In decentralized finance (DeFi), liquid staked derivatives (LSDs) have become a key innovation, enabling users to unlock liquidity from staked assets while still participating in staking rewards. LSDs allow holders of staked tokens to trade or use derivatives of their staked assets, making these otherwise locked tokens available in the market. While this boosts liquidity, the introduction of LSDs often causes a decline in the price of the underlying token—a phenomenon that can persist in the long term if demand fails to keep pace with the increasing supply. This dynamic can be explained through logical and mathematical reasoning, centering on the interaction between supply, demand, and liquidity.
Increased Liquidity
The primary benefit of introducing a liquid staked derivative is the increased liquidity of the underlying token. Liquidity, in this context, refers to the ability to easily buy or sell an asset without significantly affecting its price. LSDs facilitate liquidity by transforming staked tokens, which are typically locked and illiquid, into tradable derivatives that represent these staked positions.
For instance, in the Cosmos Hub ecosystem, ATOM holders who stake their tokens to help secure the network must lock their tokens for a fixed period, preventing them from trading. When a liquid staked derivative such as stATOM is introduced, these staked tokens become tradeable in the form of derivatives, providing users with liquidity while their original tokens remain staked and earning rewards. This significantly increases the overall liquidity of the token because both the native token and its derivative are now in circulation.
Additionally, LSDs offer users more flexibility by allowing them to trade their staked tokens without waiting through lengthy unbonding periods. This increased market flexibility leads to more trading activity and injects more tokens into the market, further enhancing liquidity.
Prolonged Price Pressure Due to Supply Expansion
While LSDs offer benefits in terms of liquidity, they also introduce significant sell pressure on both the derivative and the underlying token, leading to a potential long-term price decline. This is primarily due to the increase in effective supply and the absence of corresponding growth in demand. In cases where demand does not rise proportionally with the expanded supply, the negative price effects can persist beyond the short term.
Upon the introduction of an LSD, the total supply of the token in circulation effectively expands. Prior to LSDs, staked tokens were locked and unavailable for trading, effectively reducing the tradable supply. Once liquid derivatives are introduced, both the native token and its derivative are tradable, effectively increasing the token’s supply on the open market.
This increase in supply creates downward pressure on the price of the underlying token. For instance, some users may sell the liquid derivatives they receive from staking, leading to immediate sell pressure in the market. As more liquid staked derivatives circulate, the supply continues to increase. If demand for the token does not rise at the same pace as supply, the price of the token will inevitably fall.
This price effect can persist in the long term, particularly in cases where the introduction of LSDs does not drive sufficient new demand to offset the increased supply. Users who previously held the token may become more inclined to sell their derivatives, further increasing the supply without boosting demand. Unlike in a short-term scenario, where sell pressure could stabilize once the market adjusts, a long-term imbalance between supply and demand can maintain downward pressure on the token’s price for an extended period.
Mathematical Representation of Prolonged Price Decline
The price of a token is governed by the simple relationship between supply and demand, represented mathematically by the equation:
Where:
- P₀ = Initial price of the token before the introduction of LSDs
- D₀ = Initial demand for the token
- S₀ = Initial supply of the token
Once the LSD is introduced, the effective supply of the token increases because both the native token and the liquid derivative are now in circulation. Let S₁ represent the new effective supply and D₁ the new demand after the LSD’s introduction. The new price, P₁, can be expressed as:
If supply expands significantly over time (S₁ > S₀) while demand either stagnates or grows at a slower rate (D₁ ≤ D₀), the price of the token will continue to decline. This situation could persist in the long term if the demand side of the market does not experience a meaningful increase to match the continuously rising supply.
Example of Long-Term Price Impact
Consider a simplified scenario. Before the introduction of an LSD, the supply of a token is 100 units (S₀ = 100) and demand is 1,000 units (D₀ = 1,000). The price of the token would be:
After the LSD is introduced, the effective supply increases to 120 units (S₁ = 120) because both the native token and its derivative are circulating in the market. If demand does not increase in proportion to supply and remains constant at 1,000 units (D₁ = 1,000), the new price of the token would be:
In this case, the price has dropped from 10 to 8.33, and this decline could persist if the demand side remains weak. Without a significant increase in demand, the market may experience continued downward price pressure as more derivatives and native tokens become available for trading.
Conclusion
While liquid staked derivatives bring significant advantages in terms of increasing liquidity, their introduction often results in long-term downward price pressure due to the expansion of supply. The increase in tradable assets through both the native token and its derivative tends to outpace demand, leading to a persistent imbalance that drives prices lower over time. Although LSDs provide flexibility and unlock liquidity for staked assets, they also amplify supply, which can lead to a prolonged price decline if demand fails to rise accordingly.
This price pressure is not just a short-term phenomenon; it can persist over the long term, especially if the demand for the underlying token does not keep pace with the increasing supply. Therefore, while LSDs benefit market liquidity, token holders and investors should be mindful of the potential long-term price effects stemming from the introduction of these derivatives.
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