Why Liquid Staking could be the Answer to More Decentralization

Ethan Nelson

Ethan Nelson

November 9, 2022

6 min read

Why Liquid Staking could be the Answer to More Decentralization

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Satoshi Nakamoto's Bitcoin whitepaper was published in 2008 in response to the global financial crisis. The Bitcoin network was created early in 2009, with the headline embedded in the first block: "Chancellor on the verge of the second bank bailout." The project's objectives were to create an alternative, voluntary, transparent currency and peer-to-peer payment network which would be more resilient than existing financial institutions.

Previous attempts at digital currencies, such as DigiCash and E-Gold, have failed because they were built with centralization, which made them vulnerable to government regulation and intervention. On the other hand, Bitcoin doesn't have a central figurehead and is much more resistant to these attempts at shutdown via government regulation and intervention.

The Nakamoto consensus was a significant milestone in digital currency advancement. The Nakamoto consensus is a system in which miners generate cryptographic hashes. The network's nodes only accept the related block as genuine if the hash contains a particular number of leading zeros. This system is referred to as mining or Proof-of-Work (PoW).

The Principle Behind PoW mining

Joining the PoW network is easy! Just download the software, sync the blockchain, and look for hashes using your computer's CPU power. The chances of creating a block depend on how fast you generate hashes. Since this varies depending on your machine's processing power, mining is a competitive activity where people try to get the lowest mining costs through economies of scale.

The network can be trusted as long as trustworthy miners control most of the network's hashing power. This is what secures the network. PoW is what's behind some of the most popular cryptocurrencies, such as Bitcoin and Ethereum, but it has some severe disadvantages.

An adversary that wanted to disrupt the network would need to put a lot of computing power into taking over most of the network's hashing power. This has been a problem for a long time and has led to the development of other ways to resist attacks, the most notable being Proof-of-Stake (PoS).

The Rise of Proof of Stake (PoS)

The Proof-of-Stake algorithm is becoming more popular as a way to protect decentralized networks. PoS has several advantages over PoW, including quicker confirmations, lower operating costs, increased speed, and less environmental impact.

PoS uses native cryptocurrency tokens as collateral to decide who can participate in the consensus process of a blockchain network. The collateral is committed along with the primary duty of participating nodes, which is to follow the protocol's rules.

Understanding Validator Nodes

Validators are nodes that use private keys to execute the protocol’s software. They arrange and validate transactions, interact with other nodes, and update their ledgers to stay synchronized with the rest of the network.

As was mentioned earlier, validators in PoS networks use collateral in the form of cryptocurrency tokens (the "stake") to back them up. Token holders who stake ("stakers") help improve network security by choosing dependable validators and making it more expensive for potential attackers.

They earn tokens in proportion to their stake backing, which acts as compensation ("staking rewards"). In addition to network issuance rates and transaction fees paid inside the network, other variables that affect the quantity of these rewards include staking participation rates and validator-specific factors (like uptime and commission rates).

If a validator wants to participate in the consensus process, they need to have some of their collateral held in escrow by the network. This collateral is usually at risk of being seized if the validator breaks the protocol's rules (known as "slashing"). This is meant to discourage validators from attacking the network by double-signing.

If a participant in a decentralized financial protocol wants to withdraw their staked assets, they may have to wait a certain amount of time - known as the "unbonding time" - to retrieve them. This can put an economic cost on the owners of the at-risk assets.

The Rise of Liquid Staking

In response to the capital inefficiencies of traditional staking, liquid staking has been developed as an alternative. With centralized exchanges that pool assets and use off-chain contracts, traditional staking constraints can be easily evaded.

Liquid staking is a rapidly developing area that uses tokenized staked assets to expand their usage and application areas. Liquid staking provides more efficient use of capital, freeing speakers to take advantage of new trading and yield-generating opportunities.

The Future of Staking

There is a shift in how most blockchain networks are secured. In 2017, Polygon was created as a critical player in the Proof of Stake (PoS) ecosystem. Several more PoS blockchains have opened or will launch soon. Bitcoin and Ethereum, however, continue to operate on the older Proof of Work (PoW) protocol.

Even though blockchains are still in their early stages, much progress has been made in terms of infrastructure and identifying use cases suited for widespread adoption. There is still much room for improvement in PoS systems, and more research needs to be done to find the most efficient solutions.

Although there hasn't been enough research on the long-term effects of the restrictions typically placed on assets subject to staking, it's clear that staking will be essential for securing most blockchain networks and will probably be vital in establishing the framework for the future financial system.

The biggest threat to Proof-of-Stake systems is that exchanges will start offering staking services, giving them much control over the network. This is because exchanges can easily skirt technical limitations and make the process more straightforward and user-friendly.

The severe consequences of continuing this behavior include defunding community validators, reducing network resilience, and possibly corrupting governance processes. PoS networks can only offer moderate censorship resistance if a few parties can shut down a blockchain network or filter transactions.

Conclusion

Within a brief time frame, liquid staking has given rise to an industry that might present an option to exchange staking and stimulate a deluge of fast staking development. Like the decentralized finance ecosystem found on Ethereum, liquid staking affords composability, permissionless innovation, and an everlasting testing ground.

Assuming liquid staking would be beneficial for a blockchain network in the long term, several factors could make or break the success of liquid staking. These include how liquidity is handled, dependence on other networks, how governance rights are managed, and any legal problems that could arise.

In conclusion, liquid staking is a crucial development for PoS systems. It could improve capital efficiency, network stability, decentralization, and new business opportunities if executed correctly. This is an excellent chance for PoS protocols and investors to capitalize on.

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