Staking has become one of the most popular ways for crypto investors to earn passive income. However, traditional staking comes with one major drawback—your assets remain locked, making them unavailable for trading or use elsewhere. Liquid staking solves that problem by giving users a tradable token that represents their staked assets while they continue earning rewards.
Although liquid staking has become one of the fastest-growing sectors in decentralized finance (DeFi), it also introduces risks that many investors overlook. The biggest is the possibility of a depeg, where the liquid staking token temporarily trades below the value of the asset backing it.
This guide explains how liquid staking tokens work, why they have become so popular, and the key risks every investor should understand before using them.
What are liquid staking tokens?
A liquid staking token (LST) is a digital asset you receive after staking a proof-of-stake cryptocurrency through a liquid staking protocol.
Instead of locking your crypto and waiting until the staking period ends, the protocol issues a new token representing your staked position. This token can be freely traded, transferred, or used across DeFi applications while your original assets continue generating staking rewards.
For example, if you stake Ethereum (ETH) through Lido, you receive stETH, which represents your staked ETH plus the rewards it earns over time.
This allows investors to earn staking rewards without sacrificing liquidity, making their capital more efficient.
Why liquid staking has become so popular
Traditional staking requires investors to lock their tokens, preventing them from using those funds elsewhere.
Liquid staking removes this limitation.
With a liquid staking token, users can:
- Continue earning staking rewards
- Trade their staking position at any time
- Use the token as collateral
- Provide liquidity in DeFi protocols
- Earn additional yield through lending platforms
Essentially, the same capital can generate multiple sources of return simultaneously.
This flexibility has helped liquid staking become one of the largest sectors within decentralized finance.
Two different types of liquid staking tokens
Not all liquid staking tokens function the same way.
Rebasing tokens
Rebasing tokens automatically increase the number of tokens in your wallet as staking rewards accumulate.
A well-known example is stETH.
Instead of the token becoming more valuable, your balance gradually increases while each token remains worth approximately one ETH.
Value-accruing tokens
Value-accruing tokens keep the number of tokens fixed while increasing their value over time.
Examples include:
- rETH (Rocket Pool)
- wstETH (Wrapped stETH)
Rather than receiving additional tokens, each token becomes redeemable for more ETH as staking rewards accumulate.
These tokens often integrate more easily with DeFi protocols because wallet balances remain unchanged.
How does the peg work?
The usefulness of liquid staking tokens depends on maintaining a price close to the underlying asset they represent.
Normally, this relationship stays stable because investors can eventually redeem the liquid staking token for the original staked asset.
If a liquid staking token begins trading below its underlying value, traders can purchase the discounted token, redeem it for the full asset later, and profit from the difference.
This arbitrage process usually helps restore the peg over time.
However, redemption is not always immediate.
Most proof-of-stake networks require validators to wait through withdrawal queues before unstaking assets.
During periods of market stress, investors may prefer selling immediately rather than waiting, creating temporary discounts.
What is a depeg?
A depeg occurs when a liquid staking token trades below the value of the asset backing it.
This does not necessarily mean the underlying assets have been lost.
Instead, it usually reflects a mismatch between immediate selling pressure and slower redemption mechanisms.
One of the most well-known examples occurred in 2022, when stETH traded below the price of ETH during the broader crypto market downturn.
Heavy selling, combined with the inability to immediately redeem staked ETH, pushed the token below parity.
Once market conditions stabilized and Ethereum withdrawals became available, the price gradually returned closer to ETH.
The event demonstrated that depegs are typically liquidity problems rather than solvency issues.
How investors earn multiple layers of yield
Liquid staking offers more than just staking rewards.
Investors often use their liquid staking tokens in other DeFi protocols to generate additional income.
Typical strategies include:
- Lending liquid staking tokens
- Providing liquidity to decentralized exchanges
- Using them as collateral for loans
Each additional strategy increases potential returns—but also introduces additional risk.
Higher advertised yields often involve greater leverage or exposure to multiple smart contracts.
Understanding how those yields are generated is essential before investing.
The risks of leverage
One of the biggest dangers comes from leveraged liquid staking strategies.
Some investors repeatedly borrow against their liquid staking tokens to purchase even more tokens.
The process generally works like this:
- Stake ETH.
- Receive stETH.
- Use stETH as collateral.
- Borrow ETH.
- Stake the borrowed ETH.
- Receive additional stETH.
- Repeat the process.
While this can significantly increase returns during rising markets, it also magnifies losses if the liquid staking token temporarily loses its peg.
If collateral values fall, lenders may liquidate positions, forcing additional selling and deepening the depeg.
This self-reinforcing cycle can create sharp market corrections during periods of stress.
Concentration risk
Another concern is market concentration.
Lido, the largest liquid staking provider, controls a significant portion of Ethereum’s staked supply.
Many researchers believe excessive concentration could eventually create governance and network security concerns if a single provider controls too many validators.
Beyond network risks, widespread use of one liquid staking token also means problems affecting that token could spread throughout the broader DeFi ecosystem because it serves as collateral across numerous lending platforms and decentralized applications.
What investors should check before using liquid staking
Before investing in any liquid staking token, consider several important factors:
- Understand whether the token is rebasing or value-accruing.
- Review how the redemption process works.
- Check the protocol’s liquidity.
- Evaluate the provider’s security and reputation.
- Avoid strategies offering unusually high yields without understanding the underlying risks.
- Be cautious when using leverage.
Taking these precautions can help reduce exposure to unnecessary risk while still benefiting from liquid staking’s flexibility.
Final thoughts
Liquid staking has transformed the way investors participate in proof-of-stake networks by allowing them to earn staking rewards while keeping their assets available for trading and DeFi applications.
However, greater flexibility also introduces additional risks. Temporary depegs, leverage, smart contract vulnerabilities, and protocol concentration all require careful consideration before investing.
For many users, liquid staking remains an efficient way to maximize capital. But understanding exactly how these tokens work—and where their risks lie—is essential to using them safely in today’s rapidly evolving DeFi ecosystem.
