Staking and DeFi: Can They Coexist?Part 3

The Potential Negative Effects of PoS & Market Side Considerations

Proof-of-Stake: The Market Side Concerns

Previously, we have looked into the potential economical and security side problems of PoS. Unfortunately, potential problems do not end here, and in this article we will be considering the negative effects of PoS from the market side perspective. This article will be a simplified analysis of the possible market side problems that PoS might introduce.

1. Staking Reduces Market Liquidity

In the current designs of PoS, base tokens that are staked are effectively locked out from the ability to be traded. This means that as more tokens are staked, the amount of tokens that can be used to provide liquidity to the market is reduced. Although the act of staking tokens will theoretically cause a rise in the token price and thus it is likely that the amount of liquidity denominated in fiat won’t change (theoretically speaking).

However, the liquidity denominated in tokens will always be decreasing as more tokens are staked. From the view of an early stage investor, this decrease in token-denominated liquidity might sound alarming. As the value of their assets increase, it becomes increasingly difficult to make trades without being effected harshly by market slippage.

Liquidity is one of the most critical points of a liquid asset, where it is advantageous to have a higher level of it. Unfortunately, because unstaked tokens, compromising a small part of the total token supply are the only ones that could contribute to liquidity in current designs, the market liquidity of a token is unable to reach its potential maximum.

The ability to create liquid staking positions (e.g. Everett Protocol) could help aid the amount of total liquidity both in fiat and token denominations. The staker-generated shadow tokens could increase the amount of total liquidity, because by this the market becomes dependent both on the unstaked token market and the shadow token market and not just on the liquidity of unstaked tokens.

2. Prices are Determined by Those With a Lesser Stake in the Network

Unlike other problems, this one varies a lot by the one’s personal definition of a “method of correct token valuation”. Since only the unstaked tokens are available for trading, the market price is currently determined by people do not own a staking position (i.e. people with less stake in the network). In contrast, stakers, whom generally have firmer beliefs in the network’s success and contribute more to the network, do not have much effect in token valuation, compared to those who do not stake. The effects of stakers in token valuation is further weakened by the existence of the unstaking period, which prevents them from rapid market participation.

Believers of the effective market hypothesis might argue that the valuations set by non-stakers will be correct regardless of whether stakers participate in the market or not. However, we argue that since stakers and non-stakers have different incentives (stakers tend to be more focused in long-term benefits), and the valuations made by those who actually believe in the network will be more accurate, and not the one that are set by everyday speculators.

Everett Protocol could help with this to some degree, if the secondary shadow tokens generated could gain a significant portion of the total token liquidity. Since by design shadow tokens are 1:1 price pegged to the base token, if the trade volume of shadow tokens rise to a considerable amount, it is safe to assume that the value of the token is a combination of the price of unstaked tokens and the price of shadow tokens. So in this case, stakers are also able to contribute significantly to token valuation, since the act of trading shadow tokens generated by them will have a somewhat immediate effect on the base token valuation.

3. Staking Might Make Market Manipulation Easier

One major entity that requires holding on to a vast amount of unstaked tokens is a centralized exchange. Even if an exchange does stake their tokens (e.g. if they offer staking services themselves), because withdrawals have to be continuously processed, a significant portion of it has to remain in the unstaked form.

Following from the above explanations, current PoS designs cause the market to have reduced token-denominated liquidity. And since centralized exchanges hold their assets in tokens, it becomes highly likely that a considerable amount of the unstaked tokens will end up in the hands of exchanges.

Unfortunately, quite a number of centralized exchanges are not that hesitant to perform certain actions that are normally considered immoral by the community. One example is market manipulation, which in the worst case (where a significant amount of unstaked tokens are owned by only a few centralized exchanges), the possibility of those few exchanges colluding with each other to manipulate the price to their tastes is not negligible.

In contrast, the wide use of Everett might be able to prevent this from happening, because as explained above, the value of a token will then be also dependent on the price of shadow tokens as well. And also since stakers are now able to play an important role in valuation, attackers wishing to manipulate the token price now have to own a significant portion of not just the unstaked tokens, but also the shadow tokens too.

To Sum Up

PoS has the possibility to introduce problems that are not just economic nor security-related, but it could also create additional problems from the market & valuation side. Potential problems include the reduction of token-denominated market liquidity, determination of prices by non-stakers, and the higher risk of market manipulation by entities like centralized exchanges.

Everett, working to implement the ability to mint shadow tokens back by staking positions has the potential to help resolve the issues mentioned in this article.