Two of the defining events in crypto and the broader blockchain space are the emergence of decentralized finance (DeFi) and the transition from proof-of-work (PoW) to proof-of-stake (PoS) layer 1 networks. The next pivotal moment is poised to be the ascendance of interoperability between layer 1 blockchains, unlocking superfluid collateral, and a highly composable ecosystem of novel financial assets. 

Sarah Kim is an Ecosystem Development Associate at Terraform Labs

From Bitcoin’s founding to today 

When Satoshi Nakamoto introduced Bitcoin’s PoW algorithm in the venerated white paper, few could have foreseen the impact that it would have in both computer science and the financial world. The process of mining, converting electrical energy consumed by application-specific computer processors, has buttressed Bitcoin’s security model for over a decade. And the mining sector has scaled concurrently with Bitcoin’s meteoric price run. 

Now approaching a fully industrialized scale, where economies of scale dominate, Bitcoin’s mining economy has fallen under criticism by energy conservationists who believe the outsized consumption of electrical energy by Bitcoin mining is not an effective use of energy. Opinions on the merits of the argument aside, PoW’s energy consumption sparked a deluge of new PoS-based public blockchains — seeking to replace PoW’s electrical consumptions with financial incentives and game theory. 

Polkadot, Cosmos, Terra, and eventually, Ethereum 2.0 are a handful of the most prominent PoS chains today. We’re only a year or two removed from many PoS chains launching, but their adoption has been accelerated by an influx of new users to the crypto space. DeFi has captured the mainstream attention and that of crypto degens, leading to congestion problems on Ethereum, and a renewed emphasis on speed at both the first and second layers of blockchains. 

However, many of the blockchains today remained siloed from each other — unable to exchange value without some kind of centralized solution. That narrative is quickly changing. 

The interoperability problem and the ‘liquid staking’ solution

PoS protocols typically bond staking users’ assets into the protocol for a specific timeframe. There is a fixed, predetermined staking reward that can be earned in return, with delegation periods often a function of consensus security. 

However, locked (semi-unproductive) capital in PoS networks limits access to liquidity in the DeFi ecosystem. Although staked capital is accruing interest, either by network transaction fees or emission rates, tokenized derivatives that unlock that bonded capital would enable stakers on PoS networks to deploy a representation of their bonded assets (i.e., a claim on future cash flows) across DeFi protocols. 

Liquid staking, as the name suggests, fixes the root of this problem. It allows users to stake their crypto assets into a PoS protocol to participate in consensus and governance while unlocking that bonded capital to deploy in other DeFi opportunities. 

The primary mechanism involves tokenizing the staked assets via a derivative contract and creating a standardized framework for those derivatives to be used on other protocols. Otherwise known as staking derivatives, these claims on bonded staking positions can be traded freely among users within a specific blockchain (e.g., Ethereum) but also across different blockchains. 

Staking derivatives that can flow between layer 1 chains, such as from Terra to Polkadot, are the manifestation of superfluid collateral — a concept that vastly increases capital efficiency with crypto networks, particularly PoS chains. Imagine staking LUNA on Terra, taking a liquid staking derivative representing that position, porting it to Ethereum, and depositing it into a decentralized money market as collateral for a loan in USDC. Composability is powerful. 

Liquid staking is not without risks 

The major caveat with liquid staking derivatives, however, is the overall solvency risk that emanates from one of PoS networks’ consensus security parameters — slashing staked coins. 

With staking derivatives seeded in multiple projects with more liquidity, slashing of staked coins/tokens (an event that occurs when a validator forfeits a defined proportion of staked tokens that are either burned or redistributed to other stakeholders) will not uniformly reflect the value of the staked assets across all the projects. For example, should a staking derivative represent a specific amount of DOT by Alice delegated to a third-party node operator and that node operator forgets to maintain a 100% node uptime (or validates a wrong block), a portion of Alice’s bonded DOT would be slashed. 

If Alice is deploying her staking derivative in a money market, this would represent solvency risk for her position. With liquid staking derivatives preponderating around multiple chains in various money markets and DeFi platforms, this is even capable of creating systemic solvency risk should a severe layer 1 debacle or slashing event on a specific chain occur. The overall system becomes highly interdependent on each blockchain’s security parameters. 

Additionally, these staking derivatives are not necessarily fungible. This can lead to misappropriation of the funds that investors hold on a massive scale and can clog the industry and cripple DeFi projects before they reach their full potential.

What’s needed for the future 

DeFi and PoS blockchains are mutually beneficial components of the broader blockchain ecosystem. 

Liquid staking is an innovative solution to the issues that arise out of inefficient capital deployment and a lack of interoperability at the moment, which hampers DeFi’s potential in the process. Nevertheless, liquid staking needs to be better adapted and built to solve these issues with improved transparency. Blockchains, being publicly accessible, can be leveraged to identify misinformation in pricing, mitigating risk to a large extent. 

With the pressure in the blockchain industry to move towards PoS and with the growing need for innovation within DeFi to facilitate better lending and payments-based products, liquid staking serves as a valuable tool. Without having to unstake their assets, users can take advantage of various financial applications, improving capital efficiency without compromising network security. 

Eventually, a thriving ecosystem of cross-chain interoperability complete with liquid staking derivatives could become the gold standard for passive savings vehicles in DeFi