PoS Incentivizes Staking and Spawns Derivatives
Given this accretion dynamic, it’s no surprise that staking is so popular for PoS networks. The percentage of coins staked on PoS networks varies from 29% on Ethereum to 77% on SUI. Most PoS networks have over 50% of their coins staked, with some earning less than 3% yields (SUI). The activity has become so popular that liquid staking services, such as Lido, and restaking services, such as Eigenlayer, have emerged. These services allow users to stake their coins, earn PoS staking rewards, withdraw a derivative liquid staking token (LST) issued by the platform on a 1 for 1 basis, and use that token to do other things, like generate additional yield through DeFi activities (lending, liquidity providing, and re-staking).
However, Risks Should Not be Underestimated
The risk with these activities, however, is multifold. The first is legal/regulatory as the SEC has asserted certain staking services invoke securities laws. The second is technical risks as these systems employ a dizzying array of novel technology, including smart contracts, bridges, and sidechains. Because of the insecurity of some of these systems, DeFi protocols have been the source of some of the biggest hacks over recent years. The third is issuer risk as these platforms/protocols usually issue derivative tokens on numerous networks. Even something simple like the USD stablecoin tether (USDT) is technically 16 different digital assets issued by Tether, all on different networks such as Tron and Ethereum. Most of these protocols advertise these derivative tokens as being “pegged” but what they really mean is "issued on a 1 for 1 basis"; there is no mechanism that “pegs” prices. During the LUNA/UST crash of 2022, stETH (stake ETH issued by Lido) “depegged” in price compared with ETH purely because stETH was leveraged in all sorts of DeFi strategies while ETH was locked earning PoS rewards. There is also price risk associated with derivative tokens, as just illustrated with the stETH example, as well as with the yields themselves, which can be paid in “points”, a protocol’s native token, or some other digital asset. Finally, there is fragility introduced with restaking that uses the same capital to secure multiple networks. A slashing condition on one app chain would result in slashing in the initial stake and thus any other app chains the stake is securing. It may be easier to bootstrap security for an app chain through restaking, but it cannot collectively increase the economic security of the entire system.
How Might These Risks Appear in Markets?
How might these risks present themselves in markets? Slashing in PoS systems (removing a portion of assets staked for bad behavior) is pretty rare, but it’s easy to see how slashing a stake that is providing security to multiple chains affects all chains. While cascading slashing risk is one risk, a bigger risk to us is purely leverage across the system that all of this enables. Because these derivative assets like LSTs are then recycled back into the DeFi ecosystem for lending, LPing (liquidity providing on decentralized exchanges), and re-staking, it introduces leverage into the ecosystem, all held together by smart contracts, bridges, and sidechains. We could easily see a situation where a large trader’s capital, recycled through DeFi several times, starts taking losses for some reason that then results in a cascading unwind in this entire “trade.” These times usually coincide with pressure on spot price – the stETH/ETH “depeg” occurred in the wake of the LUNA-induced market crash for example. There isn’t anything to suggest this is imminently at risk of happening, but as a “pre-mortem,” it’s a strong candidate for what could go wrong under certain circumstances.
Bitcoin is Still Largely Idle Capital, But Other Options are Available
The big idea that platforms like Babylon have hit upon is that bitcoin is largely idle capital. As the largest, longest-standing, and most secure digital asset, bitcoin is the best collateral in the digital asset industry. The issue, however, is that it doesn’t easily integrate well with other networks, hence efforts like wrapping bitcoin (BitGo, Coinbase, Kraken, etc), Babylon, Lombard, and Solv to name a few, that seek to integrate bitcoin within other digital asset networks. It remains to be seen whether bitcoin investors, who hold the asset for appreciation and inflation protection purposes, will be enticed by the potential rewards given all the risks.
Other options exist, however, for bitcoin holders who wish to enhance returns, some of which should already be familiar to traditional market investors, like options overwriting and lending. The following table outlines the various avenues available, risks, and potential returns for holders to generate additional returns. Each involves various tradeoffs, but we have found that in investing, better information “yields” better decisions, pun intended.
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