The decentralized finance or DeFi space is growing at a gargantuan pace. Just about an year ago on January 1st, 2020, the total value locked in DeFi protocols stood at $18B. Exactly one year later, this figure rose to $238B.
This giant leap can be attributed to constant innovations in this realm.
Today, we are about to de-jargonize a few other aspects of DeFi and understand with examples how staking and related activities can help you extract the most out of your crypto. Let us take it from the top!
What is Staking?
Staking is a way to put crypto at work and earn more rewards on the top of it.
Awesome. Now that we have your attention, here is a bummer. While a quick Google search on ‘What is Staking‘ will tell you exactly what is mentioned above, that is NOT the real aim of staking. Remember! Whenever you are dealing in crypto, always ask yourself: where is the money coming from? Following the similar principal, let us understand where these so called ‘rewards‘ are being generated from?
Evolution of Consensus Algorithms:
It all started with Bitcoin and its power intensive consensus mechanism: proof of work (PoW). Think of it like this; In a centralized system, all computation is done centrally by a single authority. However, in a decentralized system, everyone is trying to do this computation in a bid to earn some rewards. But only one of them is going to make it. This means that a lot of energy is wasted in order to achieve consensus.
A real life analogy of this would be a horse race. 10 horses train throughout the year and put in all they have to win the reward money. However, only one is going to win in the end.
Proof of Stake:
To solve this problem, blockchains tried to evolve into an alternate consensus algorithm: Proof of Stake or PoS. Instead of everyone trying to validate the transaction, now only one opted node took a shot at it and won the rewards. Any one who wished to participate in validation needed to stake some native cryptocurrency of the network. This ensured that validators have skin in the game and do not defraud the system.
Yet again, there is a problem here. You see, these nodes were chosen basis the amount of crypto staked by an individual. Thus, making it accessible to someone who has the ability to stake more, defeating the entire ethos of decentralization. Deeper pockets meant more rewards.
Delegated Proof of Stake:
As a result, there was an iteration to this consensus algorithm called delegated proof of stake or dPoS. What if instead of picking up someone with most number of tokens staked, one could vote for the node which would validate the transaction?
That’s exactly what dPoS tries to achieve. Using DPoS, you can vote on delegates by pooling your tokens into a staking pool and linking those to a particular delegate. You do not physically transfer your tokens to another wallet, but instead utilize a staking service provider to stake your tokens in a staking pool.
If you would have noticed so far, decentralization is not just a function of number of nodes in the system, but also the accessibility of setting these up. If more people can take part in the network security, better it is for the ecosystem. dPoS enables that possibility.
What are Staking Rewards?
Coming back to the rewards. So when a block is forged in the blockchain, the node is incentivized with the rewards and so is the delegator. Depending on the percentage (of total reward pool) of tokens staked, you get a reward in the same proportion.
The next obvious question is that why would one stake their tokens? Obviously staking rewards is a big incentive but aren’t tokens meant for spending on transactions within the ecosystem? Well, it turns out that staking is incentivized in more than one way by the network so that more and more tokens are locked up, decreasing the supply in the market. This in turn helps in pushing up the price.
Also, this helps secure the network.
Let’s understand this with an example of staking $ATOM. Here are a few ways in which staking $ATOM could benefit you:
A. Hedge against inflation:
The annual inflation rate of $ATOM is anywhere between 7% to 20%. This means tokens deplete in value by this percentage when pegged to USD. This is because new $ATOM is being brought into the system at regular intervals.
Cosmos adjusts this inflation (or the number of new tokens coming in) by evaluating the staked quantity. So those who have staked their $ATOM have safeguarded their holdings against inflation, while others who haven’t, lose on to their value.
Airdrop is a promotional activity that involves sending tokens to different wallet addresses to raise awareness about a project. In this Cosmos ecosystem, projects often conduct airdrops to addresses that have staked $ATOM.
If you would have staked $ATOM and provided liquidity in Osmosis in 2021 then you have been airdropped a large array of these tokens which have added up to a substantial amount! Some of the main airdrops include Comdex, Stargaze, Desmos, Chihuahua, Lum Network, Bitsong, Shade Protocol, and EVMOS.
C. Liquid Staking:
“So I just buy $ATOM and stake it. That’s it?” If that question is giving you a tough time, allow me to introduce you to liquid staking. Liquid staking allows you to get liquidity against your staked assets. Doesn’t help much right? Let us try to unfold it with an example:
Imagine you buy 100 $ATOM. You can now stake it on a platform like Persistence. You would be eligible for rewards as usual. Apart from that, you would get 100 $stkATOM which is a representation of your staked assets. You could now use this $stkATOM anywhere in the DeFi ecosystem to earn a yield, borrow, lend etc.
Bottom line: you used a single asset to get dual benefits of staking rewards and yield.
Why Liquid Staking is an Integral Part of the DeFi Ecosystem:
Well, the answer is right in front of our eyes. With so many benefits of staking $ATOM, why would someone just HODL it? But if everyone starts staking their $ATOM, the ecosystem will dry up pretty soon. Who is going to provide the liquidity to the protocols?
Liquid staking helps a platform thrive. Apart from that, with liquid staking option, there is no reason for someone to NOT stake. Thus making the network even more secure.
Quantifying $ATOM Staking:
Now that we have established that staking can be fruitful proposition. Let us also understand some risks associated with it. While staking your $ATOM, there are chances that validator faces a downtime or underperforms. In that case a percentage of ATOM delegated to them may be forfeited. To mitigate these risks, it is recommended that ATOM holders delegate to multiple validators.
This means, DYOR applies here too. Let us evaluate how staking $ATOM has gone by in the past 1 year:
- Had you invested $1000 in ATOM exactly on year ago and staked your entire holding, you would have managed to fetch a 13.5% yield taking your earnings to $135.
- If you had chosen to stake it all back, you would have got $145 in rewards.
- One thing that is often overlooked is the network inflation. While you are getting 13.5% non compounded yield by staking your $ATOM, if you adjust it for network inflation, it will drop down to 4.06%.
- All of the above calculations are done by assuming the average fee charged by the delegator at 8.7%.
This further hints at the fact that staking alone might not be enough to beat $$ inflation. One needs to deploy these assets elsewhere by liquid staking to earn a decent return.
Well, conclusions are old fashioned and CTAs are overrated. So I am just going to end this one by asking you a very simple question.
That’s all from our side on today’s blogpost. We’d be back with another interesting, jargon free post soon.
Until then, here is the link some other kickass blogposts we did in the past.