Prepared by:
Introduction
Staking, an activity that allows for owners of certain cryptocurrencies to pledge their assets in support of transaction validation, sits at the intersection of blockchain security and the emergence of a blockchain-native application ecosystem. For networks like Ethereum, staking has evolved rapidly. The growth of staking is largely driven by the ETH-denominated rewards stakers receive.
At the time of writing, Ethereum has:
- Over 10 thousand active nodes that run
- Over 1 million active validators, with
- Over 34 million ETH staked (in dollar terms, greater than $100 billion is locked in Ethereum PoS consensus to help secure the network)
However, staking presents both risks and opportunity costs. This paper will cover the fundamentals of staking, its benefits and risks, and the associated opportunity costs. Additionally, we will cover what liquid staking is, how it works and its growth. Lastly, we will highlight key considerations for institutional entities when evaluating staking services.
What is Ethereum Proof-of-Stake?
Ethereum is a public blockchain powered by its proof-of-stake (PoS) consensus mechanism.
By staking (locking in protocol) ether (ETH), Ethereum’s native currency, users are granted the rights to propose and attest new blocks, ultimately progressing the blockchain.
Users participating in PoS consensus on Ethereum are often called node operators, who run validators. A validator refers to a client with a minimum of 32 ETH locked in the protocol staking contract and actively contributing to PoS consensus through validating software. Although the ability to run a validator is open to all, the requirements are not trivial, creating a barrier to entry that normal ETH holders can find challenging.
Capital requirements
Minimum ETH required for a validator: 32
Technical requirements
- Hardware: Ethereum validator software can be run on average consumer-grade computers, but many opt for specialized hardware to improve performance and minimize downtime.
- Software: Operating Ethereum validators requires a set of software: an Execution Layer client, a Consensus Layer client, a Validator client (which may be bundled with the Consensus Layer client and can “house” multiple validators concurrently), and possible add-ons.
- Operational: Operators of Ethereum validator clients must have access to a strong, reliable network connection to minimize validator downtime. Additionally, operators must have robust operational security procedures implemented to protect private keys from loss or compromise.
What is the Purpose of Ethereum Staking?
By staking ETH and running validator software, node operators work to secure the Ethereum blockchain and enforce the protocol that is designed to guard against certain attacks.
By following the consensus protocol, validators propose new blocks and attest to the validity of transactions. Having such a large pool of decentralized nodes and validators makes it increasingly expensive for an attacker to compromise the network. At current participation rates, an attacker must acquire and stake over $100 billion of ETH to perform a ~50% attack.
Underlying Ethereum’s PoS consensus is the social consensus of every individual node operator running validators on Ethereum. That is to say, in the unlikely event of a successful attack against the Ethereum network, social consensus may step in as a backstop to fork away from the attacker’s chain, rendering the attacker’s attempt to threaten Ethereum’s security futile and leaving the attacker with a significant capital loss.
What are the Costs of Ethereum Staking?
The possible costs of Ethereum staking include hardware costs, the opportunity cost of capital, gas fees to transact on the network, and utility costs (internet, electricity, etc.).
Node operators can minimize each cost depending on the specific staking setup chosen.
- Hardware costs: Ethereum staking hardware varies in cost depending on the level of specialization, but many solo stakers use consumer-grade hardware with minimal setup costs.
- Opportunity cost of capital: Ethereum staking requires ETH to be locked in the protocol, and therefore, staked ETH is inaccessible for trading.
- Gas fees: The network requires a gas fee when transacting on the Ethereum blockchain. In a steady state (low congestion) period on the Ethereum, gas fees for deposits into the staking contract should be minimal.
- Utility costs: Compared to proof-of-work consensus, Ethereum’s PoS requires far less energy but still requires a fast, unlimited, and reliable internet connection.
What are Some of the Risks of Ethereum Staking?
The benefits of Ethereum staking include the normative benefit of supporting the security of the Ethereum blockchain, incentivized by the opportunity to earn ETH-denominated rewards via protocol-issued transaction fees and maximum extractable value (MEV).
- Market risk: ETH’s market value can experience significant changes while it is staked. When a user commits their ETH to the Ethereum protocol for staking, it is inaccessible for trading or withdrawal. Additionally, rewards are denominated in ETH, whereas costs (hardware, utilities) are not and, therefore, can quickly be fully or partially offset by market volatility in the underlying asset (ETH).
- Technology risk: Nodes must run according to the protocol rules, and failure to do so, or experienced downtime, can result in protocol-enforced penalties ( In Ethereum, slashing only occurs if the network perceives that a validator has misbehaved, but validators are not slashed for being offline). Further, there is always the long-tail risk of bugs or vulnerabilities in the code of the Ethereum protocol and the implementations (software) node operators use to participate in the network or the loss of private keys, which may result in loss of funds.
- Counterparty risk: Engaging in staking through external platforms or exchanges introduces users to counterparty or custody risks. Entrusting a platform with staking capital carries the danger of loss due to theft, hacking, company failure, or poor management.
What are the Benefits of Ethereum Staking?
The benefits of Ethereum staking include the normative benefit of supporting the security of the Ethereum blockchain, incentivized by the opportunity to earn ETH-denominated rewards via protocol-issued transaction fees and maximum extractable value (MEV).
- Network Security: As previously discussed, the act of staking gives users the ability to contribute to the security of the network. Although it is outside the scope of this paper, it is worth noting that Ethereum’s PoS consensus secures not only Ethereum’s base layer but also Ethereum layer 2 rollups via making layer 2 data available to base layer nodes (see “EIP 4844” and “data blobs”).
- Protocol-issued block rewards: A programmatic schedule dictates the level of protocol-issued rewards based on the total number of active Ethereum validators. As the total active validator set increases, the protocol-issued contribution to validator rewards decreases. At the time of writing, the protocol-issued rewards are about 2.9% (note: rewards are volatile as different validator duties are rewarded differently; thus, a staker, especially one running very few validators, may realize a very different return on capital depending on how lucky their validators are and how long they have been active).
- Transaction fees: A portion of transaction fees is evenly distributed to all ETH holders via the base fee burn mechanism, and the transacting Ethereum user includes a portion to incentivize block proposers to prioritize their transactions (priority fees).
- MEV: For the randomly selected proposing validator in a given block, additional value beyond protocol-issued block rewards and transaction fees can be extracted via sophisticated block order and transaction insertion techniques.
While the above reward estimates are approximations and may vary reasonably in practice, the total incentive for individuals to stake their ETH to secure the Ethereum network is typically between 3 and 3.5% at the time of writing.
Ways to Stake ETH
There are a variety of ways to stake Ether that vary based on:
- Whether you run your own nodes (on-prem or cloud) or rely on a third party,
- Who effectively has access to capital,
- Whether staked ETH is routed in a smart contract or third-party custodian, is a liquid token minted, or not.
| Staking Model | Provider Examples | Who controls the ETH | Who operates the validators | Redemption Process |
|---|---|---|---|---|
| Solo staking | n/a | Investor | Investor | Direct with Ethereum staking contract |
| Staking-as-a-service | Figment, P2P, Kiln,Stakefish | Investor | Central Provider | Direct with Ethereum staking contract |
| Custodial staking-as-a-service | BitGo, Sygnum Bank, Hex Trust | Central Provider | Central Provider | Through central provider to Ethereum staking contract |
| Centralized liquid staking | Coinbase (cbETH), Binance (BETH) | Central Provider | Central Provider | Against a managed pool or through secondary market |
| Decentralized liquid staking | Lido (stETH/wstETH), Rocket Pool (rETH) | Smart Contract Software | Participating validators | Against an automated pool or through secondary market |
What are Some of the Risks of Ethereum Staking?
There are many risks to be aware of regarding Ethereum staking and digital asset ecosystems in general. Below are some of the major risks of Ethereum staking from an investor’s perspective.
- Market risk: ETH’s market value can experience significant changes while it is staked. When a user commits their ETH to the Ethereum protocol for staking, it is inaccessible for trading or withdrawal. Additionally, rewards are denominated in ETH, whereas costs (hardware, utilities) are not, and therefore, can quickly be fully or partially offset by market volatility in the underlying asset (ETH).
- Technology risk: Nodes must run according to the protocol rules, and failure to do so can result in protocol-enforced penalties. Offline nodes may be subject to reduced rewards, and slashing penalties are applied if the network perceives that a validator has misbehaved. Further, there is always the long-tail risk of bugs or vulnerabilities in the code of the Ethereum protocol and the implementations (software) node operators use to participate in the network or the loss of private keys, which may result in loss of funds.
- Counterparty risk: Engaging in staking through external platforms or exchanges introduces users to counterparty or custody risks. Entrusting a platform with staking capital carries the danger of loss due to theft, hacking, company failure, or poor management.
What is Liquid Staking?
Over time, several liquid staking solutions for Ethereum have emerged. However, they can broadly be classified into two distinct categories: ‘active service’ vs. ‘decentralized middleware’.
Active Service (Centralized Liquid Staking)
An active service liquid staking solution is typically operated by the underlying centralized providers, who pool investors’ ETH and stake on their behalf, operating validators in-house. Using an ‘active’ liquid staking service is akin to engaging in a contractual relationship with these identifiable third-party node operators. The software is used as a customer acquisition entryway for new deposits. One of the benefits of active staking services is that by pooling ETH these providers are democratizing access to staking by reducing the minimum contribution of any individual staking contributor.
Decentralized Middleware (Decentralized Liquid Staking)
A decentralized middleware liquid staking solution separates the software from the underlying validation activity. The software functions as neutral middleware, governing the operations conducted on ETH routed through it, and the participating node validators have no direct say in its parameters or operations. The software itself separates the validation activity from the user. It is, therefore, akin to using open-source software.
In both types of liquid staking, service providers (node operators) step in to run and monitor the technology required to stake ETH on the Ethereum network. In exchange for these services, liquid staking node operators typically charge a fee accrued as a percentage of staking rewards or a flat fee per validator.
Liquid staking tokens themselves are freely transferable and usable (e.g., for use in decentralized finance applications, exchanged between users, and tradeable on secondary markets), thus providing the opportunity to offset some of the opportunity costs when ETH is locked in the protocol for staking.
Liquid Staking Mechanics
ETH holders depositing ETH into a liquid staking platform receive a new token representing an access key to the pool (a Liquid Staking Token “LST”). LSTs can later be redeemed for underlying ETH (plus accrued staking rewards). Alternatively, LSTs can trade openly on a secondary market at various centralized (e.g., Bybit, OKX) or decentralized exchanges (e.g., Uniswap, Curve). Increasingly, provided they are liquid, LSTs can be used at the core of sophisticated strategies or structured financial products. As such, LSTs have two sources of redemption value: (1) the ‘primary’ value at which they can be redeemed directly with the liquid staking protocol (effectively the Net Asset Value “NAV”) and (2) the ‘secondary’, or market, price (determined by buying and selling market participants in the LST’s secondary markets).
Net Asset Value (NAV)
All multi-customer staking services will follow some variation of a general formula for calculating the redemption price of a given token as a proportion of the NAV. Lido stETH, for example, uses the concept of ‘shares’ owned by an address, allowing the rewards rate to accrue without incurring a gas fee to mint new tokens. In the case of Lido, the internal primary mechanism for redemption is always 1:1, but the amount of ‘shares’ a user controls with their token changes with staking rewards.
The tokens can reflect the balance accrual in one of two ways. This is a minor technical distinction as a rebasing token can be ‘wrapped’ in an accrual token with no change to its underlying liquidity:
- Accrual or cToken: As staking rewards accrue, the number of tokens the user holds stays the same (no new tokens are minted), and an underlying ‘redemption rate’ grows. In this model, the LST-to-ETH exchange rate grows as time passes. Examples include Rocket Pool’s rETH or Lido’s wstETH.
- Rebasing Token: As staking rewards accrue, new tokens are created at the same rate. Even if a user swapped for the LST on a secondary market, the LST balance in their wallet would eventually grow passively. Examples include Lido’s stETH.
| Pros | Cons | |
|---|---|---|
| Accrual | Better for integration with some DeFi protocols as token balances are fixed. | Less intuitive for some investors who may wonder why the price of the LST is different than the underlying redemption rate |
| Rebasing | Yield aggregation is more straightforward for investors as the supply increases. | Integration with some DeFi protocols is a challenge. |
LST Secondary Market Trading
ETH LSTs can trade on various centralized or decentralized exchanges. The price typically trades close to parity with NAV due to the mint (creation) and burn (redemption) functions governing the liquid staking system. These functions allow arbitrageurs to act to bring secondary market prices closer to primary market (i.e., in-protocol) exchange rates when they diverge.
The minting and burning dynamics are important mechanisms for supporting an LST’s secondary market price relative to the underlying asset’s NAV. They also allow users to transact at a discount or in quicker transactions compared to the time required for normal in-protocol redemption.
The scenarios below explain how arbitrage can act to close the gap between NAV and secondary market price.
- Scenario 1: The secondary price is greater than the primary price (NAV)
- Arbitragers can sell LST to Underlying Asset, stake Underlying Asset, mint LST, and repeat until the premium is erased.
- Scenario 2: The secondary price is less than the primary price (NAV)
- Arbitragers can buy LST with Underlying Asset, redeem Underlying Asset by burning LST, and repeat until the discount is erased (This arbitrage is only possible for protocols with “unrestricted” (by available supply) mint capacity).
There are a number of factors that can drive the secondary market price of an LST to temporarily deviate from the NAV of the underlying asset. In most cases, arbitrage activities will quickly correct these situations if the underlying asset is able to be immediately redeemed and sufficient liquidity exists to support the secondary market price. As observed leading up to the Ethereum Shanghai/Shapella Upgrade (Shapella), extended lock-up periods that make underlying assets inaccessible can cause prolonged periods of price deviation. Prior to the Shapella Upgrade, users could deposit ether to stake but could not redeem the underlying assets. During this lock-up period, Ethereum denominated LSTs typically traded at a discount relative to ETH because the liquidity and utility of the LST were far less than ETH. Post Shapella upgrade, this discount was largely erased as redemptions were enabled and arbitrageurs stepped in. Although ETH denominated LSTs now typically trade relatively close in value to the NAV, in both accrual or rebasing models, this would not necessarily be the case for other non-ETH denominated LSTs.
The Importance of Liquidity for Liquid Staking Tokens
Buying and selling LSTs through an exchange removes the need for directly minting and burning them, and enables the conversion between cash or stablecoins and staked ETH in a single transaction. However, while LST issuers ensure LSTs can be redeemed for the underlying staked ETH, secondary liquidity cannot be assured and is a function of market demand. Investors should consider the following factors when evaluating the liquidity profile of an LST:
- Circulating supply: the total number of tokens available in the market. A higher circulating supply indicates a larger market and potentially more price stability.
- Number of available exchanges: with more exchanges, investors have the flexibility to find the optimal price across venues.
- Daily trading volume: the total amount, in dollars, traded daily. A high daily trading volume reflects a broad counterparty landscape, which can lead to faster execution and narrower bid-ask spreads.
Risks and Considerations for Selecting an Liquid Staking Token
A user interested in liquid staking tokens must match their selection criteria with their own risk appetite and weigh the trade-offs for selecting one provider over another. The general areas for consideration when selecting a liquid staking provider are very similar to that of normal staking; however, some nuances must be thought through for each, as well as some additional incremental risks:
Counterparty and Custody Risk
Liquid staking solutions can operate on a spectrum of centralization, from ownerless and fully immutable contracts to centralized providers. Understanding the nature of the counterparty and the parameters that are actually governed is critical to evaluating the risks.
Decentralized liquid staking protocols, such as Lido stETH, are typically upgradeable but with great difficulty by design. Services like Lido include mechanisms to empower stETH users to delay governance motions with the addition of Dual Governance. Utility token holders enforce these governance processes, and smart contracts manage the execution of rule-set parameters. Importantly, these smart contracts control all underlying staked ETH in the pool, creating a potential single point of failure. As such, most protocols will hire external smart contract security reviewers to assess code for potential flaws. The results of these assessments are often published publicly and should be taken into consideration when assessing risk. For more information on smart contracts, refer to “Smart Contract and Compliance Risks” below.
In more centralized settings such as crypto-native exchanges or centralized liquid staking providers, stakers are provided with a seamless staking experience, governed by corporate policy and provided at a premium. There are no decentralized governance processes with centralized staking services; therefore, the individual staker is not offered transparency into the operation of the staking protocol and usually assumes a level of risk from this unilateral control that does not exist in a decentralized model. In particular, custody of the withdrawal keys remains in the hands of the counterparty, introducing an element of custody risk.
The benefits of disclosure and transparency are important features of open-source software or decentralized liquid staking tokens. While similar levels of transparency are not offered by centralized staking services, legal structures protect investors in the event of failure. In either case, the staker must be aware of how their assets are managed by carefully evaluating the available evidence.
Financial Risk
Fees
No market standard fees are associated with staking services, whether through a centralized or decentralized provider. However, in most cases, the fees associated with using a particular service are readily available through published documentation. With regard to centralized staking services, fees can range anywhere from 10-35% of the rewards generated. There are typically no direct transaction fees associated with the minting or redeeming of LSTs.
For decentralized liquid staking providers, fees are lower, ranging from 10%, in the case of Lido stETH, to 14%. Although fees are typically lower than those from centralized services, stakers should know that these percentages are subject to change through protocol governance processes. It is important for anyone using decentralized staking services to stay informed about protocol governance proposals that could change fees. There are no requirements for disclosure or service level agreements (SLAs) governing how a DAO will communicate rate changes such as fees; therefore, a more proactive approach to monitoring is necessary.
Comparing fee levels is not always the most suitable approach to determining the most economical option. The best comparison is always the staking reward rate net of all fees accrued to the user. A service that performs worse may offer lower staking rewards net of fees, even if those fees are nominally lower. Typically, exposure to as broad a set as possible of the overall validator network is a robust way of ensuring stable and high-quality performance over time.
Market Risk
Market and liquidity risks are also important to consider when selecting LSTs, particularly the depth of liquidity associated with each LST. Investors should consider the maturity of the token, its circulating supply, and its market cap to understand its liquidity profile. Liquidity depth can be assessed by asking for quotes from OTC desks and prime brokerages. Additionally, the number of exchanges (centralized or decentralized) the LST trades on is an important indicator of liquidity. The answers to these questions directly impact the prospective user’s ability to trade an LST at a desirable secondary market rate relative to other assets.
Some LSTs may have a more limited market reach or be eligible for listing on fewer centralized exchanges. In these cases, single large trades can cause dramatic price swings, increasing the need for seamless access to primary redemption at the issuer. While primary liquidity is logically unbounded upwards, it is constrained on the redemption leg of a trade from an LST to ETH by the amount of on-call withdrawable ETH. During sustained periods of market volatility, the withdrawal queue for staked ETH, shared by all stakers on Ethereum regardless of their profile, can reach days, if not weeks. Users of an illiquid LST may face illiquidity risk and be unable to exit their staked position during periods of sustained market volatility. These are, of course, periods during which secondary liquidity is at its most valuable.
Research conducted by Steakhouse Financial has shown that Lido stETH, a decentralized LST, has sufficient secondary market liquidity to strongly correlate in price with both spot ETH markets and ETH futures trading markets on the CME. Organic trading volume for stETH regularly reaches tens, if not hundreds, of millions of dollars a day. The research also found that most deviations between stETH and ETH futures greater than 10bps returned to the baseline within hours. These results suggest that an efficient market with deep liquidity and natural arbitrage activity exists for LSTs that have sufficient liquidity to sustain institutional levels of volume in demand.
The continuing maturity of LST markets suggests a future where crypto-based ETFs or other exchange-traded products could unlock the value of their underlying assets through the use of decentralized LSTs, provided these tokens feature sufficient secondary liquidity.
Penalties and Slashing Risk
Penalties and slashing are costs incurred by nodes for various negative actions. In some cases rewards are reduced and in others ETH is burned. The more egregious the infraction, the stiffer the penalty. Although significant slashing is a relatively infrequent occurrence, it is a non-zero risk that should be considered for prospective LST users.
- Small penalties can occur if a validator misses or performs duties incorrectly (penalizable duties are a subset of overall validator duties, and some duties that can confer rewards do not carry penalties if missed or performed incorrectly).
- Slashing is a special type of penalty in Ethereum incurred only if a validator violates one of three protocol rules: signing two different blocks for the same slot, signing an attestation that surrounds another, or signing two different attestations with the same target. The penalty commensurate with a slashing starts at 1 ETH. It can increase depending on how many other validators are slashed across the network within a certain period of time before and after a validator’s slashing event. A slashed validator is automatically marked for exit by the Ethereum protocol.
For centralized and decentralized LST providers, slashing decreases the underlying asset. Unless mitigated by the service provider (many staking providers will offer partial coverage for slashing events), the loss of funds and financial risk is passed on directly to the staker, undermining the value of their LSTs.
For centralized providers, it is important to understand the mitigants in place to compensate for staking penalties and the history of prior penalties incurred. While the absence of any penalties incurred is often used as a differentiator, it could also reflect a lack of experience with the range of potential slashing events and the mitigation measures’ effectiveness if such events occur. Furthermore, for many centralized providers, it’s impossible to fully ascertain the history of prior slashings (if any) as there’s no obligation to report them. While industry practice is generally to do so, large slashings in the past have not been publicly reported. Slashings are visible to everyone on the network. Still, mapping validators to staking providers is usually an exercise in inference, as the mappings for centralized providers are not public. Therefore, you may be able to see which validators have been slashed; however, you do not have a definitive way to determine if they are associated with a specific centralized provider.
Many node operators offer additional value-added services, such as deposit insurance, to minimize the risk of loss to deposited ETH. However, insurance solutions for staking are an emerging sub-industry with untested claims and currently finding insurance that covers all 32 ETH per validator can be challenging. The rates charged for insurance can either significantly reduce the net rewards rate from staking or put financial pressure on a node operator, which can threaten to compromise the economic viability of the LST issuer or make the act of operating a node economically uninteresting if the costs are not passed on.
In some decentralized protocols, rewards and slashings are socialized across all LST holders. However, in some DAOs, the use of surplus, which is collected as part of the staking fees, can be used to compensate stakers for slashing penalties. This type of program is usually an outcome of a DAO governance vote, and compensation is not guaranteed. Alternatively, a DAO can hold the individual node operator responsible for making their stakers whole as part of their agreement with the DAO.
Structurally, decentralized LSTs feature participation from a wide range of node operators. This diversification helps mitigate counterparty and operational risks related to staking penalties or slashing. It can reduce the likelihood of such events occurring or materially affecting the protocol’s ETH balances should they occur.
Technology Risks
Smart Contract and Compliance Risks
Smart contracts track the ownership and total supply of any given asset and the rules by which that asset can be created, destroyed, or transferred. Decentralized liquid staking products also automate user interactions through smart contracts, increasing the surface area of smart contract risk.
One of the benefits of the Ethereum Virtual Machine (EVM) as a standard for digital assets is the prevalent use of token standards, such as ERC-20 or ERC-721, to facilitate interoperability and speed up integrations among applications. Most LSTs, regardless of what kind, employ these standards. These standards only set forth minimum requirements that any issuer can use, whether centralized or decentralized. Application-specific extensions can enhance the functionality of their smart contracts by building upon these minimum requirements.
For example, a centralized institution may include a blacklisting function in its smart contract logic to ensure its assets are not transferred to criminal organizations, sanctioned individuals, or other publicly identified addresses of high risk. A centralized issuer may have to introduce these features or other frictions, as they share many characteristics with entities that exercise custodial control over customer assets. These requirements mitigate the risk of a centralized issuer managing customer assets for sanctioned organizations or individuals.
Decentralized liquid staking software, much like open-source software protocols, such as SMTP or HTTP, do not typically have blacklisting features. They typically do not have sufficient parameters enforced in the code to grant them the same degree of unilateral control or custody over user assets or behavior. Furthermore, they do not perform validation or asset management activities independently. They are designed and performed like software protocols with no contractual or custodial relationship. The parameters that regulate the software’s functioning are also not determined by any one individual or entity.
Custodians focus on minimizing the risk of money laundering or terrorist financing related to the movement and management of customer assets. The validation activity does not allow for fund flows in a way that could increase these risks. All staking or validation activities, whether performed by a solo staker or a self-described ‘institutional staking’ service provider, do the same thing from a technical and asset flow perspective.
All staked Ether is deposited on the same deposit contract and mapped to a validator on the Consensus Layer. No special affordances are made in the Ethereum protocol to different types of validators, ‘institutional’ or otherwise. In other words, all validators are undifferentiated from each other, do not transfer ETH from one to another and cannot be used to communicate assets from one party to another through validation activities alone.
Transferring private keys for withdrawal addresses may introduce the possibility of fund flow if one entity transfers withdrawal keys to another to conceal a movement of Ether. However, this is only possible when an identifiable entity, such as a centralized platform, controls those keys. Even in those cases, those withdrawals would be, like all withdrawals, public and visible to anyone observing the history of blockchain transactions.
It is reasonable to require centralized service providers with a degree of custodial control over user assets to execute risk mitigation processes such as KYC/AML checks on customers. However, decentralized liquid staking protocols are not equipped to adhere to those same requirements. They do not have the same degree of custodial control, ability to access user funds, or function with centralized governance and that is by design.
In the aggregate, these risk-mitigation features in centralized solutions can introduce friction to the minting and redemption process. For centralized liquid staking tokens, these frictions can result in a slower or delayed minting and redemption process, thereby slowing down the price discovery process in secondary market trading.
To help mitigate smart contract and compliance risks, it is always best practice to use pre-built and battle-tested open-source code available for smart contracts that have been reviewed by independent, reputable 3rd-parties, and have formal verification for critical system components. To supplement this, bug bounty programs can incentivize white hat hackers to identify potential vulnerabilities in smart contracts before they are exploited. Open source code can be a double-edged sword because nefarious actors have the same access to source code as everyone else and can, therefore, spend time looking for ways to exploit it. Conversely, open-source software is regularly used in high-security settings precisely because of the higher grade of security derived from more thorough vetting by a larger number of stakeholders, contributors, and institutions.
Regarding liquid staking, it is important to understand the core components used to build smart contracts that manage the creation, custody, rewards distribution, and withdrawal processes for the underlying staked assets. This includes who, if anyone, has direct access to stakers’ funds via private keys or who (including other smart contracts) has the authority to make calls to smart contracts that can access the underlying funds.
Data Risks
Completeness and accuracy of data is critical for any smart contract that needs to perform calculations using external data. LST smart contracts rely on oracle data for accurate pricing and rebase calculations performed for rewards. In trustless (without a centralized counterparty that must be ‘trusted’ for the network to function) networks a diverse network of oracles should be used to mitigate the risk of inaccurate pricing. A common practice is to identify a set of “n” oracles that require an “m” number of those oracles to arrive at an “m-of-n” consensus on data before a smart contract ingests that data. This helps mitigate the risk of inaccurate pricing and pricing manipulation. Protocols should clearly define their oracle implementation as part of their publicly available documentation. Further risk mitigation steps are possible, such as sanitizing input data on the level of smart contracts, monitoring oracle performance or providing the ability to edit and replace oracle members.
Operational Risks
Liquid staking protocols rely on a set of node operators to run the validating clients that earn the staking rewards distributed to individual stakers. This introduces third-party risk associated with the node operators, and understanding the process in which these operators are selected is important. As such, several models have emerged on how protocols select their node operators.
- The underlying node operators run and control Centralized liquid staking protocols, creating a counterparty surface-to-face.
- Decentralized liquid staking protocols separate governance of software parameters from participants, such as node operators.
- Node operators can be onboarded through a governance process in which token holders manually approve listing a new node operator or,
- permissionless which allows for any individual or entity to run validators generally using a bonding mechanism.
Each protocol, centralized or decentralized, will have its own rules and criteria for its selection processes; no set checklist accounts for all protocols, networks, and clients.
Focus can be put on an individual node operator’s maturity and its ability to demonstrate things like continuous uptime metrics, diversification of hardware and software used to run nodes, proper key management and cybersecurity hygiene, robust business continuity plans, and an overall alignment of ethos with the protocol they are serving. Hardware and software requirements are easy to validate, but ensuring that a node operator shares the same values in more decentralized models can be more difficult. In some cases, protocols will evaluate a node operator’s track record of alignment with community values and the underlying network they serve.
At the protocol level, it is important to consider the diversity of the overall node operator set. From an operational risk perspective, this is a critical mitigant to ensure operational resilience. This requires ensuring the operator set is not centralized around a specific geographic position, hardware, or software set-up. Configurations with one or few node operators increase operational risk and degrade the long-term quality of Ethereum validation by concentrating validation activities on single points of failure. Liquid staking protocols that utilize a broader and more diverse set of node operators fragment the concentration of idiosyncratic or operational risk compared to single centralized providers or centralized liquid staking tokens run by a few node operators.
Conclusion
As the markets for digital assets continue to mature, technological innovations have emerged that facilitate the integration of the blockchain economy with the real world. Liquid staking is one such innovation, providing users with access to the blockchain economy in a stable and liquid manner while simultaneously strengthening the crypto-economic security protocols of these proof-of-stake networks by lowering the barrier to participation in securing the network through staking.
Currently, there are several implementations of liquid staking tokens, each with its own risk profile that must be analysed before committing funds to it. This paper has covered several considerations for prospective users who choose liquid staking service providers. Not all protocols are the same, and making an informed decision is the best way to maximize rewards in alignment with personal or organizational risk tolerance.
Disclaimer
The information and opinions provided in this document is for general informational purposes only and does not constitute financial, investment, legal, or other professional advice. It is not intended to be a substitute for professional consultation. Any reliance you place on the information and opinions contained herein is strictly at your own risk.
The author(s) and any affiliated entities make no representations or warranties, express or implied, regarding the accuracy, completeness, or reliability of the information or opinions provided. The cryptocurrency market is highly volatile and involves substantial risks. Past performance is not indicative of future results.
The author(s) and any affiliated entities disclaim any liability for any loss or damage, including but not limited to any loss of profits, which may arise directly or indirectly from the use of, or reliance on, the information and opinions contained in this document.
It is strongly recommended that you seek advice from a qualified professional regarding any specific financial, investment, or legal matters.
