The missing pieces of DeFi liquid staking

In 2024, liquid staking became the dominant niche in DeFi. Offering an opportunity to unlock extra liquidity to the crypto industry without minting excessive Ethereum (ETH), the technology rose to the top of the DeFi mountain and crossed the threshold of $60 bln in TVL.

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It is to little surprise, as block reward accruing assets are the most productive assets in decentralized finance and should be used as high-quality collateral in DeFi. However, despite the surge in popularity of liquid staking, its key gaps remain unaddressed. Achieving its long-term potential in full is impossible without recognizing these flaws—and taking action to eliminate them.

Risks of derivative tokens

Why did liquid staking experience such rapid and widespread adoption? Locked assets earn no return besides the staking rewards for block validation—an integral part of the ecosystem security but pain for investors who sacrifice their liquidity and are exposed to opportunity costs. In traditional finance, the issue of loans earning nothing but interest was circumvented by repurchase agreements—repos. Repos represent a tradable claim to deposited assets, which is exactly what the function of LSTs and LRTs is.

However, LSTs and LRTs are subject to the same vulnerabilities as their TradFi counterparts. The value of a liquid-staked token is backed by its collateral, which is the pooled ETH powering the validator node. Ideally, there should be a one-to-one peg between the underlying value and the market price of a liquid-staked token. This means that no buyers must question whether the represented ETH will eventually be repaid when the locking period ends.

What if that’s not the case? What if a validator misbehaves and gets punished by slashing? What if the liquidity pool for a specific LST pair things to the extent that the traders are no longer willing to hold their positions? What if the protocol suffers an attack, as it often happens in DeFi?

A confidence drop, a run, and collateral de-pegging—this is the sequence that brought down the infamous Anchor protocol of Terra-Luna and rippled ominously across the whole industry. We are only at the beginning of the rabbit hole of systemic risk: for instance, liquid restaking tokens represent a claim to a staked asset and can be used to support the security layer of multiple protocols at once. When correlated slashing—now only a theoretical possibility—becomes reality, the whole DeFi industry may perish in flames.

We need diversified risk strategies, constant code audits, and reliance on multiple tokens and platforms. Otherwise, the growing backbone of the DeFi economy will forever remain fragile.

Accessibility challenges

While the inherent systemic risk is, of course, a barrier to the long-term potential of liquid staking, there are closer roadblocks to its broader adoption. Liquid staking as a technology is currently limited to experienced DeFi users, leaving ordinary crypto enthusiasts and industry newcomers behind. Complex interfaces, high gas fees, lack of onboarding, technical intricacies, general misbelief towards a convoluted technology—the list goes on. Even the sheer abundance of liquid staking and restaking tokens is confusing, especially when a user deposits abcETH, gets xyzETH back, and leaves frustrated and disappointed.

For liquid staking to become inclusive, accessible, and user-friendly, platforms must focus on intuitive design, simplified onboarding processes, and education. They need to have a consistent and familiar UI and collateral transparency, as well as provide their users with a full picture of the risk exposure and comparable yield metrics. Lowering the financial entry thresholds through layer-2 protocols could also make it more accessible to small-scale investors.

UX and UI have recently become the industry’s buzzword cliché, but it’s important to remember that the problem underneath still needs to be solved. Liquid staking can transition from a niche tool to a mainstream financial solution, but it will happen only when the users are satisfied with it.

Utility expansion and standardization

The key virtue of LSTs is the constantly accruing block rewards they offer. ETH staking is securing the economic activity of Ethereum through validator nodes. As long as there is transaction activity on the ETH network, there will be staking rewards.

But staking should not remain the only option for LST use: tens of thousands of monthly active users with billions of dollars in holdings seek utility, and their demands must be satisfied. TVL in LST and LRT are increasing faster than the opportunities to deploy those same assets into DeFi opportunities. It takes time to integrate these tokens into lending protocols, perpetual trading, etc, as these require a business-to-business partnership at the protocol level.

No, imagine if you are trying to integrate five different LST and LRT assets with Aave (AAVE). It would be a log jam! Soon, if not already, staking will turn into speculative lending.

There is nothing wrong with that per se. What is wrong, though, is that this is not recognized by the users who bear the counterparty risks and offer liquidity. The industry needs a much more diverse range of platforms to accept LSTs and offer their users access to real yield—and this must be done securely and transparently. LST- and LRT-oriented platforms can reinvigorate the DeFi economy. Powering money markets, digital asset management, and even crypto-native hedge funds—as yield-bearing collateral, LSTs will offer lots of room for adapting the existing TradFi concepts to DeFi.

Finally, standardization is key for the tokens themselves. Besides the mentioned frustration and confusion they create, another argument for token interchangeability is more consequential. Firstly, each platform needs to maintain separate liquidity pools for each trading pair. Secondly, given the inherent risk factors for an individual LST and the ripple effect on the whole market, if a token collapses, the case for a single diversified LST-derived asset is clear.

The future is now

In the early days of liquid staking, few people thought it would be possible to reach the current levels of TVL. And even this is only the beginning: liquid staking can bridge the gap between a powerful innovation and a tool for everyday use. For it to happen, however, the DeFi community must act to eliminate the technology’s current flaws and missing pieces from systemic risk and poor UX to lack of standardization and utility propositions.

The future is now — but it is up to us to make it truly happen.

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