Bitcoin and Ethereum, the two largest cryptocurrencies by market capitalization, drove the fledgling crypto sector to a valuation of $1.63 billion. Yet their Proof-of-Work (PoW) consensus mechanism poses fundamental problems.
For starters, Ethereum involves exorbitant fees for transactions relatively slow and very energy intensive. Innovations like the Bitcoin Lightning Network and Ethereum 2.0 are trying to fix the problems, but it will take time. On the other hand, many blockchain networks have adopted the Proof-of-Stake (PoS) consensus mechanism to overcome the aforementioned challenges.
Replacement of energy-intsticky PoW miners, PoS token holders stake (lock) their assets on-chain to help validate transactions and receive governance rights. Since decision-making and settlement of on-chain transactions depend on proportional staking, PoS networks no longer require massive computing power.
Additionally, the low barriers to entry for PoS protocols with less need for expensive mining equipment attract more bettors. Therefore, the market capitalization of all PoS assets amounts to more than $600 billion. But with this huge amount of cash tied up in staking protocols, they become capital inefficient from an end user perspective. Quite naturally, DeFi composability also takes a hit.
Composability DeFi: the vision of inclusive finance
DeFi protocols have grown steadily over the past year, with total value locked (TVL) reaching $233 billion. But the statistics, although impressive, hide more than they reveal. The liquidity of DeFi protocols remains fragmented, inaccessible and underutilized, idle in siled networks.
With these isolated blockchains, the lack of composability is more acute in terms of exploiting cross-chain liquidity rather than within a single ecosystem. So, despite the deep liquidity locked up in DeFi, the value remains static with little possibility of use. However, DeFi embraces the design principle of composability to develop holistic and inclusive financial practices.
Work began in 2016 when Ethereum founder Vitalik Buterin wrote a report emphasizing the need for composability. He spoke about the need to facilitate the exchange of value between multiple blockchains to improve scalability and unlock siled assets. The World Bank and the International Monetary Fund (IMF) have also published a similar reportreinforcing the need for a composable future.
Overcoming the impulse to compete with other blockchains, the focus is now on collaborating with different networks. And there is significant prominence to that end, both from crypto industry stakeholders and traditional institutions. The purpose and ultimate goal here is the holistic enrichment of the domain.
Blockchain technology innovators 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. Although each is unique and serves a specific purpose, they generally do not deal with staked tokens in PoS protocols. In other words, the liquidity locked in these protocols always remains out of reach. However, the scenario changes with liquid staking protocols.
Liquid Staking: the need of the hour
To fully access the Over $300 billion in PoS assets and make DeFi truly composable, we need liquid staking platforms. These protocols facilitate access to staked liquidity without compromising token security and network integrity. These liquid staking protocols release the value of staked tokens into PoS systems to solve DeFi’s cross-chain incompossibility crisis.
Users can deposit and stake their tokens in these protocols to mint proportional amounts of derivative tokens at a 1:1 ratio. These derivative token holders can then use their tokens on DeFi (cross-chain) protocols, for example to provide liquidity to DEXs, while their underlying assets are secured 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 receive 100 derivative tokens (let’s call them dSOL) representing the 100 SOL he deposited. Bob can then wager his 100 dSOL to earn protocol wagering rewards. Suppose he will get 6% APY by staking dSOL. Additionally, he gets 100 d1SOL for staking his derivative tokens in the liquid staking protocol.
Bob can now provide liquidity with his d1SOL tokens to DEX liquidity pools. If a d1SOL-ETH liquidity pool already exists on Uniwap, it becomes a liquidity provider on the exchange. In return, he receives a share of the trading fee from Uniswap. Suppose Bob gets 8% APY for becoming a liquidity provider.
This means that collectively he earns a total return of (6% + 8% = 14%) from staking through a liquid staking protocol. However, if he had chosen to simply stake his chips, he would only get a 6% return. Thus, liquid staking protocols help PoS token holders like Bob maximize returns from their assets.
Currently, assets staked on PoS blockchains generate around $9 billion in revenue from their locked holdings. But JP Morgan analysts believe staking payouts and returns will eventually reach $40 billion by 2025. Elaborating on their optimistic feelings, they opined this staking will reduce the opportunity costs of holding cryptos and generate a real return. However, the staking industry can provide much more value if it utilizes the hitherto untapped liquidity of staked PoS assets. Liquid staking platforms can help the staking industry achieve this dream by releasing locked liquidity from PoS networks.
Once liquid staking platforms begin to significantly free up staked assets for multi-chain use, they will open the door to unprecedented growth and revenue generation. This will truly make DeFi composable and help realize its vision of borderless finance.