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DeFi Staking Explained

DeFi Staking Explained

Blockchain Explained

By

Dimitar Bogdanov

September 8, 2021

4 Min Read

DeFi staking, in its most narrow definition, refers to the practice of locking crypto assets into a smart contract in exchange for becoming a validator in a DeFi protocol or a Layer 1 blockchain and earning rewards for performing the duties the role requires. To understand how DeFi staking works, it involves users locking their cryptocurrencies into smart contracts or protocols to support blockchain networks, earn rewards, and help maintain decentralization. Smart contracts play a crucial role in supporting blockchain operations and facilitating rewards distribution in decentralized finance staking.

A staking mechanism, or more broadly, staking mechanisms, are the core processes that enable users to participate in DeFi staking by locking assets and earning rewards, while also supporting network security and operations. The consensus mechanism, along with various consensus mechanisms like Proof-of-Stake (PoS), is essential in DeFi staking as it ensures transaction validation, network security, and decentralization. Staking works by allowing users to lock their assets into smart contracts, contributing to network operations and earning rewards in return; this staking work is fundamental to the functioning of DeFi protocols. Decentralized finance staking is the process of locking cryptocurrencies in smart contracts to support blockchain networks, earn rewards, and participate in maintaining decentralized protocols, playing a vital role in network security and decentralization.

The DeFi staking space and the broader DeFi ecosystem encompass a variety of blockchain networks and network operations, offering diverse opportunities for users to engage in staking and other decentralized finance activities. This article will provide valuable insights into the mechanics, benefits, and risks of DeFi staking. In the following paragraphs, we’ll be taking a closer look at staking and two other popular forms of DeFi investing - yield farming and liquidity mining. We’ll try to identify the subtle and not so subtle differences between them, as well as the biggest challenges that the nascent DeFi sector currently faces. Let’s get started.

Types of DeFi staking

Staking and staking rewards

As mentioned above, the purest form of staking involves locking a set amount of crypto assets to become a validator in a Proof-of-Stake (PoS) blockchain network. A staking platform enables users to stake assets and participate in network security by supporting blockchain network operations and validating transactions.

Unlike Proof of Work consensus algorithms, where ensuring transaction validity requires a lot of energy-intensive computational work, PoS relies on validators that have vested interest in the success of a network through their staked crypto assets. In other words, validators have to perform their duties diligently, otherwise they face the risk of losing a portion or even the entirety of their staked funds. Validators typically stake the network's native token or native tokens, which are the main assets staked and rewarded in the process. In addition, validators are eligible to receive staking rewards, earned rewards, and additional tokens for creating and validating blocks, which further incentivizes good behavior. Participants lock their assets to become validators and support blockchain network operations, helping to maintain network security and the network's operations. Validators play a crucial role in validating transactions, ensuring that all transactions are legitimate and maintaining the integrity of the blockchain. The importance of network's operations, network security, and blockchain network operations cannot be overstated in the staking process.

Undoubtedly, the most high-profile PoS blockchain currently is Ethereum, which is transitioning from Proof of Work to Proof of Stake as part of the eth2 (Ethereum 2.0) project. Ethereum staking is significant in the DeFi ecosystem, as it enables users to earn staking rewards, support network security, and participate in decentralized finance activities. Other notable examples include Polkadot and The Graph.

At its most basic level, the staking process boils down to an interested party posting a ‘bond’ (stake) to become a network validator, which in turn makes that party eligible for staking rewards. The staked amount, staked tokens, and tokens staked determine the share of rewards a validator receives and influence the overall network operations. The problem with this direct approach to staking is that the stake requirement is often quite high. For example, to become a validator on eth2’s Beacon Chain, you need to post a 32 ETH, which is a hefty investment. Because of this, most individual investors are typically priced out of staking opportunities. Staking protocols and staking options offer different requirements and features, so users should consider their risk tolerance when choosing between them.

Fortunately, there has been an emergence of staking service providers that allow people to circumvent the steep financial requirement. First, we have the so called staking pools, which allow people to join forces with other crypto investors in order to raise staking capital. Staking pools use staking tokens or stake tokens to represent a user's share in the pool, enabling transparent tracking of staked assets. The system enables people to deposit any amount of tokens to a staking pool and start earning passive income, earning interest, and generating passive income based on how much of the pool’s total holdings their deposit accounts for. Users can access earned rewards, earn rewards, and earn staking rewards through different staking mechanisms. Staking pools also offer competitive rewards, additional rewards, and additional tokens as incentives for participation. Users can stake assets and retain ownership while earning rewards, especially when using liquid staking and liquid staking solutions, which provide more flexibility compared to traditional staking. Staked assets and staked funds are important for the security and operation of the protocol, while token holders and governance tokens play a key role in protocol management and decision-making. DeFi staking platforms and DeFi platforms support staking and offer various DeFi staking options, including multi asset support for staking a variety of digital assets. Liquidity provision, trading fees, and transaction fees are integral to DeFi staking, as they contribute to the rewards distributed to participants. Users can participate in different DeFi protocols and various DeFi protocols to maximize returns and diversify their staking strategies. The process involves staking digital assets to earn rewards, and some platforms support staking for a wide range of assets, catering to different user needs and risk profiles.

Alternatively, users can also turn to a crypto exchange, since most major centralized and decentralized exchanges offer DeFi staking services.

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Yield farming

While lending and borrowing platforms provided the first strong use case for decentralized finance, the advent of yield farming showcased DeFi’s true power. Liquidity provision is central to yield farming, as it enables users to earn rewards by supplying digital assets to liquidity pools. Liquid staking and liquid staking solutions have emerged as innovative ways to maintain liquidity while still earning rewards. The defi space, defi staking space, and defi ecosystem form the broader environment where yield farming and related activities take place. Users can move assets between different defi protocols and various defi protocols to maximize returns and take advantage of diverse opportunities. Digital assets, such as cryptocurrencies and NFTs, are the primary assets used in yield farming. Key benefits of yield farming include earning interest, the ability to earn interest, earning passive income, generating passive income, and overall passive income generation. Participants are incentivized with additional rewards, additional tokens, and competitive rewards for their involvement. Trading fees and transaction fees contribute significantly to the rewards earned by yield farmers. Yield farming also allows users to earn or utilize native token, native tokens, governance tokens, and staking tokens. Staking platform, defi platform, and defi platforms play a crucial role in supporting yield farming activities. The importance of staking options, staking mechanisms, and understanding the staking mechanism is central to effective yield farming strategies. Many platforms support staking and enable users to participate in yield farming seamlessly. Considering risk tolerance is essential when choosing yield farming strategies. This article provides valuable insights into yield farming, helping readers understand the mechanics, benefits, and risks involved.

Of course, investing in different assets with the idea to maximize your earning potential or hedge against unexpected risks is one of the central investing strategies in traditional financial markets, as well. However, DeFi staking enables never-before-seen flexibility, as the combination of 24/7 access to markets, smart-contract-driven automation and lack of intermediaries allows for investors to jiggle between multiple DeFi protocols with little to no downtime. Such a level of flexibility creates plentiful opportunities for forming various DeFi staking strategies.

Liquidity mining and liquidity pools

Liquidity mining is a subcategory of yield farming that involves providing crypto assets to liquidity pools. Liquidity provision is the core of liquidity mining, as users supply digital assets to pools to facilitate decentralized trading. These pools are crucial for enabling trading without intermediaries on the type of decentralized crypto exchanges (DEX) known as auto market maker (AMM). A typical liquidity pool consists of the two assets that make up a particular trading pair - for example ETH/DAI - and utilizes an algorithm to ensure that the value of one of the assets is always equal to the value of the other. This means that the pool dynamically adjusts the prices of the assets to account for any changes in their respective values that might have occurred as a result of trades. To put it in the context of our ETH/DAI example, a purchase of ETH would decrease the amount of ETH in the pool, while increasing the amount of DAI. To counter this, the pool increases the price of ETH relative to DAI.

Liquid staking and liquid staking solutions are also available for liquidity providers, allowing them to maintain liquidity while earning staking rewards. Staking tokens, native token, native tokens, and governance tokens are commonly used as assets in liquidity mining, providing users with multiple ways to participate. Staking platform, defi platform, and defi platforms play a key role in facilitating liquidity mining by offering user-friendly interfaces and secure environments. Trading fees and transaction fees generated from swaps are distributed to liquidity providers as part of their compensation. Additional rewards, additional tokens, earned rewards, earn rewards, and earn staking rewards serve as further incentives for those who participate in liquidity mining. Staking options, staking mechanisms, and the underlying staking mechanism are important considerations for users seeking to maximize their returns. Some platforms support staking and enable users to participate in liquidity mining with ease. Digital assets are the primary assets used in liquidity mining, encompassing cryptocurrencies and other tokenized assets. Various defi protocols and different defi protocols offer diverse liquidity mining opportunities across the market. The defi ecosystem, defi staking space, and broader defi space all contribute to the growth and innovation of liquidity mining within decentralized finance.

At its core, this whole system relies on liquidity providers who make their assets available to liquidity pools. For that, liquidity providers can receive various financial incentives, including a percentage of the fees collected by the pool. Some DeFi staking platforms also include their own tokens in their reward programs. As we’ll see below, DeFi protocols need to have robust reward programs in order to make staking economically viable for liquidity providers.

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Drawbacks of DeFi staking

While it has some significant advantages over traditional investing, there are also some drawbacks to DeFi staking that have to be noted. One major concern is the risk of smart contract vulnerabilities, as bugs or logic flaws in smart contracts can lead to asset loss and compromise the integrity of staking applications. Before participating in DeFi staking, it is crucial for investors to assess their personal risk tolerance and choose staking methods that align with their comfort level. Additionally, the importance of thorough smart contract auditing by reputable firms cannot be overstated, as reviewing publicly available audit reports and ongoing security assessments helps ensure the security of DeFi staking platforms. The main one is the so called ‘impermanent loss’, which occurs in the process of liquidity mining.

Impermanent loss

Because the price-adjusting algorithms of liquidity pools are only concerned with maintaining a balance between the values of the assets within a pool, the same tokens can have different values within and outside of a liquidity pool. Because of this, taking your tokens out of a pool comes at a loss. Staking reward programs are meant to counter this phenomenon and make sure that liquidity providers are compensated for their efforts.

Gas prices

Another drawback stems from the limited scalability of the current generation of Layer 1 blockchains, particularly Ethereum, which is home to the majority of today's most popular DeFi protocols. The scalability problem often leads to gas price hikes, which makes DeFi activities quite pricey. Here the hopes of finding a viable solution to the problem lie with Ethereum 2.0, as well as a host of Layer 2 solutions, including rollups. One of the most popular DeFi protocols, Uniswap, was recently deployed to two of the most prominent rollup solutions currently on the market - Optimism and Arbitrum.

Conclusion

The aforementioned drawbacks reflect the fact that DeFi is still a novel concept that needs to be further developed and fleshed out. There are still some challenges that need to be addressed, especially given the fact that blockchain technology, in general, is still far from mature. Yet, even at this early stage, DeFi staking has shown that it has great potential and could provide a viable alternative to traditional investing.

In conclusion, DeFi staking represents a transformative opportunity for crypto holders, offering benefits like passive income and network security, but also comes with risks and ongoing challenges. The conclusion DeFi staking is that its future outlook remains promising as the technology matures and adoption grows.

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