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.

In order for a decentralized network of nodes/computers to function properly, the independent participants in the network need to reach an agreement over a shared state (e.g., who owns what on a blockchain). While doing this, the network should remain fault tolerant with valid consensus despite imperfect information or malicious actors (Byzantine Fault Tolerance). Different blockchains implement different methods of doing so, but all are attempting to create a “consensus algorithm” that best fits their chain. There exist different node types in many blockchain ecosystems. Different types of nodes use data in different ways. In Ethereum, clients can run three distinct node types: light, full, and archive.

Consensus algorithms are used in public blockchain/distributed computer design in order to convince nodes in a decentralized system to agree on the next valid state. Within the context of public blockchains like Bitcoin and Ethereum, this signals that at least 51 percent of network nodes agree on the network's global state. In addition, a consensus algorithm often gives a guarantee (probabilistic or deterministic) that network nodes can reach consensus on the next valid state even if a minimum number of nodes in the system are adversarial. In Bitcoin's case, the consensus algorithm is Nakamoto Consensus. For Ethereum, it is known as Ethhash.

Nakamoto’s consensus requires waiting for the creation of several additional blocks to ensure transactions cannot be reverted. As a result, Nakamoto chains have high uptime (they do not go down or stall) but low transaction speed due to their probabilistic finalization guarantee. This is because Nakamoto Consensus requires waiting for “enough” blocks to be mined on top of the block that includes the user’s transaction that reorganizing or reverting the blockchain becomes economically impractical, ensuring some “economic certainty” but never theoretic/deterministic certainty.

One issue with allowing anyone to participate in the consensus of an open network is that one malicious actor can create endless nodes, thereby creating multiple identities, as seen by the blockchain. If one person could create enough nodes, they could theoretically control the network, known as a Sybil attack. For this reason, blockchains also need a Sybil Resistance mechanism in addition to its Consensus algorithm.

A Sybil resistance mechanism, on the other hand, is the process through which a decentralized system deters Sybil attacks. A Sybil assault occurs when a single node can flood the network with several identities and utilize them to obtain an outsized amount of power.

Ideally, each node in a decentralized system would represent one vote. If a node can impersonate multiple other nodes and get 100, 1,000, or more than 10,000 votes instead of one, then the system is vulnerable to assault. Sybil attacks are often deterred by requiring nodes to show proof of a difficult-to-fake resource (unlike online identities, which are easy to forge).

Proof of Work - Hash power (e.g., Bitcoin)

Proof of Stake - Tokens (e.g., Cosmos, Polkadot, Tezos)

Proof of Space-Time - disk space (e.g., Chia, Filecoin, etc.)

Proof-of-Authority - (e.g., Algorand)

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.

PoS token lockup period — 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

Staking services and other features on centralized exchanges (CEXs) often offer higher yields but at the cost of transparency. This tradeoff, however, poses potential risks to users. CEX staking is a "black box" process in which the exchange's database manages the customer's custodial asset information, making it difficult to track whether staked assets are indeed participating in the network unless the exchange explicitly discloses the assets staked through CEX directly.

Exchanges rely on maintaining a balance between fulfilling customer withdrawal demands and keeping reserve levels intact. CEX staking offers a fixed rate to customers, incentivizing exchanges to invest the remaining assets in instruments with higher expected returns. Essentially, CEX staking services operate in a similar manner to traditional banking systems. However, the lack of transparency in these services has been a direct and indirect factor in the recent FTX bank run, highlighting the potential risks associated with CEXs.

As such, it is crucial for cryptocurrency holders to remain vigilant and aware of the potential dangers of CEXs. While they may offer higher yields, CEX staking and other related services come with considerable risks, and users must exercise caution when engaging in such activities. Transparency is key to ensuring users' trust and confidence in CEXs, and exchanges must prioritize it to prevent potential future risks.

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.

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 staking april 2023 — 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.

Yield farming diagram — 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.

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.

Different Types of Yield Farming

Yield farming strategies typically engage in four core types of economic activities, both passively and through delegation:

Farmers provide lending for traders.
Farmers provide liquidity to token holders.
Farmers provide management and governance to protocols.
Farmers enhance protocols’ marketing efforts.

The second major form of yield farming is a generalization of the first, where farmers lend their cryptocurrency positions not just to validators but to anyone. Yield farmers deposit tokens into funding pools, allowing borrowers to take out loans using suitable collateral. Popular examples of these protocols include Aave, Compound, and Anchor.

In terms of economic value, yield farmers allocate holdings towards capital-constrained traders, allowing them to express views on asset prices more efficiently. Farmers are compensated by borrowers, who pay continuous interest back to farmers (with protocols taking a cut).

Liquidity provision has been democratized and expanded by DeFi protocols, enabling retail traders to passively provide liquidity. Yield farmers deposit cryptocurrency positions into common liquidity pools (automated market makers or AMMs) and earn fees and/or spreads by facilitating two-way liquidity. Major protocols running liquidity pools for yield farmers include Curve, Uniswap, and Sushiswap.

Yield farmers provide value by offering liquidity to those who need it, allowing them to enter and exit positions with minimal market impact. Liquidity providers are compensated in three main ways:

Direct rewards (trading fees and spreads) are paid by users who take liquidity from the pool.
Native token rewards issued by AMMs, such as CRV tokens issued by Curve, often come with special rewards schemes and governance rights.
Rewards are paid by individual protocols to those who provide liquidity for their specific token, usually by purchasing governance tokens of large liquidity protocols.

By participating in yield farming, farmers not only contribute to the network's stability and efficiency but also earn rewards and returns on their investments.

Yield farming strategies are often hands-on activities that involve directing capital, upgrading protocols, and addressing systemic threats. The fourth major form of yield farming is to power pooled management systems and manage tokens in passive and delegated ways. Examples of such protocols include Convex and Yearn, which direct liquidity and allocate assets across multiple lending and liquidity protocols.

Yield farmers can create value through more efficient management and reallocation of liquidity towards particular markets. They can be compensated both explicitly and implicitly, earning better returns by redirecting resources towards high-value opportunities and saving on transaction costs by utilizing pooled protocols.

However, farmers can also profit from value extraction, taking advantage of protocol-based rewards and direct "bribes" to allocate tokens to specific pools. This can lead to value being transferred rather than created.

The fifth and final activity of yield farming is marketing. Yield farming allows protocols to gain attention and trust through asset allocation (total value locked, or TVL). Protocols often reward illiquidity by asking farmers to purchase and lock tokens in exchange for token distributions, which drives higher awareness and usage.

Yield farmers provide increased TVL to protocols, driving higher awareness and more usage. They are compensated by the protocol, which typically provides rewards in the native token. This means that in the short run, non-farmers pay for these rewards by bearing the inflationary burdens, while in the long run, the protocol hopes to attract new users and create value.

This approach is conceptually nebulous and prone to Ponzi-like dynamics, but it can be effective if managed carefully. Protocols must strike a balance between offering no rewards and being overly aggressive to gain and retain user attention without collapsing in the long run.

Impermanent Loss Risk

Aside from the unlikely instances of technical exploitations within staking smart contracts, single-side staking on DeFi protocols is generally considered a risk-free passive income endeavor. Investors simply secure their tokens without concern for a reduction in quantity. However, the notion of real yield arises where unsustainable token emissions within the protocol may result in a substantial decline in value.

Yield farmers, on the other hand, face the potential risk of fluctuations in the quantity and value of committed tokens, primarily due to impermanent loss. Impermanent Loss (IL) is an opportunity cost that liquidity providers (LPs) can suffer if their staked token pair loses value compared to simply holding the tokens. Impermanent loss refers to the decrease in the value of tokens contributed to a liquidity pool resulting from an imbalanced demand for the assets.

Impermanent Loss diagram — Source: Finematics

Consequently, investors receive a diminished asset value compared to simply storing tokens in their wallets. This loss is deemed 'impermanent' as the contributed assets will revert to their original proportion if the two assets return to their initial values at the time of pool contribution. Impermanent loss occurs when an asset provided to the pool experiences a surge in demand and value relative to the other, causing liquidity providers to receive the other asset as traders deposit more of it into the pool in exchange for the former.

IL is a product of the design of Constant Product Market Makers (CFMMs). Because most liquidity pools force stakers to lock up equal USD amounts of the trading pair (e.g., ETH-USDC), a pool may begin with $1M in ETH and $1M in USDC. However, the ratio of ETH to USDC in the pool can shift when the market demand for one asset significantly outweighs the other. Losses can be temporary and mitigated if the token prices (relative to each other) return to the level they were at when the stake in the pool was acquired. Oftentimes, IL can outweigh the fees generated, providing a lower ROI than if the user simply just held the base asset (ETH).

Some DEXs, like Kyber’s Dynamic Market Maker (DMM), are working to reduce IL through dynamic fees based on volume. A DMM operates like an AMM during periods of normal market conditions but will raise fees when transaction volume spikes (usually during periods of increased volatility). When trading volumes are lower than usual, the DMM reduces its fees.

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

Yield farming programs generally offer higher profitability. On-chain ETH staking yield is around 4%, while yield farming programs can offer APR exceeding 100%. This is expected as investors commit multiple assets to the pool, and the assets in the liquidity pool are crucial for the protocol's functionality. DeFi projects often provide higher APR or APY for liquidity farms to counterbalance the risk of impermanent loss and retain liquidity providers. However, a scenario where single-side staking pools offer higher reward rates is unsustainable for the project. Learn more with this article about the interplay of a project’s tokenomics, yield, and sustainability.

Nonetheless, the net profitability of a yield farming program also depends on the volatility of the tokens in the pool, assuming the APR remains constant. When the assets are highly volatile, the impermanent loss might offset the rewards

Conversely, staking rewards are solely dependent on the APR or APY offered by the project.

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