Staking 101: What It Means For Balancer
Staking incentivizes users to maintain the integrity of the network they are participating in. Below we walk through the staking process and its benefits to Balancer.
Consensus Mechanisms — A Brief Overview
Blockchain technology is the foundation upon which all cryptocurrency is built. They operate as a ledger — storing transaction data on an open-source and decentralized database. The decentralized nature of this storage model makes the blockchain secure but also requires a mechanism to ensure all network participants are in sync. These are called consensus mechanisms.
Proof of Work and Proof of Stake are the main consensus mechanisms. Let’s look under the hood at Proof of Stake and how it’s implemented in DeFi.
History of Proof of Work
Bitcoin pioneered the Proof of Work algorithm, which requires network participants, or “miners,” to expend large amounts of computation to solve the next block’s hash. Once the answer is found, the next block on the chain forms. The Bitcoin blockchain adjusts the difficulty of the problem so that a block forms roughly every ten minutes. As the network grew, the computation became so complex that the electricity required to solve the next block was too substantial to manage.
Bitcoin is not the only network utilizing the environmentally costly Proof of Work algorithm. Ethereum — crypto’s second largest network — also uses PoW. However, it plans to pivot to a new algorithm called Proof of Stake (PoS) that will reduce electricity consumption by over 99%, increase scalability, and make transaction fees more affordable.
Proof of Stake: A Bird’s Eye View
Instead of requiring network participants to solve for a block, Proof of Stake requires users to prove ownership in the network or Protocol and to risk that ownership to preserve integrity. By staking their crypto, a user is incentivized to maintain the integrity of the network they are participating in; if they were to include false transaction data in a block, it could compromise the entire network. If this weren’t incentive enough, networks often reward stakers with freshly minted crypto whenever a new block mints. It is also not uncommon for networks to impose penalties on dishonest stakers, paid for by the coins they’ve staked.
Ethereum’s Pending PoS Upgrade
As previously mentioned, Ethereum is transitioning from a proof-of-work system to a proof-of-stake consensus mechanism. While its transition date is unknown, it is expected to occur by the end of Q3 2022. This transition, known as “the Merge,” is made official when the Ethereum Mainnet successfully merges with the Beacon Chain, marking the end of mining and enabling staking for the entire Ethereum network. The Merge will improve energy efficiency and set the stage for future major upgrades to Mainnet, such as sharding, which will bring long-awaited scalability to the network.
To become a validator for Ethereum and begin staking, a user must post 32 ETH as collateral. While this may be too significant of an investment for some, liquid staking options such as stETH and rETH are available — allowing users to invest in staked ETH with smaller portions.
Proof of Stake for Protocols
PoS is not reserved only for networks — Protocols like Balancer have integrated it into their tokenomic models. However, instead of proving ownership to maintain the integrity and security of the network, Protocol PoS ensures the longevity and sustainability of a platform. This is achieved through token locking, governance rights, and fee distribution. Many versions of Protocol token staking exist, but the vote-escrow (ve) model is the highest regarded.
The Vote Escrow mechanism utilizes time-locking for a set period of time. The longer a user stakes their veToken, the more Protocol voting power they receive. The idea is that users who lock their tokens longer hold greater conviction in the longevity of the Protocol and should have more influence over its future.
A key feature to the success of the veModel is that stakers decide how token rewards are allocated. By allocating this power to those who believe in the Protocol the most, stakers are incentivized to allocate rewards to Pools that will A) ensure long-term sustainability and B) generate the most income for the Protocol. To understand this, let’s look at two hypothetical scenarios:
In our first scenario, a project dedicates all token emissions to small-cap coins with small communities. While this may generate great APY for those Pools, liquidity for large-cap Pools starts to leave the platform to seek higher incentives elsewhere.
In our second scenario, veBAL stakers decide to dedicate emissions to BAL Pools only. The unforeseen consequence of this is that trading volume for other Pools dries up, taking fee revenue with it.
Mismanagement of a Protocol can lead to its failure. By requiring users to lock their stake, Protocols work to ensure their longevity because in doing so, users preserve or increase the value of their stake. Stakers also benefit from Protocol fees, so they are directly incentivized to promote Pools that generate the most profit for the Protocol.
Balancer’s Take on Vote Escrow
Curve Finance was the pioneer of the veModel. Stakers locked their CRV and received veCRV in return. Balancer has adopted this model, but with a twist: instead of locking BAL tokens directly, stakers lock BAL liquidity with a one year max timelock versus Curve’s four year requirement. To receive veBAL, one must first deposit 80% BAL and 20% ETH into a liquidity Pool. The BPT token they receive can then be staked and locked to receive veBAL.
The result of this unique ve-model is all of the aforementioned benefits, along with extremely deep liquidity for the BAL token. Such deep liquidity helps BAL to retain its value, lower volatility, and amplify sustainability.
Closing Thoughts
Staking is a dynamic tool that empowers networks and Protocols to become more efficient and sustainable. For networks — it lowers energy consumption and carbon footprint while maintaining security and integrity. For Protocols, it increases liquidity and keeps incentives aligned with the Protocol’s best interest.
About Balancer
Balancer’s mission is to accelerate innovation in DeFi by providing access to secure infrastructure for liquidity applications. As a core building block of DeFi, Balancer Protocol is community driven and is reliable, open-source, and permissionless. Projects build on Balancer to create new, innovative types of pools and financial dApps.
Communications from Balancer Labs OU are intended solely for informational purposes, and should not be construed as investment or trading advice and are not meant to be a solicitation or recommendation to buy, sell, or hold any tokens mentioned. All figures are estimated and unaudited unless otherwise noted. As a technology company, Balancer Labs OU provides access to software.
