How Safe Is Liquid Staking?
While crypto has seen marginal relief from the depths of crypto winter, one corner of the of the crypto world is back to record highs. That corner belongs to liquid crypto staking. Anyone who followed the hype and jumped into crypto at the 2021 $60,000+ Bitcoin peak should not be faulted for being skeptical. How safe is liquid staking? For that matter, just what is it and is it something that anyone can do? Like crypto itself in the days before its peak, liquid staking looks attractive and potentially quite profitable. However, there are significant downside risks to consider before jumping into this red hot sector of the crypto realm.
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What Is Staking?
At its most simple and basic level staking involves parking crypto assets with Ethereum, Solana, Tezos, Cardano, Cosmos, and others and earning rewards. The tokens that are staked become part of a consensus mechanism for proof of stake. This is a way to verify crypto transactions without using a bank or other agency as a middleman. This is a proof of stake approach to transaction verification as opposed to a proof of work approach like Bitcoin uses. Proof of stake uses much less energy to accomplish than does proof of work. Those who stake their tokens to accomplish this task receive payment in tokens for tying up their Ether or other crypto assets.
Drawbacks of Staking
When a person puts their tokens to work staking they are tying up their assets. This is similar to purchasing a certificate of deposit at a bank. The best interest rates are on the longer term CDs. While these investments provide a better rate of return for investors than shorter term CDs, they also leave the investor open to exchange rate risks and interest rate risks. The same applies to basic staking. Your tokens are tied up for a period of time during which they could fall significantly in value against the US dollar.
Liquid Staking to the Rescue
Also known as soft staking, liquid staking allows a person to have access to their staking assets for other activities in cryptocurrency while still earning rewards on their deposit. How does it work? Liquid staking is one of a number of staking options. All of them involve depositing tokens and receiving newly minted tokens as rewards. The advantage of liquid staking over basic staking is that a person has access to their funds for other crypto investments. The drawback is that if they lose their money in the other investment, they no longer have staked crypto assets nor any rewards.
Types of Staking - Self Staking
What all types of staking have in common is that they allow for a proof of stake validation protocol which is much more efficient in terms of energy consumption than the proof of work protocol that Bitcoin still uses. At the top of the staking food chain is self staking. An individual or business stakes a large number of tokens and takes on the job of validating transactions. In the Ethereum system this costs 32 ETH. Because the person takes on the responsibility of validation, they also carry the responsibility for any losses if they make mistakes. Mistakes in Ethereum commonly cost half of a person’s stake which they have to replace in order to continue working as a validator and receiving rewards for their stake. With this type of staking all of one’s assets are tied up in the system and not available for other investments.
Exchange Staking
A cheaper way to stake is through a centralized exchange. Customer assets are pooled. The person is not directly involved in or responsible for validation. Their funds are still locked up with no access for other investments but they do receive new tokens as rewards. It is much easier to unstake in this situation much like a person simply withdraws money from their bank savings account. However, there are typically withdrawal fees.
Risks of Liquid Staking
The attractive part of liquid staking is that a person can deposit their tokens, receive rewards, and have access to their tokens for other crypto investments. This sounds like eating your cake and having it too! In other words you are depositing your tokens, getting rewards, and still getting to use them. Sounds too good to be true. When a person takes crypto out of their staked deposit to use elsewhere they receive a “tokenized” version of their original token. Unfortunately, the tokenized version can “depeg” from the original token becoming significantly less valuable. When they are finished with their separate crypto business venture they may not have enough value to replace what they borrowed. And, if their outside venture was a total failure they will have to come up with what they originally borrowed in the original token to replenish their account. The point is, there is no free lunch in the crypto world or anywhere else.
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Originally published at https://profitableinvestingtips.com on September 11, 2023.
