What Is Liquid Staking? A Guide to Liquid Staking Tokens

Liquid staking is a mechanism that allows cryptocurrency holders to secure a proof-of-stake blockchain network and earn rewards without locking up their capital. In traditional staking, participants must commit their digital assets to a smart contract or validator node, making those funds illiquid and inaccessible for trading or other financial activities. Liquid staking resolves this capital inefficiency by issuing a tradeable digital token, known as a liquid staking token (LST), which represents the user's staked asset and its accrued rewards.

To understand this mechanism, one must first understand proof-of-stake. On blockchains like Ethereum, validators secure the network by locking up native assets, such as $ETH, to earn the right to propose and verify new blocks. The Ethereum Foundation specifies that native staking requires a minimum of 32 ETH, technical expertise to run a validator node, and subjects the staker to lock-up periods during which their assets cannot be moved. Liquid staking protocols lower these barriers to entry by pooling user funds, managing the underlying validator infrastructure, and issuing LSTs in return.

How Liquid Staking Protocols Work

When a user deposits cryptocurrency into a liquid staking protocol, the protocol routes those assets to professional node operators who run the physical validator hardware. In exchange for the deposit, the protocol mints and issues an LST to the user on a 1:1 basis. This token acts as a claim ticket on the underlying staked asset plus any rewards generated, minus a protocol fee.

For example, if a user deposits 10 ETH into a protocol like Lido, the protocol stakes those assets on the Ethereum network. The user receives 10 stETH, the liquid staking token representing their share of the pool. The user can then hold this token, sell it on a decentralized exchange, or use it as collateral in decentralized finance (DeFi) applications, all while the underlying ETH continues to earn staking rewards.

Rebasing vs. Value-Accruing Tokens

Liquid staking protocols generally use one of two token design models to distribute staking rewards to token holders: rebasing or value-accruing.

Rebasing tokens maintain a 1:1 price peg with the underlying native asset. To distribute rewards, the protocol automatically adjusts the token balance in the holder's wallet at regular intervals. Lido's stETH is a prominent example of a rebasing token. If a user holds 10 stETH and the protocol generates a 4% annual yield, the user's wallet balance will gradually increase to 10.4 stETH over the course of a year, while the market price of 1 stETH is designed to trade closely to the price of 1 ETH.

Value-accruing tokens do not change in quantity within a user's wallet. Instead, the token's exchange rate relative to the underlying asset increases over time as rewards accumulate in the pool. Rocket Pool's rETH and Coinbase's cbETH use this model.

To illustrate this with a numeric example, assume a user mints rETH when the exchange rate is exactly 1.00 rETH per 1.00 ETH. The user deposits 10 ETH and receives 10 rETH. Over the next year, the underlying pool of ETH grows by 5% due to validation rewards. The exchange rate shifts to 1.05 ETH per 1.00 rETH. While the user still holds exactly 10 rETH in their wallet, those 10 tokens can now be redeemed for 10.5 ETH from the protocol, or sold on the open market for an equivalent value.

The Role of Restaking

Restaking is an extension of liquid staking that allows users to secure multiple networks simultaneously. Pioneered by protocols like EigenLayer, restaking takes staked ETH or LSTs and applies them to secure external systems, such as oracle networks, bridges, or data availability layers, known as Actively Validated Services (AVSs).

By opt-in restaking, users expose their assets to additional slashing conditions in exchange for additional yield. Just as liquid staking created LSTs, restaking has led to the creation of liquid restaking tokens (LRTs). These tokens represent a user's restaked position, allowing them to remain liquid while earning both base staking rewards and restaking rewards from various AVSs.

Risks of Liquid Staking

While liquid staking offers capital efficiency, it introduces several layers of risk that do not exist with native, self-custodial staking.

• Smart Contract Risk: Liquid staking protocols rely on complex smart contracts to pool funds, distribute rewards, and mint tokens. If these contracts contain vulnerabilities or exploits, users risk losing their entire deposited principal.
• Slashing Risk: On proof-of-stake networks, validators can be penalized, or "slashed," for malicious behavior or prolonged downtime. If a protocol's node operators fail to maintain uptime or double-sign blocks, the network will confiscate a portion of the staked assets, reducing the value of the corresponding LST.
• Depeg Risk: Although LSTs are backed by underlying assets, their market price on secondary exchanges is determined by supply and demand. During periods of market stress or liquidity shortages, the market price of an LST can trade at a discount to the underlying asset, a phenomenon known as depegging. This can trigger liquidations for users who have used LSTs as collateral in DeFi lending protocols.
• Centralization Risk: If a single liquid staking protocol controls a dominant share of the staked assets on a blockchain, it poses a systemic risk to the network's decentralization and security. This concentration of power could theoretically allow the protocol to censor transactions or influence governance decisions.

Tax and Legal Considerations

The tax treatment of liquid staking varies significantly by jurisdiction, and tax authorities continue to update their frameworks.

In the United States, the Internal Revenue Service (IRS) ruled in Revenue Ruling 2023-14 that taxpayers must include the fair market value of staking rewards in their gross income in the taxable year they gain dominion and control over those rewards. However, the specific tax implications of swapping native assets for LSTs, or receiving rebasing tokens versus value-accruing tokens, remain subject to interpretation. Some tax professionals argue that swapping ETH for an LST is a taxable event, while others view it as a non-taxable deposit.

In the United Kingdom, His Majesty's Revenue and Customs (HMRC) has published guidance suggesting that the transfer of tokens to a staking platform may be treated as a disposal for Capital Gains Tax purposes, depending on the platform's terms of service. Because rules are complex and subject to change, market participants should consult qualified tax professionals regarding their individual circumstances.

Common Misconceptions

• Misconception: LSTs are always worth exactly the same as the underlying asset. While LSTs represent a claim on the underlying asset, they trade independently on open markets. Liquidity imbalances, smart contract exploits, or systemic market panics can cause the market price of an LST to drop below its redemption value.
• Misconception: Liquid staking is risk-free passive income. Liquid staking carries distinct technical, operational, and financial risks. Users are exposed to the operational competence of third-party node operators and the security of the protocol's smart contracts.
• Misconception: You must own 32 ETH to participate in Ethereum staking. While native validation requires 32 ETH, liquid staking protocols allow users to participate with fractional amounts of cryptocurrency, often with no minimum deposit requirement.

How This Connects to the Market

Liquid staking has become the largest sector in decentralized finance by Total Value Locked (TVL). The liquidity provided by LSTs serves as a foundational building block for the broader DeFi ecosystem. LSTs are frequently used as collateral in lending markets, as trading pairs in automated market makers, and as yield-bearing assets in structured financial products.

Consequently, the health and stability of major LSTs directly impact the systemic stability of the entire DeFi market. Disruptions in LST liquidity or smart contract failures can trigger cascading liquidations across multiple protocols, making the monitoring of LST liquidity pools a critical task for market participants.