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Liquid staking derivatives (LSD) have revolutionized the staking landscape by combining pool staking and tokenization. Holders of Proof-of-Stake assets can deposit their tokens into Liquid Staking Protocols in exchange for newly minted LSD tokens. Just like pooled staking, LSD tokens carry the title to a share of the staking rewards of the pool. However, contrary to pool staking, they can be transferred on-chain to other wallets or smart contracts. This feature of LSDs has two important applications:
- Liquidity: holders of LSDs can simply sell their tokens to exit their stake, which allows them to get liquidity without being subject to any constraints imposed by the protocol.
- Composability: LSDs allow to use of staked assets with other smart contracts. For instance, holders of LSDs could deposit their tokens into a borrowing and lending protocol to get leverage against their stake. As another example, they could deposit their LSD tokens into an Automated Market Maker (AMM) to engage in liquidity mining.
While this innovation offers compelling advantages, it introduces nuanced risks, especially concerning regulatory challenges and market dynamics. A deeper dive into these aspects reveals critical considerations for participants in the liquid staking ecosystem. We present three main risks that should be critically evaluated by participants in these protocols: regulatory risk, market risk, and liquidity risk.
Regulatory Risk
The regulatory framework for crypto assets remains a complex and evolving landscape. Despite being often advertised as receipt tokens, many LSDs share many features with financial derivatives and securities, most notably with fund shares due to the underlying pooling mechanism adopted by many LSD protocols. Without clear guidelines, there’s a risk that future regulatory actions could disrupt the operations of liquid staking platforms, particularly those operating without stringent anti-money laundering (AML) and know-your-customer (KYC) protocols. The absence of AML/KYC measures makes these platforms vulnerable to regulatory scrutiny, which could lead to sudden enforcement actions, affecting the liquidity and operational viability of liquid staking derivatives. Moreover, regulatory bodies might classify liquid staking tokens as securities or other regulated financial instruments, imposing stringent compliance requirements that could reshape the market or limit participation.
Market Risk
Liquid staking derivatives are increasingly integrated into decentralized finance (DeFi) ecosystems, serving as collateral for loans or facilitating leverage trading. This integration, while beneficial for ecosystem liquidity and utility, introduces compounded market risks. For instance, a significant downturn in the market could trigger a cascade of forced liquidations if the staked assets used as collateral fall below certain thresholds, leading to market instability and amplified losses for participants. Given that most PoS protocols impose unbonding constraints, a disproportionate amount of forced liquidations could cause the protocol to run into a duration mismatch, where no liquid tokens are available to meet withdrawals from LSD holders. Additionally, the reliance on these derivatives in DeFi protocols could exacerbate the impact of smart contract vulnerabilities, affecting not just the liquid staking platforms but the broader DeFi ecosystem.
Liquidity Risk
Due to the uncertain regulatory treatment of LSDs, the liquidity of these tokens on regulated centralized exchanges and over-the-counter (OTC) markets tends to be poor. Participants may find it challenging to exit large positions without experiencing significant slippage. This risk is particularly acute in extreme volatility scenarios. Such situations can lead to a vicious cycle where the attempt to sell off tokens en masse further depresses prices and liquidity, potentially leaving investors with illiquid assets during critical times.
Other risks
The three risks presented thus far are by no means an exhaustive list. Indeed other risks such as smart contract risk, slashing risk, and counterparty risk, are important to consider and can lead to significant losses.
Takeaways
LSDs can be used to improve the performance and liquidity of crypto asset portfolios and should therefore be considered by investors and asset managers that intend to engage with staking. However, given the significant risks involved, it is important to:
- evaluate thoroughly the issuer and the underlying smart contracts.
- analyze the liquidity of the LSD token and ensure it is in line with the liquidity needs of the token holder.
- Fully consider the regulatory implications of investing in such tokens.
As a heuristic, the degree to which LSDs can be beneficial for an investor’s portfolio depends on, how heavily regulated the investor is, the duration of the investor’s liabilities, and how thoroughly the investor understands the mechanics and technical risks of the protocol.
