Liquid Staking 101: A Guide for Institutional Investors

The era of Proof of Work (PoW) systems has come to an end, due to several reasons, leading to their abandonment. Consequently, the world transitioned towards Proof of Stake (PoS) systems. However, PoS systems encountered their own set of challenges. For instance, individuals staking their assets faced difficulties in withdrawing their funds. Nevertheless, the Shapella upgrade, following the merge, resolved this issue, enabling stakers to finally withdraw their funds.

This pivotal change sparked a surge in staking activities. The staking market has undergone remarkable expansion in recent years, witnessing a substantial increase in the Total Value Locked (TVL) within staking protocols. From approximately $10 billion in 2019, the TVL surged to over $70 billion by 2022. Notably, Ethereum stands as the leading staking chain, boasting over $30 billion in staked ETH.

Image: 1.ETH Staked vs Validators

Despite this impressive growth, stakers continue to grapple with numerous challenges, prompting speculation that Clean Liquid staking might emerge as the next significant development.

So, what exactly is Clean Liquid staking?

Image: 2. What Exactly Clean Liquid staking

Liquid staking is staking but the users are able to earn staking rewards while maintaining access to their staked assets. This is achieved by issuing a tokenized representation of the staked asset, often referred to as a liquid staking token (LST).

The term “Clean” indicates the implementation of KYC procedures for all involved parties. This essential practice ensures full transparency regarding the tokens’ origin and destination. KYC not only fosters awareness among all parties involved but also guarantees adherence to regulatory standards and requirements.

Here’s how it works:

Image: 3. Clean Liquid staking – How its works?

1. A user deposits their cryptocurrency into a liquid staking protocol.
2. The protocol stakes the deposited assets on the user’s behalf, delegating them to validators in a Proof-of-Stake (PoS) network.
3. The user receives liquid staking tokens (LSTs) in return, representing their ownership of the staked assets.
4. The user can then use those LSTs in various DeFi applications, such as lending and borrowing, while still earning staking rewards.
5. When the user wants to redeem their original staked assets, they simply exchange the LSTs back at a 1:1 ratio. 

Why Does Liquid Staking matter?

Traditional staking mechanisms pose several challenges for institutions, hindering their full participation in the staking ecosystem. These challenges include:

Limited Liquidity: According to a report by CoinShares, institutions lost an estimated $5 billion in liquidity in 2022 due to traditional staking lock-ins. Traditional staking requires locking up assets for extended periods, often months or even years, making them inaccessible for other purposes. This limited liquidity can hinder institutional investment strategies that require flexibility and the ability to deploy assets in different market conditions.

Slashing Risks: Slashing is a penalty imposed on validators who misbehave or fail to perform their duties adequately. In traditional staking, institutions bear the full brunt of slashing penalties, potentially resulting in significant financial losses.

Complexity and Operational Overhead: Setting up and managing a staking infrastructure can be complex and resource-intensive for institutions. This involves maintaining servers, validating blocks, and keeping up with protocol updates, which can be challenging for institutions with limited technical expertise.

Lack of Control and Transparency: Traditional staking often lacks transparency and control over staked assets. Institutions may have limited visibility into the performance of their validators and may struggle to track rewards distribution and manage their staking portfolios effectively.

Clean Liquid Staking Solves it All:

Liquidity Access: Liquid staking protocols allow institutions to mint derivative tokens representing their staked assets, providing them with access to liquidity. These tokens can be traded or used in other DeFi applications, enabling institutions to utilize their staked assets more effectively.

Reduced Slashing Risks: Liquid staking protocols often spread slashing risks across a pool of validators, mitigating the impact on individual institutions. This risk-sharing mechanism helps protect institutions from substantial financial losses due to slashing penalties.

Simplified Infrastructure: Liquid staking protocols often handle the technical complexities of staking infrastructure, such as server maintenance and protocol updates. This reduces the operational burden on institutions and allows them to focus on investment strategies.

Enhanced Transparency and Control: Liquid staking protocols often provide greater transparency and control over staked assets. Institutions can track validator performance, monitor rewards distribution, and manage their staking portfolios more effectively.

Other than these, the lack of regulation has been a major concern, especially for institutions. This issue, also known as the regulatory vacuum, refers to the absence of clear and comprehensive guidelines from governmental bodies to govern the operation and trading of cryptocurrencies. The absence of regulatory guidance poses several risks to institutional investors, like Uncertainity and legal risks, Compliance challenges and reputational risks as well. 

How clean liquid staking addresses regulatory concerns for institutions:

Clean liquid staking platforms integrate KYC and AML procedures into their staking process, ensuring that only compliant institutions can participate. This helps to mitigate the risks associated with money laundering and other illicit activities. This proactive approach also helps to bridge the gap between the crypto industry and regulatory bodies.

By participating in regulated staking platforms, institutions can significantly reduce their regulatory risks and demonstrate their commitment to compliance. Institutions can attract and retain investors by operating in a compliant and transparent staking environment, fostering greater trust and confidence. A more regulated and transparent staking space will encourage more institutional participation, driving the growth and maturity of the staking ecosystem.

Conclusion: 

As the liquid staking market skyrockets beyond $2 billion in staked assets, institutional interest seems to be intensifying. A recent study conducted by Messari reveals an astounding growth of over 200% in the TVL within liquid staking derivatives over the past year. This surge isn’t merely numerical; it’s accompanied by a remarkable increase in participants. The community of LST holders has swiftly escalated from a modest 10,000 in January 2022 to an impressive 100,000 by January 2023.

Despite this phenomenal expansion, liquid staking remains in its infancy, with only about 10% of staked Ethereum actively engaged in this groundbreaking approach. This signifies enormous potential for further market development.

According to Messari’s forecasts, a staggering TVL of $100 billion in liquid staking protocols is anticipated by the close of 2024, while CoinGecko envisions an even more colossal $500 billion market cap by 2026. Considering these projections, now is the opportune moment for institutions cautiously exploring liquid staking to fully immerse themselves in this burgeoning landscape.