Key Takeaways

• Liquid Staking Derivatives (LSDs) revolutionize crypto staking by allowing you to earn rewards while retaining liquidity.
• While LSDs enable “yield stacking” to increase your returns, they introduce additional layers of risk.
• Features like smart contracts are still in their conception phase. Despite regular audits, undiscovered bugs may still exist that could lead to security issues.
• LSDs represent another integration of traditional finance into the decentralized world, but will they bring the same problems?

What Are LSDs and Why Are They Booming?

In the early days of PoS networks, staking meant locking tokens in a wallet and waiting. While you earn rewards, you can’t access your tokens without unstaking, limiting your financial capabilities. The process is a lot like putting money in a savings account: it generates interest, but you can’t do anything with it.

Imagine putting money into a savings account, earning interest on it, and then using those funds to make even more money. In the crypto world, this is often called restaking. Restaking may sound like a dream, but alongside their use in conventional decentralized finance (DeFi) applications, this is exactly what LSDs allow.

From Staking to DeFi: Unlocking Liquidity in Locked Assets

When you stake on an LSD protocol, your tokens are delegated to a network validator, and you receive derivatives representing your stake’s value. For example, if you stake Ethereum’s Ether (ETH) on the Lido staking platform, you receive the stETH derivative in return. 

You can use stETH as you would any other token:

• Use them as collateral: Put up your tokens as collateral for loans, allowing you to make a big purchase like a home or a valuable non-fungible token (NFT) collection.

• Participate in yield farming: Place your tokens in yield farming protocols to earn even more from your investment. 

• Reinvest them: Simply reinvest your tokens into the crypto ecosystem. Participate in new investment strategies, or attempt to buy and HODL! 

This profit potential begs the question: why would you conventionally stake when you can restake through liquid staking tokens? Well, conventional staking can appeal to less experienced investors, as restaking can be complex and time-consuming.

Let’s break it down:

Conventional staking benefits

• More accessible: Conventional staking is straightforward. Most crypto wallets support native staking, while centralized exchanges (CEXs) and decentralized exchanges (DEXs) often offer staking opportunities for a percentage of your rewards.

• Decreased risk: Staking within an established protocol, such as Ethereum, mitigates risk. Ethereum is widely decentralized and is unlikely to fall to a threat like a 51% attack. Some LSD protocols might be more centralized and exist without Ethereum’s development prowess.

• Less involvement: You can stake your assets and leave them for years without micromanagement. This is great if you lead a busy life and don’t have time to check in on your crypto.

While LSDs present all-new funding opportunities, they’re not without their downsides. Problems like depegging and poor smart contract development can wreak havoc on LSD restakers. This article will get into the downsides of LSDs in a later section. For instance, during extreme market volatility, the liquidity of stETH can be insufficient, leading to a depeg from ETH’s value. So it’s up to you to decide which method suits your investment style.

Also, it’s important to note that while most LSDs consist of liquid staking tokens (LSTs) like stETH, they also include financial instruments like the following:

• Derivatives contracts: Some platforms support futures and options contracts on liquid staking tokens, expanding their financial utility further.

• Index funds: Some liquid staking tokens might represent an index fund of LSTs, allowing you to benefit from their price movements without actually holding the fund. 

Key Players: Lido, Ether.fi, and the Growing LSD Ecosystem

Multiple protocols enable you to take advantage of LSDs. The ecosystem consists of liquid staking platforms, yield farming protocols, and decentralized exchanges, amongst others. Here are some popular platforms that utilize LSDs:

Lido

Lido operates on the Ethereum and Polygon (MATIC) networks. Governed by the Lido decentralized autonomous organization (DAO), the protocol mints stTokens (like stETH) to represent your staked assets.

The protocol stands far above its competitors regarding total value locked (TVL), with $23.22 billion as of May 2025, according to CoinMarketCap.

Ether.fi

Ether.fi is an Ethereum-focused liquid staking protocol with a TVL of $6.94 billion as of May 2025, according to DefiLlama. It offers basic staking processes, but stands out with its “Bond 2 ETH for BNFT” mechanism. This process allows you to manage your own private keys without giving up control to another platform, but it is quite complex. It also requires you to stake a minimum of two ETH.

Rocket Pool

With $1.74 billion TVL as of May 2025, Rocket Pool provides rETH in exchange for staking ETH. You can also become a node operator for only 16 ETH instead of the traditional 32, making Rocket Pool a more accessible route toward node operation.

Yield Stacking and Risk: Are We Rebuilding TradFi in DeFi?

Yield stacking, also known as return stacking, means stacking multiple profit methods on top of each other to maximize returns. 

An example of yield stacking:

• John stakes Ethereum and earns 4% interest. He receives stETH
• John puts his stETH in a liquidity pool, earning 3% interest. He receives reward tokens from that liquidity pool.
• John places his liquidity pool reward tokens in another protocol to generate a 3% yield.

Now, John is earning 10% interest on his initial investment. On its surface, yield stacking is a great way to diversify your portfolio. But it’s not a risk-free endeavor. 

Here are some potential consequences of yield stacking:

• Validator slashing: When you stake cryptocurrencies, you typically commit those funds toward a network validator. That validator votes on network proposals and should act in its best interest. However, validators who act out of line have their rewards slashed. Your rewards as slashed as a byproduct, lowering your stack’s profit potential.

• Network vulnerabilities: Diversification is a smart investment method, but decentralized networks are hardly the programmatically sound platforms you need them to be. It only takes one network weakness, one smart contract vulnerability, for a bad actor to break in and steal your funds. In this sense, more exposure means more risk.

• Market volatility: If you’re using LSDs as collateral for a loan, market volatility can force liquidation. If your stETH is liquidated, you’ll no longer have the reward tokens to stake elsewhere, causing a cascading effect on your entire yield stack.

While all of this profit potential may be enticing, it’s crucial to note yield stacking’s similarities to the 2008 US housing crisis. The housing market crashed (partly) because financial institutions created mortgage-backed securities (MBS), a group of mortgage loans bundled into one security that investors can buy. Institutions then used those securities as derivatives to generate further profits, and the entire stack collapsed. 

Regulatory Perspective: Securities, Custody, and Systemic Risk

Regulations have yet to catch up to LSDs and yield stacking opportunities. When it comes to taxation and lawmaking, regulators must consider the following:

• LSD classification: Are LSDs a security or a commodity? Does earning stETH constitute income? How are they taxed?

• Compliance: If Coinbase or Gemini want to offer LSDs, how do they register for compliance? What policies should they have in place?

Innovation or Fragility? The Double-Edged Sword of LSDs

LSDs have value due to price pegging. For example, stETH is pegged 1:1 to ETH’s price.

Depegging, a problem often found with stablecoins, is when an asset deviates from the value of its pegged asset, like stETH suddenly being worth 0.90 ETH instead of 1. This can be due to market volatility, technical issues like a network shutdown, or smart contract failure. Even if smart contracts, like Lido’s, are subject to various open-source audits, certain bugs or other issues may go undiscovered due to their nascent nature. 

Value fluctuations can cause a myriad of problems across your yield stack. If traders see stETH depeg from ETH, many might sell their holdings to mitigate losses, causing the price to drop further. As a result, stETH loans might liquidate as the asset’s value tanks while investors withdraw from liquidity pools. With a lack of stETH liquidity in comparison to ETH liquidity, the former might sell at a discount when compared to the latter.

Centralization is another concern. Lido has billions more in liquidity than competing platforms. If one LSD protocol manages all the money, can you call it decentralized? 

Are LSDs the Future of On-Chain Capital Markets?

Despite these risks, the potential for profits through LSDs is immense. While many LSD protocols began on Ethereum, they’re expanding to Solana and Polkadot to satiate demand.

This isn’t to mention LSD’s potential integration into traditional finance. You’ve already witnessed crypto futures and derivatives appear on conventional trading platforms like eTrade. Who’s to say LSDs aren’t next in line? 

All this to say, LSDs are more than a potential experiment. They’re already delivering billions in value, and proper regulation with better risk management will likely increase that amount. One is only left to wonder: will a decentralized approach to LSDs win out, or will the early protocols dominate the space?