WEEKLY CRYPTO BYTES #3
Liquid Staking 101
What is Staking?
Staking in blockchain refers to locking up a portion of a cryptocurrency for a chosen period to support the security and operation of a blockchain network. Staking is only possible on blockchains that run on the Proof-of-Stake (PoS) consensus mechanism, a specific method certain blockchains use to select honest participants and verify new blocks of data being added to the network. This is much faster, energy efficient, and scalable than the mining-based consensus mechanism used in Bitcoin. When a crypto investor stakes their holdings, the network can use them to create new blocks on the blockchain. The more crypto you’re staking, the better the odds your holdings will be selected.
Proof-of-Stake (PoS) is a blockchain consensus algorithm that uses validator nodes based on staked tokens. Validators are randomly selected to create new blocks and send them out to other nodes on the network. Time in PoS is divided into slots and epochs, and one validator is randomly selected to be a block proposer in every slot. Validators receive incentives for proposing new blocks and attesting other validators’ blocks. At the same time, they can lose a portion of the stake if they go offline and fail to validate or lose their entire stake if they attest to a malicious block or for deliberate collusion. PoS creates blocks by relying on validators, who are users who stake tokens.
Investors can earn newly minted crypto coins in the blockchain network as a reward for staking. Staking is similar to depositing money in a bank, where an investor locks up their assets and earns rewards or interest in exchange.
One step ahead of Staking in PoS-based blockchain networks is Liquid Staking.
Liquid staking is a Smart Contract based solution that enables users to stake directly on a proof of stake (PoS) network such as Ethereum and receive a liquid staking token (LST) or Liquid Staking Derivative (LSD) programmatically minted by the protocol when the user stakes. This LST or LSD provides access to liquidity while the user stakes.
The key difference between Staking and Liquid Staking is that Liquid Staking is more liquid.
In Liquid Staking, users can retain the liquidity of their tokens even though they are locked in the blockchain. The Liquidity Tokens (LSDs or LSTs) minted are usually on a 1:1 ratio of their original token staked. The Liquidity Tokens can generate more yield in other DeFi protocols. Some examples of Liquidity Tokens available on the Ethereum Mainnet are Lido’s stETH, RocketPool’s rETH, Stakewise’s SETH2, and Coinbase’s cbETH. Each LSD has its mechanism, pricing, and methods for generating secondary liquidity.
Access to Liquidity anytime is the main advantage of Liquid Staking. But there are drawbacks as well.
One of the side effects of Liquid Staking is Yield Commoditization which can lead to Centralization and Cartelization.
A common argument with yield commoditization by liquid staking is that big staking pools with huge capital and professional validators have an advantage over small retail stakers in executing proprietary MEV strategies. This will drive out competition from small retail stakers and lead to cartelization.
What is MEV in terms of Proof of Stake Protocols?
Maximal extractable value (MEV) refers to the maximum value that can be extracted from block production in excess of the standard block reward and gas fees by including, excluding, and changing the order of transactions in a block. MEV accrues entirely to validators because they are the only party that can guarantee the execution of a profitable MEV opportunity. But a large portion of MEV is extracted by independent network participants referred to as “searchers.” Searchers run complex algorithms on blockchain data to detect profitable MEV opportunities and have bots to automatically submit those profitable transactions to the network. ~ Ethereum Docs
But there is hope with roadmap protocol level changes planned on ETH2 to attain better security and decentralize yield commoditization, making Proof-of-Stake Consensus more resilient.
One of these is called Proposer-Builder Separation or PBS.
Present-day Ethereum validators create and broadcast blocks. PBS aims to separate block production from block validation by creating a new stakeholder called the block builder. The block builder is an entity that determines which transactions are included in a block. This means that validators merely need to choose the builder proposing the highest value block instead of ordering transactions. This will democratize access to sophisticated MEV strategies and promote fair competition between small and big staking pools.
Another one is Distributed validator technology or DVT.
Currently, each Ethereum Validator runs on a single node. By Distributed Validator Technology, a validator’s private key — used to sign on-chain operations like block proposals and attestations — can be split across several node operators. As a result, the duties and responsibilities of a validator can be distributed and shared across a cluster of node operators instead of a single node. This means multiple parties spread over different geographies can run a single Ethereum Validator. This will prevent a single point of failure on validator nodes and promote solo stakers. DVT will prevent bigger staking pools from turning malicious as the staking keys are spread across different machines and are difficult to collude.
#NewsOfTheWeek
COMP token price surged over 50% in the last seven days. One of the reasons that fueled this surge is Compound Finance founder Robert Leshner stepped down from the protocol to launch his own mutual fund to connect blockchains and traditional markets. Here is the #NewsOfTheWeek
But do you think Liquid Staking is an Infinite Money concept and hence not digestible with our understanding of a traditional financial asset? Reply with your comments. Cheers!
