cTokens Explained: Guide to Liquid Staking Models and Potential Tax Impact
Liquid staking allows users to stake their cryptocurrency tokens while maintaining liquidity, with the key difference between cToken and aToken models being how the accrued staking rewards are represented - the cToken model adjusts the conversion rate, while the aToken model adjusts the token supply. The cToken model used by protocols like Liquid Collective may be more favorable from a tax perspective, as the increase in the token's value is treated as capital gains rather than ordinary income.
TL;DR
Liquid staking tokens like LsETH use a "cToken" model where the conversion rate to the underlying asset (ETH) dynamically adjusts to reflect accrued rewards and fees, rather than just increasing the token supply.
The cToken model used by LsETH can provide a more precise representation of the user's staked position compared to the "aToken" model used by some other liquid staking protocols.
From a tax perspective, the cToken model's capital gains treatment on the increase in token value may be more favorable than the ordinary income treatment on token supply increases in the aToken model.
What is Liquid Staking?
Liquid staking is a process that allows users to stake their cryptocurrency tokens in a proof-of-stake (PoS) blockchain network while maintaining the liquidity and accessibility of their staked assets. The key aspects of liquid staking are:
Staking: Users lock up their cryptocurrency tokens (e.g. ether, Solana) in a smart contract or platform that supports staking. This contributes to the security and consensus of the blockchain network.
Liquid Staking Token (LST): In return for staking their tokens, users receive a liquid staking token (LST) that represents ownership of their staked assets. This LST can be freely traded, used as collateral in DeFi protocols, or transferred to other users.
Rewards: Users continue to earn staking rewards in the form of additional tokens, even while holding the LST and maintaining liquidity.
Unstaking: When users want to unstake their tokens, they must burn the corresponding LST, typically incurring a small fee.
The main advantage of liquid staking is that it allows users to access the liquidity and utility of their staked assets, rather than having them locked up as in traditional staking. Other key benefits of liquid staking are increased flexibility, liquidity, capital efficiency, diversification, governance participation, and potentially additional opportunities to participate in other yield-generating activities - all while still earning staking rewards on the underlying assets. This makes liquid staking a more attractive option compared to traditional staking for many crypto users.
There are two major models for liquid staking: the cToken model adjusts the conversion rate, while the aToken model adjusts the token supply.
What is a cToken?
In the rapidly evolving world of cryptocurrency and decentralized finance (DeFi), cTokens have emerged as a unique and powerful tool. These value-accruing tokens are playing a crucial role in the growth and development of the DeFi ecosystem.
cTokens are a specific type of crypto token that have been made popular within decentralized lending protocols, such as Compound. When a user deposits an asset, like ether (ETH) or the stablecoin DAI, into the Compound protocol, they receive the corresponding cToken, such as cETH or cDAI, in return.
The role of cTokens within lending protocols is to represent a user's deposited collateral. As the underlying assets earn interest through the lending protocol's activities, the value of the cToken increases relative to the original deposit. This allows users to gain exposure to the interest-earning potential of their assets without directly managing a constant flow of lending repayments.
How are cTokens different from aTokens?
While both cTokens (the model developed by Compound) and aTokens (the model developed by Aave) are types of crypto tokens, the critical difference is in how interest is accrued within their lending protocols.
cTokens use an "exchange rate increase" model, where the value of each cToken rises relative to the underlying asset. aTokens, on the other hand, use a "unit increase" model, where the number of aTokens in a user's wallet increases over time.
As an example, suppose a user deposits 100 DAI into the Compound protocol and receives 100 cDAI tokens in return. Meanwhile, the same user deposits 100 DAI into the Aave protocol and receives 100 aDAI tokens.
Over time, as the underlying DAI in each protocol earns interest from borrowers, the tokens will accrue that interest differently:
cDAI (Compound):
Initially, the user has 100 cDAI tokens.
As interest accrues, the exchange rate between cDAI and DAI increases. For example, after 1 year the exchange rate might be 1 cDAI = 1.05 DAI.
The user still holds 100 cDAI tokens, but each one is now worth 1.05 DAI, so the total value has increased to 105 DAI.
aDAI (Aave):
Initially, the user has 100 aDAI tokens.
As interest accrues, the number of aDAI tokens in the user's wallet increases. For example, after 1 year the user might have 105 aDAI tokens.
The exchange rate between aDAI and DAI remains 1:1, but the user now holds 105 aDAI, representing 105 DAI worth of value.
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How does the cToken model work in liquid staking?
The cToken model is used by protocols like Liquid Collective for their liquid staking token, LsETH. In this model, the liquid staking token (LsETH) represents the user's staked ether (ETH) plus any accrued staking rewards. However, the key difference is that the conversion rate between LsETH and ETH dynamically adjusts over time to accurately reflect the growing number of ETH each unit of LsETH can be redeemed for as ETH network rewards are received.
Unlike some other liquid staking tokens that follow an "aToken" model, LsETH does not mint new receipt tokens to represent the earned rewards. Instead, the conversion rate of LsETH increases to account for the accrued ETH network rewards. This allows LsETH to have simplified rewards management and to be more widely integrated into diverse platforms and DeFi protocols—instead of managing separate reward payouts, everything is consolidated under one token..
The Liquid Collective protocol automatically stakes ETH rewards as they are received, so users don't have to claim them and manually stake them to new validators to effectively ‘compound’ their rewards. The protocol's internal "Protocol Conversion Rate" governs how much ETH each unit of LsETH can be redeemed for, and this rate is updated automatically by the protocol to adjust for the staked ETH, rewards, fees, and penalties.
Some other liquid staking protocols, like Lido's stETH, use an "aToken" or "rebase" model for their liquid staking tokens. In this model, the number of liquid staking tokens in the user's wallet increases over time to represent the accrued staking rewards, while the conversion rate between the token and the underlying asset (e.g. ETH) remains fixed at 1:1.
The advantage of the cToken model used by LsETH is that it simplifies rewards management by consolidating the original staked position along with ETH network rewards received under one token, instead of having to manage the challenges of accounting for a constantly-changing balance of tokens.
Are there different tax implications for the cToken model in liquid staking?
In the cToken model used by protocols like Liquid Collective, the conversion rate between the liquid staking token (e.g. LsETH) and the underlying asset (e.g. ETH) dynamically updates to reflect the value of the staked assets plus any accrued rewards, minus fees/penalties. The number of cTokens held remains constant, but the conversion rate changes over time.
This would mean any increase in the cToken's value due to accrued rewards is treated as capital gains when the cTokens are eventually sold or redeemed.
In the aToken or "rebase" model used by some protocols, the number of liquid staking tokens in the user's wallet increases over time to represent the accrued staking rewards. The conversion rate between the aToken and the underlying asset (e.g. ETH) remains fixed at 1:1.
The increase in the number of aTokens is typically treated as ordinary income when received, rather than capital gains.
Capital gains are generally taxed at a lower rate than ordinary income. Also, the cToken model can allow the user to control when they would like to exercise those gains, because the gains may not be realized until the user redeems the cToken for the underlying staked assets plus staking rewards received. This is in contrast to the aToken, which sends new tokens to a user’s wallet constantly as staking rewards are received.
As the cToken model results in capital gains treatment rather than ordinary income, and provides a more dynamic and automated way to account for staking rewards, it could be advantageous in tax planning.
Frequently Asked Questions
How does the cToken model used by protocols like Liquid Collective differ from the aToken model?
In the cToken model, the conversion rate between the liquid staking token (e.g. LsETH) and the underlying asset (e.g. ETH) dynamically adjusts to reflect the value of the staked assets plus any accrued rewards, minus fees/penalties. In the aToken model used by some other protocols, the number of liquid staking tokens in the user's wallet increases over time to represent the accrued staking rewards, while the conversion rate remains fixed at 1:1.
What are the potential tax implications of the cToken model compared to the aToken model?
In the cToken model, the increase in the token's value due to accrued rewards is typically treated as capital gains when the tokens are eventually sold or redeemed. In the aToken model, the increase in the number of tokens to represent the accrued rewards is typically treated as ordinary income when received. Capital gains are generally taxed at a lower rate than ordinary income, making the cToken model potentially more favorable from a tax perspective.
What are the key advantages of liquid staking compared to traditional staking?
Liquidity, DeFi Composability & Increased Rewards. Liquid staking allows users to access the liquidity of their staked assets, rather than having them locked up. Liquid staking tokens can be used in various DeFi protocols and applications. Users can earn additional yield by using their liquid staking tokens elsewhere in other DeFi activities.
