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Staking in General
Staking refers to the process of locking up a crypto asset on a proof-of-stake (PoS) blockchain, where holders delegate their tokens to validator nodes (or become validators themselves) and receive rewards in the blockchain's native token. Staking contributes to the security of a PoS chain.
Most PoS chains are secured by economic guarantees, decentralization, and game theory. Generally, increasing the amount of stake in the protocol makes attacking/corrupting the blockchain more costly. If the correct incentives are in place, it becomes 1) increasingly less financially beneficial to act maliciously (negative expected value on an attack) and 2) increasingly less possible as only people with billions of dollars would be able to attempt the theoretical attack.
To comprehend staking's mechanics, it is essential to understand how a blockchain operates. A blockchain is a decentralized, distributed ledger that transparently and securely records and stores transactions. It is made up of a sequence of blocks that contain multiple transaction records. For a new block to be added to the chain, it must be authenticated by network participants known as validators.
Source: Xangle
Validators play a crucial role in securing a blockchain network. They ensure the network's integrity by verifying transactions and preventing fraud using their stakes. In exchange for their services, validators receive a percentage of transaction costs and/or newly minted coins. However, if a validator acts dishonestly, their staked crypto can be forfeited. To participate in staking, users must hold a minimum amount of a specific cryptocurrency and operate a node on the network. A node is a software component that interacts with other nodes on the network to validate transactions and add new blocks to the chain. The larger the stake, the more influence a user has on the network and the greater the rewards they can earn.
Proof-of-Stake (PoS) and delegated PoS (DPoS) are two common types of staking. In a PoS system, validators are chosen by the network based on the amount of cryptocurrency they hold and stake. The more they stake, the greater the likelihood that they will be selected to authenticate a new block. In a DPoS system, validators are elected by the community and represent the interests of stakeholders.
Benefits
Staking cryptocurrencies offer numerous benefits, including the ability to generate interest on idle crypto holdings more easily than other investment strategies, such as yield farming. By depositing and locking up their cryptocurrency according to the staking agreement, users can earn staking rewards even if they do not have enough cryptocurrency to operate as solo stakers. Additionally, staking does not require expensive mining equipment like crypto mining. Furthermore, users help to maintain their preferred PoS blockchain's security and efficiency. With liquid staking, users can unlock the liquidity of their staked assets, which they can then use for other DeFi activities.
Risks
Crypto staking presents numerous benefits for users, including the ability to earn rewards while helping secure blockchain networks. However, staking also entails various risks that users must consider when choosing a platform. One such risk is market risk, which stems from the potential negative price movements of staked cryptocurrencies. This risk is influenced by factors such as volatility, competition, and regulatory changes.
Another risk is the lock-up and waiting periods that most staking platforms impose. Users must consider the duration of these periods and their liquidity requirements before staking on a platform.
Source: Xangle
Many PoS chains offer ~5-20%+ staking rewards. A 20% staking reward is attractive, especially if you're bullish on the underlying asset. However, that advertised staking reward isn't a net value. We must account for the token inflation that is subsidizing those rewards, staking fees, lock-ups, and token price action. For an extreme and totally made-up example: 20% staking rewards are negligible if the token inflation rate is 80%, the token USD price is dropping 90%, and the ecosystem is dead. Therefore, one mustn't make decisions based solely on staking rewards.
Counterparty risk is another significant factor involving the potential for the exchange or platform on which the user is staking to fail or become insolvent, resulting in the loss of staked cryptocurrencies. Validator risk is also a concern, as a dishonest validator node can result in staked cryptocurrencies being confiscated.
Custody risk is yet another factor that users must consider when staking cryptocurrencies. Losing control of digital assets due to the failure of a third-party custodian can occur for various reasons, such as hacking, insolvency, or mismanagement. Finally, validator costs, such as electricity bills and storage costs, must be factored in when considering staking
cryptocurrencies. These costs can sometimes surpass the rewards earned from staking, making it problematic for users operating under a tight budget or with small staking profits. As such, it is essential for users to consider these risks carefully before staking cryptocurrencies on any platform.
Staking with a CEX
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LSDs
Liquid staking is redefining how incentives are earned for holding and staking assets. Conventional staking requires depositors to lock up an asset for a pre-determined amount of time, and that asset cannot be used for any other purposes while staked. With liquid staking, users can still use their staked assets in other DeFi protocols while still earning rewards. This increases the overall yield while also providing stakers with additional flexibility and control.
The process is simple: firstly, an Ethereum holder deposits ETH into a liquid staking service, and secondly, the service issues liquidation tokens to the holder. Thirdly, the service operates as a validator, generating and verifying blocks, and finally, the service rewards the holder with staking rewards in exchange for a limited fee.
Rise of LSDs
Liquidity staking protocols face intense competition, and comparative advantages can be found in two ways. Firstly, by cooperating with other Dapps to provide more application scenarios for minted certificates, particularly on revenue-bearing products. Secondly, by deploying on more L1 chains and improving the security level of the protocol, such as on verifiers. The future of liquidity staking protocols depends on the overall development of the main chain in the long term. Incidents such as the crash of LUNA could mean doomsday for such protocols. Furthermore, factors such as the capability in capturing value and constructing the on-chain DeFi ecosystem also have an impact on the protocol. The deflation of Ethereum and the increase in returns from staking have brought opportunities for liquidity staking protocols in the bear market.
Source: Blockworks
The liquid staking derivative market has been largely dominated by Lido Finance since the Beacon Chain launch in 2020. However, over time, this market share has been slowly reduced by the growing presence of other LSD competitors, including Rocket Pool, StakeWise, and Frax.
ETH staked by entity, highlighting Lido's leading position. Source
Lido is currently the most dominant liquid staking protocol on Ethereum, having captured over 29% of the 16.8M ETH that has been staked to date. Throughout its history, Lido has had a single, permissioned validator set consisting of 30 professional validator operators. This highly scalable model, combined with stETH's extensive DeFi integrations, has led to Lido's success. However, as the proportion of Lido's stake approached a third of all staked ETH, it led to centralization concerns from prominent members of the Ethereum community. Recently, the protocol announced Lido V2, an important step towards further decentralization, centered around two major upgrades: withdrawals and the staking router.
Staking and DeFi Begin to Blur But With Key Differences
Decentralized Finance (DeFi) encompasses an array of financial services that function on blockchain technology, eschewing centralized intermediaries. These services provide users with an inclusive and alternative means to participate in financial activities, ranging from trading to lending. Cryptocurrency investors have largely embraced DeFi, seizing opportunities to earn crypto through yield farming and staking. Both of these mechanisms allow enthusiasts to generate additional income by supporting DeFi protocols, incentivizing their involvement to ensure the continuous, smooth operation of the protocols.
Decentralized Finance (DeFi) has expanded the realm of staking possibilities. DeFi protocols incorporate the fundamental structure of staking, albeit with nuanced distinctions. A significant deviation lies in the absence of a validator, the presence of a consolidated pool, and the elimination of an unstaking period. Staking rewards in DeFi protocols may be allocated in any token chosen by the project, typically featuring the project's native token. DeFi staking programs may be developed by any DeFi project as long as the blockchain supports smart contracts and Web3 products.
Contrary to PoS staking, DeFi staking functions primarily as a tokenomics program rather than a security mechanism. Stakers on DeFi platforms do not contribute to the security of the blockchain network; instead, the supply is regulated as their staked tokens are sequestered from active circulation.
Tokens staked on DeFi platforms can generally be unstaked instantaneously, and the prevailing APR/APY is contingent upon the number of investors engaged in the pool. In contrast, PoS staking typically entails an unstaking period (7 days to a month) and relatively stable APR/APY rates.
A recent development in the PoS blockchain domain is the emergence of liquid staking derivatives, wherein users can stake their ETH with a liquid staking provider and obtain a Liquid Staked Derivative token of comparable value in return. This token effectively enables users to employ their staked ETH in DeFi activities.
Yield Farming: An Overview
Yield farming constitutes a high-interest incentivization scheme for liquidity providers participating in DeFi protocols. As the name implies, providers typically receive passive rewards in the form of interest for contributing their tokens as liquidity to liquidity pools. Yield farming emerged as a prominent feature of the DeFi boom in 2020-2021, drawing the attention of enthusiasts and investors. For investors, it functions as a rewards program; for DeFi projects, it is crucial for maintaining robust and sustainable liquidity pools.
Source: Changelly
Contemporary DeFi protocols do not facilitate end-to-end services where buyers are directly matched with sellers. Instead, they employ a pool system, contrasting with earlier decentralized exchange technologies such as Atomic Swap, which relies on time-based peer-to-peer transactions.
DeFi protocols leverage liquidity pools to fulfill requests for asset exchange. Individual holders contribute assets to these pools, which in turn supply Automated Market Makers (AMMs). AMMs execute requests and update the protocol with the status of assets within the pool, thereby serving as the foundation for decentralized swaps and lending protocols. Investors who contribute to liquidity pools typically provide an equal value of the assets paired in the pool (e.g., an ETH-USDC pool). Contributors receive liquidity pool (LP) tokens, representing their share of the total liquidity.
Source: CoinDesk
Yield farming rewards investors for playing this vital role. Liquidity providers can increase their investments through income derived from fees paid by platform users, known as liquidity provider fees. Additionally, they can generate yields by staking their LP tokens in liquidity pool farms, as demonstrated by PancakeSwap, where LP tokens can be staked in the Farm to earn rewards (more CAKE tokens). The profitability of such programs hinges on the platform's offered APR/APY and the sustainability of the platform's token value.
Impermanent Loss Risk
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Yield Farming Requires Users to Consider Capital Efficiency
Capital efficiency (CE) refers to the amount of trading volume that’s executed against the amount of liquidity provided (trading volume/TVL). The more trading volume that can be executed with the same liquidity pool TVL, the higher the CE. Simply put, CE means facilitating more trading with less locked-up capital. Liquidity providers (LPs) want high CE because it means they can earn more on fees/LP rewards while locking up less capital. Traders and whales prefer high CE because it results in less slippage, given the TVL.
The Benefit of No/Little Lock-Up Period
Yield farming programs rarely impose a lock-up period. The lock-up period refers to a time interval during which tokens committed to the contract are inaccessible. This is typically observed in PoS and DeFi staking. PoS staking also includes an unstaking or 'cooling' period. The cooling (or cool-down) period is the time between an unstaking request and the token release. During the cool-down period, stakers usually do not receive staking rewards.
In contrast, yield farmers can withdraw and transfer the assets they contributed to the liquidity pool at their discretion.
Increased Profitability
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