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Liquid Staking Is the Future of Proof of Stake Blockchains

The worldwide financial crisis of 2008 gave rise to Satoshi Nakamoto’s Bitcoin whitepaper. Early in 2009, the Bitcoin network was founded with the following headline embedded in block 0: “Chancellor on the verge of second bank bailout.” The project’s objectives were crystal clear. The search for an alternative, voluntary, transparent currency and peer-to-peer payment network started after exposing the fragility of existing financial institutions.

Transparent peer-to peer payments have been a fantasy of crypto-anarchists and cypherpunks for a long time. Previous efforts, such as DigiCash and E-Gold, had a fatal defect. These systems were not robust since they needed a central operator. By focusing on this core source of failure, formidable enemies such as the government would be able to shut them down.

The creation of the Nakamoto consensus by Satoshi was a significant milestone. In Nakamoto consensus, each miner generates cryptographic hashes, and the network’s nodes accept the related block as genuine only if the hash contains a particular number of leading zeros. This is referred to as mining or Proof-of-Work (PoW).

The Principle Behind PoW mining

Participating in the PoW process is as easy as installing software, synchronizing the blockchain, and searching for hashes using the computer’s CPU power. The probability of creating a block is proportional to the pace at which one can generate these hashes. Given that this is essentially a function of the machine’s processing capability, mining is a capital-intensive, competitive game in which parties strive to achieve economies of scale in order to achieve the lowest mining costs.

As long as trustworthy miners control the bulk of the network’s hashing power, the network can be trusted. This criterion assures the network’s security. PoW is the driving force behind the most prominent cryptocurrencies, including Bitcoin and Ethereum. Despite this track record, PoW has severe drawbacks.

If an adversary intended to disrupt the network, it would have to commit substantial computational power to obtain control of the bulk of the network’s hashing power. For many years, these constraints have prompted the development of alternate Sybil resistance techniques, most notably Proof-of-Stake (PoS).

The Rise of Proof of Stake (PoS)

PoS is gaining popularity as a means of safeguarding decentralized networks. PoS provides several benefits over PoW, including quicker validations, reduced operating costs, more throughput, and less environmental impact.

PoS is an umbrella name for Sybil resistance strategies that use native crypto assets as collateral to decide membership in a blockchain network’s consensus process. The word collateral derives from the medieval Latin collateralis, from col- “along with” and lateralis (from latus, later) — “side,” meaning that collateral is anything that is committed along with a contract’s primary duty. In the case of PoS, the primary duty of participating nodes is to adhere to the protocol’s rules, which are enforced by posting native cryptocurrency tokens as collateral.

Understanding Validator Nodes

Validators are nodes connected with private keys that execute the protocol’s software. Validators arrange and validate transactions, interact with one another, and update their ledger to remain in sync with other network members.

As previously mentioned, validators in PoS networks are backed by collateral in the form of cryptocurrency tokens (the “stake”). Token holders who stake (“stakers”) help network security by choosing dependable validators and raising the cost of a prospective attack.

As compensation, they earn tokens proportional to their stake backing (“staking rewards”). In addition to network issuance rates, transaction fees paid inside the network, staking participation rates, and validator-specific factors (like uptime and commission rates), other variables affect the quantity of these rewards.

To register validators in the consensus process all PoS systems need collateral to be held in escrow by the network. In most protocols, the staked collateral is subject to seizure if the associated validator deviates from the protocol’s norms (“slashing”). This approach is meant to discourage network assaults, such as double-signing.

Escrowing staked assets prohibit their transfer or use in decentralized financial applications. In addition, protocols often mandate a wait (“unbonding time”) when a participant wishes to withdraw in order to retrieve staked assets. These limitations put economic costs on the owners of the assets at risk.

The Rise of Liquid Staking

As a result of capital inefficiencies related to traditional staking, alternatives, such as liquid staking, have been developed to evade constraints on staked assets. By pooling assets and using off-chain contracts to encumber them without depending on on-chain enforcement, centralized exchanges may easily evade these limits.

Liquid staking is a developing area that seeks to tokenize staked assets in order to eliminate limits on their usage and expand their application space. Liquid staking is expanding fast as a method to maximize capital efficiency freeing stakers to take advatadge new trading, yield generating opportunities.

The Future of Staking

We are on the verge of a monumental shift in how the majority of blockchain networks are protected. While Bitcoin and Ethereum continue to operate on PoW, Polygon — a staple in the PoS ecosystem — was created in 2017. Several more have opened or will launch in the near future.

Blockchains are still in the early stages of constructing essential infrastructure and identifying use cases suited for widespread adoption. However, the design space around PoS systems is enormous, and there has been little rigorous research on the best economical solutions.

There has not been sufficient study of the long-term effects of limitations usually put on assets subject to staking. Specifically, the inability to utilize pledged assets as security for subsequent applications and how long unbonding periods incur high economic costs. What has become evident, however, is that staking will play a vital role in securing the majority of blockchain networks and will likely be critical in laying the framework for the future financial system.

Exchange staking is the most existential threat to PoS networks. Exchanges have swiftly acquired market share and amassed staking assets on their platforms, due in part to their ability to evade on-chain constraints and in part to the simplification of user experience and brand.

If this continues, the consequences will be severe. They vary from defunding community validators to reducing network resilience to possible governance process corruption. PoS networks can only give a moderate level of censorship resistance if a few parties can shut down a blockchain network or filter transactions.

Conclusion

In a short period of time, liquid staking has given rise to a sector that might offer an alternative to exchange staking and unleash a wave of fast staking innovation. Similar to the decentralized financial ecosystem on Ethereum, liquid staking allows composability, permissionless innovation, and infinite testing ground.

Suppose liquid staking is to benefit a blockchain network in the long term. In that case, there are several factors to consider, including the degree of liquidity given, dependence on other networks, management of governance rights, and legal problems.

Overall, liquid staking is an essential next step for PoS. It could increase capital efficiency, network resilience, decentralization, and the availability of several new business models if properly implemented. This is a fantastic opportunity that PoS protocols and investors should take advantage of.

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Renato Zamagna

Renato Zamagna

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Finance, Blockchain, Cryptocurrency, and Data Security researcher, writer, and educator. www.linkedin.com/in/rzamagna