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The Three Current Challenges of Liquid Staking No One Talks About

Oct 10 2022
Nesting

Staking is gradually picking up pace as the prevailing market conditions impel users to look for alternative ways of generating yield. The ecosystem is gradually maturing, and the space is now encountering new challenges and problems. One of the biggest challenges that impact and lead to other challenges is stake centralization.

But is it the only challenge? No, it isn’t. There are more challenges that are not talked about that often.

In this article, we'll will go over some of them and explore solutions.

Stake centralization

No conversation about liquid staking and/or PoS is complete without a discussion on stake centralization. It has gradually become one of the core concepts that people like to throw around in conversations. But the sad part is that it is often misunderstood.

The Problem

Stake centralization is caused by several protocols/pools/centralized exchanges staking their/investors’ assets via the same validators. Or when a single protocol has a majority stake on a PoS network spread across its own limited set of validators.

These validators can either be run by the protocols/exchanges themselves and/or they can be validator-nodes-as-a-service offerings that might be dominating the stake. This can lead to extensive stake centralization as if the validator suffers from downtime/slashing, the concerned PoS network can come under the influence of a single entity - thereby impacting its health and even compromising billions of dollars worth of users’ funds.

Another contributing factor to stake centralization is a protocol having a majority stake across a given PoS network and staking assets via a limited validator set.

These challenges now arise as centralized exchanges (and even decentralized staking/liquid staking protocols) have now managed to garner a lot of stake - either because of offering a much simpler UX or being first in the space. But both these things have led to the same problem.

Naturally, a regular crypto user is more likely to utilize their exchange for all things crypto related as it is a much simpler user experience - as opposed to worrying about whether it is a centralized entity. Only a few PoS maximalists or those who believe in the power of that network move away from utilizing those exchanges and use decentralized protocols. But the latter is a smaller proportion as compared to the former.

And that is why this challenge warrants a solution.

The Solution

Decentralized liquid staking protocols make an attempt to distribute their stake via different validators, so no single validator becomes a dominant player over the PoS network (at-least not via that protocol itself). This diversification is usually looked over by the DAO of the protocol, which sets up different parameters for selecting new validators that have significantly reduced chances of suffering from downtime or getting slashed. This is not the perfect solution as measuring validators against the set parameters, selecting the right ones, and then passing the vote through a community of (potentially) millions of users is a tough job.

The second solution is to spread awareness. For a profit-seeking trader, staking is just a share of their portfolio. They’d much rather stake with an entity that offers them

  • comfort,
  • security,
  • (in most cases) instant liquidity in some shape or form,
  • bonuses (increased APYs etc.), and/or
  • even all of this!

And there are only a very few entities that can do this - the perfect example is a centralized exchange that already has millions (if not billions) of dollars worth of transactions happening every day. At some point in our crypto journey, we all laughed at this meme.

But how many of us have put in the effort to ensure that our funds are not locked inside servers prone to hacks, failures, and - at worst - compromises due to human greed?

Let’s say it again, not your keys, not your crypto.

But to get those users off the centralized exchanges and onto decentralized staking protocols, we need to educate and inspire them. By helping share the awareness of how crucial it is for a PoS network to have its stake distributed via multiple protocols and validators, we are more likely to inspire users. Since staking has always been the unsexy granddaddy-styled investment, there is a huge lack of such awareness.

But does that mean that staking through a decentralized entity solves all problems of stake centralization? No. There are several challenges to decentralized liquid staking as well.

The First-Mover Advantage

This isn’t necessarily a challenge, but it is something that we must be aware of. The first to sow the seeds reaps the sweetness of the benefits first. This is true for the pioneers in the decentralized liquid staking ecosystem. But that is where the problem lies.

The Problem

We believe that first-mover advantage harms any decentralized ecosystem as the dominant player can become a critical liability to the entire PoS network. Instead, we push for a vibrant ecosystem with enough competition between various players. Take Ethereum, for example.

The majority stake on that network is predominantly through a single protocol and centralized exchanges. As the ecosystem matures and the protocol garners more stake, they are likelier to enhance their overall user experience to ensure that users stick with them. While this is expected of any pioneer business in any market, it can become a deterrent in the case of liquid staking. The protocol can become too big to self-limit its staking, thereby becoming a huge point of failure in the network.

This challenge is further fuelled by the narrative that liquid staking is a winner-take-all market. I have always been of a strong opinion that it indeed is the opposite.

The Solution

In this case, the solution is hidden in the problem itself.

Liquid staking is the perfect example of an ecosystem where multiple protocols can coexist by competing against each other to offer the best user experience to their users while ensuring stake diversification through decentralized governance.

How? Let me explain.

It is the protocols’ prerogative to give a simplified, smooth, and efficient experience to their users to they are enticed to stake via them. Exchanges have always had an edge here because of cash and human capital availability. In an ecosystem where there are multiple protocols, they all compete to offer a unique experience, which further eats into the market share of exchanges.

Think integrations. The more effective and usable integrations a protocol has, the more likely it is to gain popularity amongst DeFi users. These integrations help the more mature/advanced users to build complex money legos to build useful yield spirals. If Protocol A has effective integrations, then just to compete, the team at Protocol B is likelier to think in a similar direction.

This creates a healthy competitive atmosphere between various protocols. And who gets to benefit the most? The users because they have the power to choose!

User experience also plays a great role here. Users who wish to stake their assets are more likely to stake with a protocol that offers a much smoother and more efficient experience. This is an additional breeding ground for competition.

However, this competitive landscape can also work in the opposite direction. Fierce competition can also create winners and losers: the protocol gets the most users (and hence, stake) and the protocol that gets the least. The former leads to another serious challenge.

Systemic Risks

This is probably a critical challenge to the PoS network in the long run, especially when integrations pick up some pace. We talk about how liquid staking unlocks the staked assets’ ability to be used across multiple protocols. These integrations can also prove risky if the protocol where the liquid-staked derivative is being used goes bust, or worse, if a major decentralized liquid-staking protocol gets compromised.

The Problem

Let’s suppose you are using your liquid-staked derivative as a collateral token to borrow more assets via a leading lending/borrowing protocol. Furthermore, you plan to utilize those borrowed assets on a yield farming protocol. You are effectively building a money lego based on the liquid-staked derivative you used as collateral. Let’s say that the leading lending/borrowing protocol gets compromised and all your collateral is effectively stolen. This then can have a domino effect on the protocol where you’d initially deposited that collateral. This can, then, topple all other connected DeFi protocols potentially causing huge chaos.

Think about the liquid staking protocol itself. If it suffers from a smart contract vulnerability, then there are chances that a hacker can exploit that to drain all assets. This creates a massive systemic risk for DeFi.

The Solution

The solution to this challenge is a bit hard to find because smart contract vulnerabilities do exist and they can be exploited. While it is always recommended to get the protocol’s architecture thoroughly vetted and battle-tested, such hacks can happen (and they have happened). A protocol can get compromised due to an old-but-ignored vulnerability or a new one can be discovered and then exploited. A workaround to this is constant monitoring of the protocols' architecture and running bug bounty programs to ensure these problems are kept at bay.

Closing Thoughts

As you’d notice, most of these problems are interconnected. Stake centralization can lead to system risks. And the former can be caused by a protocol having the first-mover advantage as well. While this list is not exhaustive, these are some of the problems that we are seeing in the whole crypto ecosystem at the moment - and these are the problems that need solving.

The suggested solutions are good starting points for discussions around how these problems can be mitigated. We, at ClayStack, have always been cognizant of these challenges and proactively follow a security-first approach. Thus, we always aim to contribute towards finding solutions that can both keep the ecosystem space and aid in its growth.

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