It's Called Incompossibility, It's a Big Problem, and Liquid Staking Protocols Can Solve It
Guest writer Tushar Aggarwal delves into the thorny problem of incompossibility and liquidity staking.
By: Tushar Aggarwal •Op-ed
Bitcoin and Ethereum, the two largest cryptocurrencies in terms of market cap, have led the nascent crypto sector to a valuation of $1.63T. Yet their Proof-of-Work (PoW) consensus mechanism carries fundamental issues.
For starters, Ethereum entails exorbitant fees for transactions that are relatively slow and very energy-intensive. Innovations like the Bitcoin Lightning Network and Ethereum 2.0 are trying to address the issues but it will take time. On the other hand, many blockchain networks have embraced the Proof-of-Stake (PoS) consensus mechanism to overcome the aforementioned challenges.
Replacing the energy-intensive PoW miners, PoS token holders stake (lock) their assets on-chain to help validate transactions and receive governance rights. Since decision-making and on-chain transaction settlements depend on proportional staking, PoS networks no longer require massive computational power.
Moreover, the low entry barriers for PoS protocols with less need for expensive mining equipment are attracting more stakers. Consequently, the market cap of all PoS assets stands at more than $600B. But with this huge amount of liquidity locked into the staking protocols, they become capital-inefficient from an end-user perspective. Quite naturally, DeFi composability also takes a hit.
DeFi Composability: The Vision Of Inclusive Finance
DeFi protocols have grown steadily over the last year with the total value locked (TVL) rising to $233B. But the statistic, though impressive, hides more than it reveals. The liquidity in DeFi protocols remains fragmented, inaccessible, and underutilized, lying idle in siloed networks.
With these isolated blockchains, the lack of composability is more acute in terms of leveraging cross-chain liquidity rather than within a single ecosystem. Thus, in spite of the deep liquidity locked into DeFi, the value remains static without much opportunity for use. However, DeFi is adopting the composability design principle to develop holistic and inclusive financial practices.
The work began in 2016 when Ethereum founder Vitalik Buterin wrote a report emphasizing the need for composability. He talked about the necessity of facilitating the exchange of value across multiple blockchains to improve scalability and unlock siloed assets. The World Bank and International Monetary Fund (IMF) have also published a similar report, bolstering the need for a composable future.
Overcoming the impetus to compete with other blockchains, the thrust is now upon collaborating with different networks. And there’s a significant emphasis to this end, both from crypto-industry stakeholders and mainstream institutions. The purpose and ultimate goal, here, is the domain’s holistic enrichment.
Innovators in blockchain technology have come up with a variety of designs and architectures to make DeFi composable. These include integrating sidechains, bridges, Layer 2 solutions, and other such infrastructure into blockchain networks. While each is unique and serves a specific purpose, they usually do not address the tokens staked in PoS protocols. In other words, the liquidity locked in those protocols still remains out of reach. However, the scenario is changing with liquid staking protocols.
Liquid Staking: The Need Of The Hour
To fully access the $300+ billion worth of PoS assets and make DeFi genuinely composable, we need liquid staking platforms. These protocols facilitate access to staked liquidity without compromising token security and network integrity. Such liquid staking protocols unlock the value of tokens staked in PoS systems to solve DeFi’s inter-chain incompossibility crisis.
Users can deposit and stake their tokens in these protocols to mint proportionate amounts of derivative tokens at a 1:1 ratio. These derivative token holders can then use their tokens across DeFi protocols (cross-chain) e.g. to supply liquidity to DEXs, while their underlying assets are secure in the native chain and generate staking rewards.
An ideal liquidity staking protocol is essentially blockchain agnostic, thus able to integrate with all PoS networks including Cosmos, Polkadot, Ethereum 2.0, Solana, and Terra.
Suppose Bob has 100 SOL in his crypto wallet. Instead of keeping them idle, he can deposit (wrap) his tokens in a liquid staking protocol. In return, Bob will get 100 derivative tokens (let’s call them dSOL) representing the 100 SOL he deposited. Bob can then stake his 100 dSOL to earn staking rewards from the protocol. Let us assume that he will get 6% APY from staking dSOL. Additionally, he gets 100 d1SOL for staking his derivative tokens in the liquid staking protocol.
Bob can now supply liquidity with his d1SOL tokens to DEX liquidity pools. If a d1SOL-ETH liquidity pool already exists on Uniwap, he becomes a liquidity provider on the exchange. In return, he gets a share of the trading fees from Uniswap. Suppose Bob gets 8% APY for becoming a liquidity provider.
This means, collectively he earns a total yield of (6%+8%=14%) from staking through a liquid staking protocol. However, if he had chosen to simply stake his tokens, he would get a mere 6% yield. Thus, liquid staking protocols help PoS token holders like Bob to maximize their returns from their assets.
At the moment, staked assets on PoS blockchains generate a revenue of around $9 billion from their locked holdings. But JP Morgan analysts believe that the payouts and staking yields will eventually rise to $40B by 2025. Elaborating on their optimistic sentiments, they opined that staking will lower opportunity costs for holding cryptos and generate real yield. However, the staking industry can provide a lot more value if it utilizes the hitherto untapped liquidity of staked PoS assets. Liquid staking platforms can help the staking sector realize this dream by liberating the locked liquidity of PoS networks.
Once liquid staking platforms begin to significantly free up staked assets for multi-chain usability, they will unlock the door to unprecedented growth and revenue generation. This will truly make DeFi composable and help realize its vision of borderless finance.