backed with LSTs
Exchange-traded products (ETPs) track the performance of specific assets. Exchange-traded funds (ETFs), one of the most common types of ETPs, are a type of pooled investment fund for a basket of assets, which can be traded on a stock exchange. While LSTs represent a new opportunity for ETP developments of all kinds, the potential for integrating LSTs and ETFs is particularly topical given the potential for a near-term approval of BTC or ETH ETFs in the US.
By incorporating LSTs, ETPs could mirror the performance of staked tokens. LST-based ETPs could pool various LSTs, offering a diversified exposure to staking rewards across multiple networks. Such ETPs could attract both crypto-native and traditional participants, offering a simplified entry into the staking world.
With the potential development of a Spot ETH ETF on the horizon it is likely that holding ETH will not be effective enough for the companies offering these funds; backing the fund with staking could give their participants a higher return on their ETF holdings, providing the issuers with a competitive edge. The innovation of LSTs, allowing stakers to retain liquidity while participating in staking, would likely present an excellent solution for managing staked ETH in light of ETFs’ redemption periods.
Fixed-rate yield strategies
Though ETH staking represents a durable reward rate, there is potential for upward variability in staking rewards considering factors like Maximum Extractable Value (MEV), or the value of adding and reordering transactions in a block to improve the quality of blocks proposed by validators.
By separating the staking reward rate from the LST and offering it as a fixed yield, a builder could offer participants with increased predictability in returns. In a market where reward rates can vary, a fixed yield offers a haven of stability, especially appealing to risk-averse institutional investors. For example, a DeFi platform could offer a product where LST holders receive a fixed interest rate, while the platform manages the variability in staking rewards, effectively acting as a buffer for the participant.
Future innovations
These examples illustrate just a narrow segment of the potential innovations unlocked by LSTs. Platforms could offer LST-backed savings accounts where participants deposit LSTs to earn an additional yield beyond standard staking rewards, achieved through various DeFi strategies. LSTs could be used as collateral to mint stablecoins, which are pegged to stable assets like USD. Tranched staking pools could be developed by pooling diverse LSTs together, with the pool's rewards divided into different tranches, each with its risk and reward profile. As a composable token based on Ethereum’s core participation method, the possibilities are endless.
Liquid staking tokens are more than just a representation of staked assets—they're a primitive for financial innovation. Many of these developments are being built right now, on the tail of liquid staking’s recent adoption and massive flows of capital into liquid staking participation despite volatile market conditions globally. As the ecosystem evolves and matures, it's likely that even more innovative strategies will emerge, further enhancing the utility and potential of LSTs.
If you're intrigued by the possibilities LSTs like LsETH offer, don't stop here. Explore how Liquid Collective’s LsETH can benefit stakers here. You can follow Liquid Collective on X or subscribe to monthly Liquid Collective Updates to be in-the-know about the latest LsETH integrations being developed.
