Steak and liquid steak (LSD)

Kosmonavt
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Kosmonavt
9 MIN READ
Cryptocurrency
13 March 2024
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Blockchain and consensus algorithms

Blockchain and trust

The very first thought that comes to people interested in the crypto market and cryptotechnology is that blockchain allows for the creation of a foundation for a future economy without the total influence of the state. For some reason, the belief that this is happening because of blockchain has taken hold.

Blockchain is just one of the directions of development of DLT (Distributed Ledger Technology), or distributed ledger technology.

Steak and liquid steak (LSD)

If we try to keep things as short as possible, each of the strands of DLT technology tries to work with the structure of data distribution, for certain advantages in cost, security, scaling, etc.

Bitcoin 's breakthrough was in combining blockchain technology and consensus algorithms for mass use. It was the algorithms that were the innovation that was able to allow the database to be handled with complete trust.

What does that trust consist of? You have to be sure that no one can hack into the network, harm its performance, gain control over the execution of transactions and make changes.

The Proof-of-Work/PoW (proof-of-work) consensus algorithm was invented for this purpose. The nodes of the network perform computational work on the selection of values. The node that completes the selection the fastest gets rewarded for mining and the fees spent on these transactions.

Over time, enthusiasts began to realize that in order for the technology to be massively adopted and utilized to its full potential, the network would need to be cheaper, faster, more scalable, and less energy intensive, as the larger the Bitcoin network becomes, the more it will require energy to maintain Proof-of-Work.

In 2012, a new type of consensus algorithm, Proof-of-Stake/PoS (proof-of-ownership), was proposed. It was proposed as an alternative to the PoW algorithm to improve the scalability of networks. In PoS, participants called validators block a certain number of coins in the system (staking) to obtain the right to validate blocks of transactions.

liquid steak (LSD)

The first project on Proof-of-Stake was Peercoin. This approach distinguished it from the Proof of Work (PoW) system used by BTC. Peercoin combined PoS and PoW, initially emphasizing PoW but shifting towards PoS over time.

liquid steak

Comparison of Proof-of-Work and Proof-of-Stake

Compared to the Proof-of-Work (PoW) model, the Proof-of-Stake (PoS) model uses different processes to validate transactions and achieve consensus. Although PoS also uses a cryptographic algorithm, the goal is quite different.

With Proof-of-Stake, the creation of the next block depends on how many bets have been made. The bid is based on the number of tokens of a user of a particular blockchain, the commission from which they are trying to mine. From a technical point of view, participants are not mining, but foraging, as no reward can be received for a block (in theory).

DLT (Distributed Ledger Technology)
Comparison of Proof-of-Work and Proof-of-Stake

What is steaking?

Staking is the process of blocking tokens in a smart contract (betting pool) in order to be able to participate in validation and keep the network up and running.

A validator with a higher token rate, can be selected to validate transactions and create blocks. The blocks created in this way are added to the blockchain.

Stages of Proof-of-Stake

Stages of Proof-of-Stake

  1. Users who own native blockchain tokens safely store them in betting pools.
  2. An algorithm pseudo-randomly selects the next validator in the queue.
  3. The selected validator must propose a block and the number of transactions in it.
  4. Other participants must approve and validate the proposed transactions.
  5. A new block is added to the blockchain.
  6. The selected validator receives a transaction fee.

The system has a rule that a certain minimum of tokens is required to run a validator. If you look at the market, tokens are quite expensive. For example, to launch an Ethereum node you need to block 32 ETH. At the time of writing (11.03.2024), that's $129,000. Quite an impressive amount, which not everyone can afford.

Classic Staking

So only wealthy users can participate in network validation? As it always happens, the market has created solutions that allow ordinary users to participate in the process.

Types of Staking

Classic Staking

The problem described above caused the emergence of services that allow users to contribute their tokens to a common pool and receive a percentage of the pool's total yield.

Liquidity derivative steaking (LSD)

For example, you want to participate in network validation and get rewards, but you don't have 32 ETH to start your node, you only have 1 ETH. You can use a service that allows you to contribute your tokens to the pool.
For providing the service, the provider collects a small percentage of the yield. This is a whole business, as it allows generating revenue by creating infrastructure for those willing to participate in validation. Previously, the Proof-of-Work consensus algorithm followed a similar path. A large number of mining pools were created to allow for a portion of the total reward. The reason for the creation was simple - it became very difficult to work alone.

Classic - the most common type of steaking. Providers of the service are exchanges and individual services. You can often see the interface for steaking inside native network wallets, which host large steaking providers.

Liquidity derivative steaking (LSD)

To gain additional profitability and competitive advantages over classic steaking providers, liquid derivative steaking venues were created.

The main problem with classic staking is that you lock tokens in the system and can no longer use them in any way until you withdraw them. If you withdraw them, you stop getting rewards.

Liquid steaking has come to the rescue. As in classic token pooling, you get the opportunity to place tokens in the pool, but you are also given a copy of a token of equal value.

Risks of staking

For example, the Lido project. You want to participate in network validation and get rewards, but you don't have 32 ETH to start your node, you only have 1 ETH. You can use a service that allows you to contribute your tokens to the pool and get stETH tokens equivalent to your ETH stake. If you want to withdraw your bet, you need to return the stETH tokens.

You get rewards from validation, and you can fully operate the asset in the DeFi ecosystem.

Risks of staking

Like any finance-related activity, staking also has its risks.

Falling token price

All returns are not calculated to fiat currency, but to the token. You can even get 100% annualized returns in a token, but its price can fall by 99%.

You bought 1 unit of token at $10. Deposited it into the staking. A year later you took another token. You have 2 units of token. During the year the price fell by 99% and became equal to 0.1$. You deposited 10$, it became 0.2$. Not so profitable.

Slashing

The main purpose of blockchain is to protect the network from attack and modification by an attacker. With PoS, nodes validate each other. If the validator that uses your tokens for betting breaks the rules of the network, then the bet will be burned and you will get nothing.

Hacking a smart contract

When dealing with liquid derivative staking, tokens are placed into a smart contract (betting pool). Imagine what a huge amount of assets are in these pools. Lido is the largest liquid derivative staking platform, with TVL ETH at $14.6 billion. A very sweet target for an attack.

Falling token price

Earnings from steaking

Stackers receive rewards in the form of tokens of the network in which the tokens are blocked.

  • Commissions. As described above, for keeping the network running, stakers receive commissions for transactions within the network.
  • Rewarding the network. Some networks, in order to create artificial scarcity in the market, reward users for blocking tokens. Such projects have inflationary economics, which further induces users to block their tokens. Example, Cosmos.

When users see the huge interest rates, they immediately have their internal calculator counting switched on. How much will I get? When will I get it?

However, the basic information is usually not shown by anyone. Let's understand with the example of the Cosmos ecosystem, which has an inflationary economy. This means that the supply of tokens is constantly increasing. Taking an analogy from the classic financial market, imagine a company constantly creating new shares.

Interest rates are expressed in two metrics:

APR (Annual Percentage Rate) - the annual rate of interest, if the APR is 7% and you make a bet of 1000 ATOM, after one year you will take 70 ATOM.
APY (Annual Percentage Yield) - AnnualPercentage Yield, taking into account constant reinvestment, roughly speaking "compound interest". Usually the accruals go every new block in the network (for Cosmos - 7 seconds), so instead of 7% you get 11% (this figure is taken from the sky for example).

Slashing

The more users contribute ATOM tokens to the staking, the lower the inflation rate. As mentioned above, when inflation increases, the project incentivizes users to contribute their tokens to the tokenization so that they do not depreciate. Thus, the system balances itself. Since the parameter is dynamic, you should not be surprised by the rise and fall of yields in ATOM tokens in the future.

We need to calculate the reward that the staker will receive. To do this, let's use the formula:

Reward = APY Rate - Network Token Inflation - ISP Commission.

At the time of writing, Cosmos' APY is 9.7%. The token inflation is around 7%. ISP commission is on average 4-5%.

Reward = 9.7 - 7% - 0.48% (5% of 9.7%) = 2.2%.

Something has gotten a little less lucrative. Recall, this is with reinvestment, if your provider does not support automatic depositing of rewards back into the pool, you will have to do it manually. There is a growing risk that you will forget or you will fail. In the end, you will not gain 2.2%, but will get less.

Examples of projects

Everstake

Hacking a smart contract

The Everstake platform is quite informative, as you can easily find out how much the pool pays and find answers to your questions by clicking on the net.
On the platform, you will find all the statistics you need to make the right decision, and when it comes to calculating your earnings, there is a reward calculator that will show you how much you will earn if you use a certain strategy. Everstake has a team of highly qualified and experienced fintech experts and software engineers behind it, ensuring that the platform is completely safe and secure. In addition, each blockchain has its own team of blockchain managers and DevOps providing all the technical support you need, whether you are new to the platform or a regular customer.

Within the article, we will discuss the major platforms in the market. The leaders are Lido and Coinbase Wrapped Staked ETH.

Earnings from steaking
Blockchain and consensus algorithms

Lido

When a user deposits ETH through the Lido smart contract, the tokens of all stakers are pooled and then distributed to validators. Users receive "stETH" (staking ETH), a liquid betting token minted at a 1:1 ratio to deposited assets.

The token is actively used as collateral in credit applications such as Aave or Compound. This simple idea has led to liquid staking tokens becoming the underlying asset for use in DeFi. Overall, the growing integration with DeFi protocols could increase the liquidity of steaking tokens by creating secondary markets.

It is important to note such a thing as the discount/premium on a liquid steaking token and its underlying asset. In the case of Lido, the divergence between stETH and ETH reflects liquidity, smart contract and collateral risks. For example, if the market realizes that Lido's smart contract cannot deliver the underlying ETH, the derivative will be sold at a discount.

APR (Annual Percentage Rate)

Coinbase

Coinbase 's centralized exchange is the second player in the liquid steaking market. Unlike the relocation token used by Lido, cbETH is issued/redeemed based on a floating exchange rate.

In other words, the user's cbETH balance does not increase as the steaking reward is received, but represents:

Principal amount (locked ETH) + accrued staking reward - penalties.

This exchange rate is then applied when the user "unwraps" their staked ETH. Thus, 1 cbETH does not necessarily correspond to 1 delivered ETH. This ERC-20 compatible token model, in addition to Coinbase's trusted brand, convenience, and regulatory security, has led to cbETH becoming the second most popular liquid staking product. cbETH has also received several integrations with DeFi protocols such as Uniswap, Curve, Aave and Compound to further expand its use.

Cryptocurrency steaking: is the game worth the candle? CRYPTOLOGY.KEY Team Opinion

Cryptocurrency steaking is attracting attention due to the potential profits.
The steaking process involves locking up cryptocurrency to support the blockchain network, which in return provides rewards. The main benefit is the ability to earn interest on your crypto asset, making it actively work for you. However, the key point here is the blockchain, as you lose access to your assets for a certain period and expose yourself to risks - at the very least a possible increase in the price of your blocked asset without access to it. Liquid staking extends these possibilities by allowing you to keep your assets liquid while they are frozen - you get an escrowed equivalent of your coins instead of your assets. However, the risk of smart contracts being hacked still remains. In addition, it is very important to scrutinize the issue and the promised interest, as the actual reward may differ due to inflation and commissions, and then the question arises whether the game is worth the candle. Staking cryptocurrencies can be profitable, but it requires a conscious approach, careful reserch and willingness to accept possible risks.

Frequently asked questions about steaking

What is steaking?

Stacking is the process of blocking cryptoassets in a smart contract to support blockchain network operations. Staking participants block their coins to enable them to validate blocks and earn rewards.

What is liquid steaking?

Liquidity staking is a process where users lock their cryptocurrencies to participate in the staking process, but at the same time retain access to liquidity. In regular steaking, when a user deposits their coins, they are frozen and cannot be used for any other purpose. In the case of liquid staking, users receive a derivative (a copy of a token of equal value) representing their locked assets.

What is the difference between APR and APY?

APR (Annual Percentage Rate) and APY (Annual Percentage Yield) are two different measures used to evaluate investment returns.
APR is the annual rate of interest without the compounding of interest during the year. APY includes the effect of compounding interest - meaning that it shows the real return on an account or investment, taking into account how interest accrues and is added to the principal. APY is usually higher than the corresponding APR because it takes into account interest compounding.
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