DeFi liquid stake missing parts

DeFi will be dominated by liquid staking in 2024. Offers an option to increase the liquidity of crypto without having to mint excessive Ethereum.ETHThe technology has risen to the summit of DeFi and reached the threshold of $60 bln TVL 

As block reward assets have the highest productivity in decentralized financing, they should be considered as collateral of high quality in DeFi. Liquid staking is gaining popularity, but its major flaws remain untouched. Achieving its long-term potential in full is impossible without recognizing these flaws—and taking action to eliminate them.

The risks of tokenized derivatives

Why has liquid staking been so popular? Locked assets earn no return besides the staking rewards for block validation—an integral part of the ecosystem security but pain for investors who sacrifice their liquidity and are exposed to opportunity costs. In traditional finance, the issue of loans earning nothing but interest was circumvented by repurchase agreements—repos. Repos act as a tradeable claim over deposited assets. This is the same function that LSTs, LRTs serve.

LSTs, LRTs and TradFi are all vulnerable to the exact same flaws. A liquid staked token’s value is backed up by the collateral. This is the pooled ETH that powers the validator node. Idealy, the liquid-staked token’s market value should match its underlying price. It means buyers will not have to worry about whether ETH represented during the lock-in period is refunded.

What if this is not true? What happens if the validator is punished for misbehaving by being slashed? What if there is a liquidity problem for a particular LST pair to the point that the traders will no longer hold their position? What if there is an attack on the protocol, like it happens often in DeFi.

A confidence drop, a run, and collateral de-pegging—this is the sequence that brought down the infamous Anchor protocol of Terra-Luna and rippled ominously across the whole industry. The systemic risks are just beginning. For example, liquid restaking tokens can represent an asset claim and be used as a security layer for multiple protocols. When correlated slashing—now only a theoretical possibility—becomes reality, the whole DeFi industry may perish in flames.

It is important to have diversified strategies for risk, conduct constant code reviews, and use multiple platforms, tokens, and currencies. The growing economy of DeFi will remain fragile if it does not diversify its risk strategies, conduct constant code audits and rely on multiple tokens and platforms.

Accessibility problems

Although the inherent systemic risks are a roadblock to liquid staking’s long-term viability, other obstacles to its wider adoption exist. As a current technology, liquid staking is only available to DeFi experts. This leaves crypto enthusiasts as well as newcomers in the industry behind. Complex interfaces, high gas fees, lack of onboarding, technical intricacies, general misbelief towards a convoluted technology—the list goes on. It’s confusing to have so many liquid tokens and restaking options, particularly when you deposit abcETH and get xyzETH in return.

To make liquid staking accessible and inclusive for all, platforms need to focus on an intuitive design and simplify onboarding. They also must educate users. The platforms must have an intuitive design, transparent collateral and a familiar interface. They should also provide their users a complete picture of risk and yield metrics. By lowering the entry barriers for small investors, layer-2 protocol could make this more accessible.

UX and UI have recently become the industry’s buzzword cliché, but it’s important to remember that the problem underneath still needs to be solved. It is only after users have been satisfied that liquid staking will become a mainstream solution.

Standardization of utility services and expansion

LSTs’ main virtue is their constant accumulation of block rewards. ETH staking secures the economic activity in Ethereum by validator nodes. There will always be staking reward as long there are transactions on the ETH Network.

The only use of LST should be staking. But there is more to it than that. Tens of thousands monthly active users, who hold billions in assets, want utility. And their needs must be met. TVLs in LST/LRT have increased faster than DeFi deployment opportunities. These tokens require time to be integrated into protocols such as lending, perpetual trading and other business-tobusiness relationships.

Imagine trying to combine five LST or LRT assets into Aave.AAVE). This would cause a traffic jam. Staking is likely to become speculative loaning soon, if it hasn’t already.

It’s not wrong in itself. It is wrong that the users, who are the ones taking on the counterparty risk and providing liquidity, do not recognize this. The industry needs a much more diverse range of platforms to accept LSTs and offer their users access to real yield—and this must be done securely and transparently. LST and LRT platforms are a great way to revitalize the DeFi market. Powering money markets, digital asset management, and even crypto-native hedge funds—as yield-bearing collateral, LSTs will offer lots of room for adapting the existing TradFi concepts to DeFi.

Standardization of the tokens is crucial. Aside from the frustration and confusion that they cause, there is another more important argument in favor of token interchangeability. Each platform should maintain separate pools of liquidity for each pair. Second, due to the risk inherent in an LST, and its ripple effect across the entire market, it is obvious that a single, diversified LST-derived investment would be the best option if the token were to collapse.

Now is the time to act

In the beginning, liquid staking was not widely accepted. This is not the end: liquid staking will bridge the gap that separates a revolutionary innovation from an everyday tool. To make this happen, DeFi must eliminate all the current problems and gaps in the technology, from the systemic risks and the poor UX, to the lack of standardization, and the utility propositions.

The future is now — but it is up to us to make it truly happen.