Kryptolesson #19

Managing illiquidity when staking

Proof-of-stake (PoS) consensus mechanisms were devised in response to the challenges surrounding Proof-of-work (PoW) mining. Benefits of PoS blockchains vs. their PoW counterparts include, among other things, improved scalability, a lower energy footprint, lower capital expenditures and operating costs. PoS is the idea of selecting block producers based on how much capital they have, i.e. the proportion of tokens they own in the system. The process of locking up a token in a PoS system to ensure its economic security is referred to as staking. In theory, 100% of the tokens on a PoS blockchain could be staked but this would mean prioritizing security at the expense of liquidity. Liqudity in turn is crucial for things like trading, borrowing and other applications, particularly in DeFi. For example, 75% of Solana’s ↗ outstanding SOL tokens and 63% of Polkadot’s ↗ outstanding DOT tokens are currently being staked. Conversely, this means that only 25% and 37%, respectively, of tokens are in circulation. In addition, it takes 28 days to unlock staked tokens from the Polkadot network, with other blockchains having similar un-staking periods. If the portion of tokens in circulation becomes too low, this could severely constrain liquidity. With respect to Ethereum, a low free float of tokens could prove detrimental to its vibrant DeFi ecosystem that relies on the liquidity of ETH.

The launch of Ethereum 2.0 in particular presents some challenges with respect to future liquidity. PoS validators can already stake their ETH in Ethereum’s future consensus network called the Beacon Chain. However, early stakers will not be able to unlock their ETH until transactions are enabled on Ethereum 2.0 which could be by the end of 2021 or years later. This means that while the ETH staked in the Ethereum 2.0 deposit contract ↗ is eligible for staking rewards, it cannot be unlocked or sold on short notice and is therefore illiquid. What’s more, users cannot use their staked ETH in DeFi, forcing them to forgo attractive yield opportunities in the short to medium term. Once Ethereum and the Beacon Chain merge, stakers will continue to face additional issues absent in other PoS networks such as Cosmos, Polkadot or Solana. First, Ethereum 2.0 sets a fairly high bar for users to stake their ETH in that it requires at least 32 ETH to run a validator. Further, it does not offer a protocol-native way to simply delegate ETH to other validators. This raises two important questions: 1. How can users with any amount of ETH participate in staking? 2. How do users deal with the illiquidity arising from lockups and the lengthy un-staking process?

Staking pools are the community’s answer to the first question. Users with less than 32 ETH (or less than multiples thereof) will be able to add their stake to professionally-managed staking pools. Additional benefits provided by these staking services might include operational expertise, high uptime, and an ETH reserve that allows for instant withdrawals. A plethora of staking pools ↗ have already emerged that can be broadly divided in two groups: those run by centralized exchanges and those run by decentralized services. The former group simply offers their customers to opt in into staking their ETH in exchange for a fee. In contrast, decentralized staking pools use a radically different approach. They aim to solve the liquidity issue by offering a liquid and fungible token, called a staking derivate, representing the staked ETH which can then be used in other applications. Put differently, these derivatives allow users to borrow against their locked-up ETH by issuing a synthetic asset. This new token, we call it sETH, represents the staked ETH plus all future staking rewards that will accrue going forward. While the sETH token might be issued at a ratio of 1:1 to the amount of ETH staked, it will grow in ETH value over time since it contains the combined principal stake and staking rewards. Ankr’s StakeFi ↗ and Lido ↗ are two of several decentralized services that are at the forefront of enabling instant ETH liquidity for the nascent Ethereum 2.0 network.

Looking ahead, staking derivatives could have a profound impact on the Ethereum ecosystem and the PoS landscape as a whole. Well-engineered products will likely prove beneficial to both stakers and end users. Stakers can access instant and long-term liquidity to improve capital efficiency, and end users are able to gain exposure to the underlying assets and yields without an in-depth knowledge of staking and delegation. Given their far-reaching benefits, researchers even consider it possible that staking derivatives might replace ETH ↗ in many use cases - and potentially ETH altogether.

Importantly, the existence of staking derivatives for public PoS blockchains like Ethereum 2.0 can go way beyond increasing liquidity. Since the opportunity costs and entry barriers of staking are now much lower, the portion of staked ETH could theoretically be as high as 100%, thus enhancing the PoS network security. Interestingly, this the beneficial effects of staking derivatives also extends to some DeFi protocols ↗ where staked assets are used as insurance. On the other hand, staking derivatives are likely to inject more leverage into the system. In the event of a cascade of liquidations in DeFi that ultimately affects staking derivatives, this in turn could have implications for the security of the PoS network.

Photo by Alessandro Rossi