Foundations of DeFi Token Standards and Liquid Staking

In the world of DeFi, token standards feel a bit like the alphabet of the space.
When you first see an ERC‑20 ticker, you might assume it’s just another way to say “a piece of digital money.” But underneath that smooth surface lie rules, contracts, and, ultimately, trust models that shape how we use, value, and interact with each token.

The stakes are high because these standards do more than define a currency—they set the foundation for borrowing, lending, staking, and every other financial activity that has popped up in the last few years.
And when a new concept like “liquid staking” starts to gain traction, it’s not enough to just throw a token into existence; we need to understand the building blocks that make it reliable, transparent, and defensible for the long run.

Let’s walk through the essentials of DeFi token standards, why they matter, and how they fit into the larger puzzle of liquid staking derivatives (LSDs).

Why standards matter

A token standard is to the crypto world what a USB port is to computers or a USB‑C cable is to phones. It is a well‑defined interface that every participant expects to work. In DeFi, lack of a common standard would mean custom contracts for each token, massive friction, and an easy way for bad actors to slip in.

The early days of Ethereum introduced ERC‑20, a bare‑bones specification for fungible tokens. The community’s decision to adopt a single, reusable pattern changed everything. Tokens could be swapped easily on exchanges, added to DeFi protocols, and leveraged in new financial products.

But the ecosystem grew and the needs changed. The next big shift was ERC‑721 for non‑fungible tokens (NFTs), which solved the problem of uniqueness. Later came ERC‑1155, a more versatile token type that can handle both fungible and non‑fungible assets. Each new standard responded to gaps in the market while maintaining backward compatibility.

For liquidity, staking, and derivatives, the standards that matter most right now are:

• ERC‑20 – basic fungible tokens.
• ERC‑777 – an ERC‑20 extension with richer controls (operator roles, hooks for message passing).
• ERC‑2612 – permits that let you sign off on approvals without sending a transaction, reducing gas costs.
• ERC‑1155 – mixed token types, used notably by some LSD protocols.
• ERC‑4626 – the emerging “savings” token standard that formalises how vaults that accept deposits and issue a derivative share should behave.

The building blocks of an LSD

Liquid staking is a clever idea: you lock up your staked asset, get a liquid token in return, and still earn the staking rewards. It turns a traditionally illiquid position into a tradable asset that can be used as collateral or to generate additional yield.

Below is the classic LSD flow:

1. User deposits a base token (e.g., ETH).
2. Protocol locks it up with the underlying network (Ethereum 2.0 validator deposit).
3. Protocol mints an LSD token (e.g., stETH).
4. User can trade, lend, or use stETH as collateral.
5. Protocol eventually redeems the stETH for the original ETH plus rewards.

Underlying mechanics

a. Staking:

• On Ethereum 2.0, validators deposit 32 ETH to start earning rewards.
• In liquid staking, we bundle many users’ deposits into one “validator” to spread risk.

b. Reward accrual:

• Rewards accrue over time, not instantly.
• The LSD token’s price reflects the underlying base token plus accumulated rewards.

c. Redemption path:

• Protocol locks the LSD, waits until network conditions allow a safe unbond to re‑exit the validator, then returns ETH.
• This can take up to 6 months on Ethereum 2.0.

Why we call them derivatives

An LSD represents a claim on future rewards and the underlying asset. The token’s value is a leverage of the base asset: one unit of stETH is worth more than one ETH as rewards build up. From a finance lens, you can think about it like a futures contract where the future price is the total value accrued.

In a pure fiat context, you might call it a bond or certificate of deposit—the same story: deposit cash, earn interest, retrieve principal + earnings.

The “token standard” for the future: ERC‑4626

ERC‑4626 is the first official standard that tells vault protocols exactly how to accept deposits, give out share tokens, and handle withdrawals. It is often called the Vault Token Standard.

Why does it matter for LSDs?

• Transparency: The standard defines a view function for totalAssets() and supply().
• Interoperability: Other protocols that rely on these metrics can trust that a vault follows a common interface.
• Safety: By following the standard, the code is audited more often because the logic is predictable.

In practice, most liquid staking protocols that aim for wide adoption have either wrapped their logic around ERC‑4626 or at least made sure they expose the same function names.

When you look at the interface, you see functions such as:

deposit(uint256 assets, address receiver)
mint(uint256 shares, address receiver)
withdraw(uint256 assets, address receiver, address owner)
redeem(uint256 shares, address receiver, address owner)

These look a lot like ERC‑20, but with a twist: they deal with assets and shares. Think of assets as the base underlying token (ETH) and shares as the liquid staked token. The mapping from assets to shares happens automatically, making it easier for you to understand that one share may represent more than one asset as rewards accumulate.

Some LSDs still use a custom implementation, but the move towards ERC‑4626 has been strong in the last year, primarily because of the safety, composability, and the way protocol designers can rely on a proven standard instead of reinventing every function.

Risk story: what happened when protocols didn’t follow standards

In 2021, a popular LSD on Optimism launched with a custom staking wrapper that omitted some safety checks. The system allowed users to withdraw more vault shares than they had validly deposited – an implementation flaw that let a small team “borrow” beyond their stake. One of the affected users posted their experience on Discord, framing the incident as a breach of trust.

The community’s response was strong: the protocol had to implement a patch, and, meanwhile, the platform that had built the initial reward calculation was no longer considered trustworthy. The fallout was not just loss of funds; it was a dent in brand reputation, and it sent wave of caution for other LSD projects that had yet to fully adopt ERC‑4626 or a clear interface.

What you learn from this?

• Standards are not just about syntax; they encode expected behavior.
• Deviations can lead to user confusion and security errors.
• The protocol should openly document how the shares are calculated and what guarantees they map back to the underlying asset.

The value of “permit” in a gas‑efficient world

Every transaction in a public chain costs gas — a fee in native tokens (ETH on Ethereum, AVAX on Avalanche, SOL on Solana). If users have to send two separate transactions (one to approve, one to deposit or spend funds), the cost can be prohibitive for small positions.

ERC‑2612 introduced the concept of a permit, where a user signs a message that gives a spender permission to move a certain amount of tokens. The spender can then submit that signature in the same transaction that moves the tokens.

In an LSD context, when you deposit into a vault that follows ERC‑4626, the protocol can call permit on the ERC‑20 base token first, then immediately deposit.

Why does this improve user experience?

• Reduced cost: Only one transaction, one gas fee.
• Atomicity: The allowance is granted just in time, preventing misuse.
• Security: Signatures are per amount, deadline, and nonce; they’re hard to replay.

A few LSD projects, such as those built on Cosmos, integrate permit logic. Even if a token doesn’t support this natively, some wallets allow you to sign a meta-transaction that includes the allowance call.

Comparing the major LSD token classes

Below is a quick comparison of commonly used LSD tokens. I’ve taken the view from a portfolio‑builder’s perspective: how do they behave from a risk and liquidity standpoint?

The main difference among them is how they handle the conversion between base asset and share units. ERC‑4626-based tokens make this conversion explicit, easing integration with other protocols. Tokens that still use custom logic tend to be harder to port but can offer unique features (e.g., Rocket Pool’s validator‑level incentives, or wstETH’s 1:1 wrap to increase efficiency in AMMs).

Composability: the “What if?” question

DeFi thrives on the idea that you can combine products like building blocks. A user can stake ETH to get stETH, then use stETH as collateral on DEX aggregators or lend it on a lending protocol. The power comes from cross-protocol consistency.

When an LSD token follows a standard, other protocols that are built for that standard can interact out of the box. For instance, a staking derivative that follows ERC‑4626 can plug into a lending platform that expects ERC‑4626 tokens for collateral automatically.

A case in point: a year ago, a large DeFi leverage product added stETH as collateral under the ERC‑4626 standard. Suddenly, a whole new path opened for risk‑averse users to get leveraged exposure without a second unwrapping or bridging step.

What a good LSD should look like

When you’re evaluating an LSD, some concrete criteria to look for aren’t just bells and whistles; they’re the cornerstones of safety.

1. Transparency:

   • Publicly available code, open‑source repository.
   • Clear documentation of the share‐to‐asset mapping.

2. Robust Standard:

   • Implementation of ERC‑4626 (or other well‑established standard).
   • Use of permit (ERC‑2612) if available.

3. Rebalancing mechanism:

   • Protocol should periodically rebalance the staking allocation to keep the staking rate optimal.

4. Exit strategy:

   • Clear instructions on how and when you can redeem your shares for base assets.
   • Understanding of withdrawal windows on the underlying protocol.

5. Security audits:

   • Recent, independent audits that cover both the vault logic and the underlying staking contract.

A “real world” analogy: gardens and ecosystems

Think of a portfolio that includes LSDs as a garden.
You plant a seed (stake your ETH), water it (earn rewards), and wait for it to grow. If you want a bush that you can harvest now and use as compost, that’s your LSD token.
The compost (stETH) can now be spread over other plots (liquidity pools, lending) while still feeding the original garden.

When the gardener (protocol) follows a standard, all the tools (spades, hoses, seeds) fit together. The gardener can switch between plots without breaking the soil because the tools are designed for a particular system.

If the gardener uses a custom, incompatible spade, some plots might get damaged (security bugs), the soil might be uneven (mispriced assets), and the whole ecosystem collapses (loss of confidence).

That’s why we put a big emphasis on using a standard that other gardeners in the ecosystem already trust and use.

A practical tip for every investor

When you’re ready to dip your toes into liquid staking, start small.

• Demo on a testnet: many protocols offer testnet deployments of their staking wrappers.
• Track the ratio: the market price of the LSD token vs. the underlying asset gives you a clear idea of performance.
• Keep an eye on the validator health: some protocols may shift their stake allocation; if the validator is underperforming, your LSD will under‑perform accordingly.

And remember: LSDs do not magically double your money. They give you more liquidity for the same staking exposure, which can be powerful if used prudently.

The long‑term picture: why the standard matters

In the current landscape, the DeFi world is still young and evolving.
If a protocol refuses to adopt a standard, it risks isolation: other protocols won’t integrate it, users might be hesitant to trust it, and security will be harder to verify.

On the other hand, protocols that follow ERC‑4626 align themselves with a community‑approved framework, making them easier to audit, safer to use, and more likely to survive in the long run.

For you, as an investor or educator, that means you can feel more confident about where you put your money and how you explain it to your peers.

One actionable takeaway

Before you deposit into an LSD, scan for the following:

• Is the token an ERC‑4626 vault?
  If yes, that’s already a good sign.

• Does the contract expose a public view of totalAssets()?
  If the ratio of totalAssets() to supply() increases over time at a rate consistent with the staking rewards schedule, you’re in a healthy system.

• Is there a permit function?
  That reduces your gas costs and enhances safety.

If any of these checks is missing, consider keeping your stake in the base token or look for another protocol that follows the standard.

In the end, liquid staking is a practical tool for turning lock‑up into yield. But like every tool in finance, how you wield it depends on the consistency of the interface and the integrity of the custodian.

By making standards a priority, the DeFi ecosystem keeps moving toward a more transparent and accessible future — a future where more people can see money as freedom, not as a status symbol.