Stake pools vs. liquidity pools

Blockchain lending, in the decentralized finance ecosystem (DeFi), has become the most popular financial application today, with liquidity pools, the most widely used instrument.

DeFi boasts over $86 billion dollars locked (TVL) and a crypto market dominance of 17%, and growing. DEXs are one of the important instruments in this market, and the other, liquidity pools, have a yield that exceeds 5% per year, and in some pools reaches 15%. (Source: DeFiPulse).

To participate in a liquidity pool it is required to immobilize cryptocurrencies, in exchange for the token representing the investment, and for a minimum time to obtain a profitable interest.

In Cardano, the Proof of Stake (PoS) requires participating with ADA in the network consensus through a pool, if you are an operator, or like most, delegating funds to obtain rewards in the order of 5 to 6% per year.

A PoS system is safe when there are many delegated coins. In most PoS algorithms, as long as a minimum of 2/3 of the coin circulant is in delegation, and moreover diversified in several actors, the blockchain will be secure. On the contrary, when the delegation is less than 60% of the circulant, and more than 50% of it is concentrated in a few hands, the network is insecure.

Now, imagine that an attacker wants to break a PoS system. How would he do it?

He could accumulate more than 50% of all tokens in circulation and thus dominate the network consensus, but that is difficult and expensive. Another possibility would be to convince the majority of delegators not to delegate, and thus with less delegation, take control of the network much more cheaply.

The second option seems attractive in principle, but how do you get the current set of delegators to withdraw? There is one way, offer them a more attractive return elsewhere.

PoS only works if delegators are incentivized to staking, but if they can get better returns elsewhere, then they can be expected to withdraw their cryptocurrencies and go with their funds where it yields more. If this happens, the network becomes less secure.

This somewhat extreme approach serves to illustrate the competition that does not exist today and is coming, between DeFi and staking, which means an impact on the security of the protocol.

As long as a PoS network is in an open ecosystem, such as Cardano, any lending market in the chain can cannibalize its security by offering higher returns. In fact, even if the system does not directly support smart contracts (such as Cosmos, ATOM), if the delegation asset can be tokenized and transferred across the chain (wrapped), a tokenized loan market on another chain, could have the same effect.

Recall that at the beginning of this article I discussed how much it yields annually to delegate into a stake pool or tie up funds in a liquidity pool.

How can PoS maintain delegation?

Two options: either force the lending markets in the chain to cap their interest rates, or compete with the lending markets.

The first strategy would be akin to imposing capital control, and obviously this is not possible on permissionless blockchains, and if it were it would be very bad for the latter, because it would discourage adoption.

The second option would be for the network validators themselves, the stake pools, to offer smart contracts for loans, competing in the DeFi environment.

Yes, why not?. In this way the return they would offer would be, in addition to the rewards of the network for participating with delegation in the consensus, the proper return of a liquidity pool.

The delegation would have double play, it would be part of the network consensus and of a liquidity pool for loans. The stake pools would have the original function of validators, and the aggregate function of liquidity pools, retaining the delegators with double income, rewards and DeFi interest.

The liquidity required for these instruments must be substantial and competitive with the liquidity pools, with their large tokenized funds. For the business to be viable, large amounts are needed to atomize risks and monetize loans, where the question of economic scale plays a preponderant role.

In order to compete in this ecosystem, it is likely that several stake pools with their delegated funds will need to meet, issuing a liquidity token, so that the delegator, and in turn “lender”, should exchange this token to recover funds, and only then, withdraw the delegation.

In this scenario, the delegator who would like to participate in the liquidity pool would have to buy the token with the funds (or part of them) under delegation. This participation in the DeFi liquidity would not be mandatory, considering that Cardano has a policy of incentives and not restrictive obligations.

Goguen prepares this year, a challenge for the stake pools, and for the whole community, the DeFi financial business is as important as the social mobilization it produces, facilitating access to credit to people who today do not have it, but it is no less important to sustain the blockchain in operation with its consensus, above 60% of the circulating, and decentralized in different actors.

It is quite a challenge, but one that the Cardano community is undoubtedly ready to face.

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Researcher — ϚʁyptøWriter — Content Creator | Twitter @liberlion17 website: liberlion.com