Liquid Staking: The Natural Evolution of Proof-of-Stake
When Bitcoin first started, it was necessary to verify transactions without need for a third party. This was achieved by using a consensus mechanism called Proof-of-Work (PoW). At the time, it was a novel and ingenious idea but the downsides quickly became apparent. At scale, the process needs significant amounts of energy and only a limited number of transactions can be processed concurrently. The consensus mechanism called Proof-of-Stake (PoS) was designed as an alternative. “Staking” is a method where a deterministic algorithm would assign nodes based on the number of coins an individual owns. However, this new consensus mechanism was not without its own issues.
The Issues with Proof-of-Stake
There are a handful of challenges with a proof-of-stake consensus mechanism, including but not limited to initial distribution, monopolization, and while unlikely with a PoS protocol, the so-called “51% attack”. Proof-of-stake has evolved and continues to evolve to address the challenges confronting PoS blockchains. Initial distribution could be resolved through a temporary Proof-of-work phase and monopolization could be solved through an equitable distribution method and a reasonable holding period. The issue I would like to discuss here is the cost enforced by the PoS protocol on those who are staking, as well as how it affects Protocol Security.
Staking requires locking up holdings for a period of time, in which the network can use those holdings to forge new blocks on the blockchain as rewards. Staked assets are inaccessible to the token holder while they are being used to secure the network and those who want to remove their staked assets have to wait for the unbonding period to end. The locked asset also counts as collateral to ensure the proper behavior of validators. The network has access to the collateral to enforce penalties. A good analogy to this is that of a deposit on rent imposed by the landlord as safeguard against infractions by the tenant.
The unbonding period, however, comes with costs to those who are staking. One is the opportunity cost associated with staking assets being locked which could be used in DeFi applications with higher rates of return such as lending and yield farming. Another is the cost associated due to the exposure to holding the staked assets while it is being unbonded. Lastly, and most importantly, some token holders may not want to stake their tokens due to the long unbonding period as well as relatively lower staking rewards versus DeFi yields, thus reducing the overall security of the network.
This is where liquid staking comes in.
Liquid Staking
Liquid staking solutions allow stakers to use their locked assets as collateral for other trading or investment opportunities. In addition to the interest earned from their staked assets, stakers can obtain additional returns from investing opportunities such as trading, lending, or yield farming.
Liquid staking works by having the stakers use the staked assets as collateral to receive tokenized assets, sometimes also referred to as staking derivatives, which can then be used to freely trade these assets or use them in other DeFi applications.
Let’s look at a couple of types of liquid staking solutions. There are native liquid staking, non-native, synthetic liquid staking, and custodial liquid staking.¹
Native liquid staking refers to liquid staking as an intrinsic part of the core protocol design. Tokenized representations of staked assets are issued by the core protocol itself.
Non-native refers to liquid staking where a secondary, trustless on-chain protocol is in charge of the staked assets and issues tokenized claims.
Synthetic liquid staking refers to purely financially engineered staking positions. This means tokenized financial agreements between entities that mirror the cash flows associated with staked assets.
Custodial liquid staking refers to approaches in which a centralized entity in control of the private keys participating in staking issues tokenized representations of staked assets.
These types of liquid staking have their own benefits and disadvantages but ultimately, they managed to resolve several key issues that come with Proof-of-stake. However, if there are no liquid markets or integrations into other applications, a tokenized version of the staked asset is basically useless. The staked representative tokens need to be compatible with other products within the industry, including DeFi protocols on different chains.
An example of a liquid staking solution is pStake. pStake allows compatibility with other products by using an innovative design — a dual token model, where one token represents a staked token and the staking rewards accrued are represented by another token.² This allows pStake to achieve wider adoption — by having tokenized assets be compatible with the broader DeFi ecosystem, these assets can be easily and comfortably integrated into other applications.
Final Thoughts
Liquid Staking is an inevitable evolution of the Proof-of-stake mechanism. As more platforms make use of liquid staking, it’ll be interesting to see what impact this will have on decentralized finance as we know it. Given the novelty of the liquid staking mechanism, there will be problems to work out but we expect the industry will rise to the challenge. Innovative solutions are constantly being tried and tested as we anticipate the next stage in the evolution of DeFi.
References:
1. Chorus One. (2020, June). Liquid Staking Research Report. Https://Mirror.Chorus.One/Liquid-Staking-Report.Pdf.
2. pSTAKE Finance. (2021, June 11). Introducing pSTAKE: Unlocking Liquidity of Staked Assets. Medium. https://medium.com/pstakefinance/introducing-pstake-unlocking-liquidity-of-staked-assets-c704738ab37f
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