DeFi vs. Proof-of-Stake staking debugged. What are the similarities, differences, benefits, and doubts for each? Read it now.
Blockchain technology and cryptocurrencies have revolutionized the way we think about financial systems. An interesting and vital concept within this space is staking, which sometimes allows individuals to participate in the validator and security of a blockchain network while earning rewards. The option for potential passive income is what attracts most users to staking. Interestingly, staking has obtained many forms as its popularity increased over the last few years.
Today’s article compares three prominent staking methods: Proof-of-Stake (PoS), Liquid, and DeFi staking. Each method represents a unique approach to staking and offers distinct advantages and limitations. By understanding these differences, investors and stakeholders can make informed decisions about the most suitable staking method for their needs.
Proof-of-Stake (PoS) is a consensus mechanism certain blockchain networks use as an alternative to the energy-intensive Proof-of-Work (PoW) system. In PoS, the probability of being chosen to validate and add a new block to the blockchain is determined by the number of cryptocurrency tokens an individual holds and "stakes" within the network. So, while PoW requires miners to solve complicated puzzles, PoS mechanisms require validators to hold and stake tokens to earn inflation yield and transaction fees. It’s important to note that no PoS mechanism is the same, and there are many derivatives. Some examples of blockchains offering PoS Staking are Polygon, Cosmos, Ethereum, and Sui. For more networks, you can have a look at our network overview via stakin.com/stake.
Staking in Proof-of-Stake requires participants to lock some of their digital assets in a designated wallet to support network operations and secure the blockchain. Thus, in PoS, staking is the act of pledging your coins to be used for transaction verification. While you stake your coins, they are locked up, but you can unstake them if you want to swap them. It’s possible to set up your validator nodes to stake and verify blocks, but in most cases, it's also possible to delegate a desired amount of digital assets to a validator or node operator. Leaving you with all the benefits of staking without having to worry about uptime or the technical knowledge to validate.
Benefits of PoS Staking
- Energy efficiency and reduced environmental impact: Unlike PoW, which relies on energy-intensive computations and mining equipment, PoS staking significantly reduces the energy consumption associated with securing a blockchain network. This shift towards a more energy-efficient consensus mechanism aligns with growing concerns about the environmental impact of cryptocurrency mining.
- Increased security through economic incentives: PoS staking introduces economic incentives to ensure the integrity and security of the network. Participants have a financial stake in the network's proper functioning by staking their tokens. This aligns their interests with maintaining network security and discourages malicious behavior, as validators risk losing some of their staked assets if they engage in fraudulent activities.
- Lower barrier to entry: PoS staking generally has a lower entry barrier than other blockchain consensus mechanisms. For example, participants can stake their existing cryptocurrency holdings without investing in expensive mining equipment, making it more accessible to a broader range of individuals.
- Network scalability: PoS staking offers the potential for improved network scalability. With PoS, the selection of validators is based on the number of tokens staked rather than computational power. This removes the need for complex computations and allows the network to process transactions more efficiently, leading to higher throughput and scalability.
- Alignment with long-term investment strategies: PoS staking provides an opportunity for long-term token holders to participate in network validation and earn passive income. This aligns well with investors with a long-term investment strategy who prefer holding their tokens rather than continuously trading them.
- Governance participation: Many PoS networks provide governance rights to token holders who stake their assets. By participating in staking, token holders can have a say in the decision-making processes of the network, such as protocol upgrades, parameter adjustments, and voting on proposals. This allows participants to actively contribute to the evolution and governance of the network.
Limitations of PoS Staking
Naturally, there are risks or limitations to PoS staking. First, while highly unlikely, there is a potential for centralization. PoS staking introduces a potential challenge of centralization, as it tends to favor participants with a larger stake. Those with significant token holdings are more likely to be selected as validators, which may concentrate power and decision-making within a small number of entities. This concentration of power can raise concerns about the decentralization and governance of the network.
Second, in many PoS systems, participants are required to lock their tokens for a specific period as a commitment to the network. While this contributes to network security, it restricts participants' liquidity and their ability to freely use or trade their staked tokens. Token holders should carefully consider the trade-off between potential rewards and the liquidity needs of their assets. Finally, PoS introduces a slashing risk to validators with malicious behavior. Whenever a validator gets slashed, you will not receive any staking rewards. This is why it's vital to do your research and find trusted validators or node operators that are trusted by the community, have high up times, and low slashing incidents.
Decentralized Finance, or DeFi, refers to the ecosystem of financial applications and platforms built on blockchain networks, primarily Ethereum. DeFi staking within this ecosystem involves staking tokens through smart contracts in various DeFi protocols and platforms. These platforms leverage the programmable nature of blockchain to offer users the ability to earn rewards by staking their tokens directly on the network.
It’s important to note that when it comes to DeFi staking, unlike PoS staking, participants do not contribute to the inherent security and consensus mechanics of the blockchain protocol. They may be able to participate in governance.
DeFi staking is more a way to reward token holders for holding tokens with a long-term perspective and locking these for a certain period of time. It’s inspired by Proof-of-Stake staking, but the locked tokens do not give voting power to validators. Some examples of platforms utilizing DeFi staking are Aave, Pancake Swap, and Chainlink.
Benefits of DeFi Staking
- Accessibility and Inclusivity: DeFi staking opens opportunities to a broader range of participants, allowing anyone with compatible digital assets and an internet connection to participate. This inclusivity promotes financial empowerment and greater accessibility to staking rewards.
- Reward Long-term Token Holders: DeFi staking is a beneficial and easy way for protocols to support long-term token holdings by incentivizing their users with rewards.
Risks and Considerations in DeFi Staking
- Smart Contract Vulnerabilities and Risks of Hacking: DeFi staking relies on smart contracts, which may have vulnerabilities or bugs that could be exploited. Users must be cautious when interacting with DeFi protocols, conduct thorough due diligence, and consider the security measures and audits of the platforms they choose to minimize the risks associated with smart contract vulnerabilities.
- Regulatory Uncertainties and Lack of Oversight: The evolving regulatory landscape surrounding DeFi introduces uncertainties and potential risks. Users should stay informed about the regulatory environment in their jurisdiction and be aware of potential legal and compliance implications associated with participating in DeFi staking.
During DeFi staking offers accessibility, higher potential returns, and additional earning opportunities, users should be mindful of the risks associated with smart contract vulnerabilities and regulatory uncertainties. By understanding these factors, individuals can make informed decisions when engaging in DeFi staking activities.
Now that we’ve examined these options, let’s compare the key features and characteristics of PoS staking and DeFi staking.
- Proof-of-Stake (PoS) Staking: PoS staking offers energy efficiency, increased security through economic incentives, and the potential for network scalability. However, it does require digital assets to be locked for a particular period.
- DeFi Staking: DeFi staking offers accessibility and is a great way to incentivize DeFi platform users to become long-term holders of that platform's digital asset. Nevertheless, it comes with risks related to smart contract vulnerabilities and regulatory uncertainties.
PoS staking emphasizes energy efficiency, security, and scalability. However, it may face challenges regarding centralization and token liquidity. Liquid staking addresses the liquidity concerns of traditional staking, but users must carefully consider the associated counterparty risks and potential effects on network decentralization.
Factors such as security, decentralization, liquidity, and accessibility play a crucial role in selecting the most suitable staking method:
- Security: PoS and DeFi staking requires users to be cautious about smart contract vulnerabilities. It’s also important to note that with PoS staking, you contribute to the security of the network by giving validators governance power. This is not the case in DeFi staking.
- Decentralization: PoS staking contributes to the decentralization of networks, whereas liquid staking may introduce concerns regarding network centralization. DeFi staking does not have a particular impact on the centralization of a network.
- Accessibility: DeFi staking offers broader accessibility, allowing anyone with compatible assets and an internet connection to participate. PoS staking may have varying levels of accessibility depending on the specific requirements and platforms involved.
A third staking option is Liquid Staking, also known as staking derivatives or wrapped staking, which is a process that allows individuals to maintain ownership of their staked assets while simultaneously accessing liquidity in the form of tradable tokens or derivative instruments. It bridges the gap between the illiquid nature of staked assets and the need for flexibility and liquidity in the cryptocurrency market.
In liquid staking, a third-party service provider, often referred to as a "Liquid Staking Derivative" (LSD) platform, facilitates the process. These platforms include Stader Labs, Lido Finance, and Stake.link. Users deposit their tokens into the platform, which then takes those tokens on their behalf. In return, the platform issues a representation of the staked assets in tokens or derivative instruments, often called wrapped tokens or staking derivatives. These wrapped tokens can be traded, utilized in decentralized finance (DeFi) protocols, or used as collateral for borrowing or lending activities. Liquid Staking is functions as a smart contract on top of the protocol, such as with Ethereum, but can also be implemented for liquid staking on DeFi staking platforms such as Chainlink.
Key players in the liquid staking ecosystem include staking service providers, token issuers, decentralized exchanges, and DeFi platforms that support wrapped tokens and derivative instruments.
Advantages of Liquid Staking
- Flexibility and liquidity of staked assets: Liquid staking addresses the inherent liquidity constraints associated with traditional staking. It allows users to unlock the value of their staked assets without waiting for the staking period to end. This flexibility enables users to respond to market opportunities, access capital when needed, or participate in other investment strategies.
- Access to additional DeFi products and services: By converting staked assets into tradable tokens or derivative instruments, liquid staking opens up various possibilities. Users can leverage their staked assets to participate in decentralized exchanges, liquidity providing, yield farming, lending and borrowing platforms, and other DeFi protocols. This access to additional financial products and services enables users to maximize their returns and explore various investment strategies.
- Makes staking options available for holders with low amounts of digital assets: In some blockchain networks, such as Ethereum, the threshold for running a validator or directly staking your assets is very high and thus costly. In these cases, liquid staking solutions offer an affordable solution for those interested in staking who need access to the high amounts required to stake.
Challenges and Risks of Liquid Staking
As with PoS staking, Liquid Staking also comes with its challenges and risks:
- Counterparty risks and security concerns: In liquid staking, users entrust their staked assets to third-party service providers. This introduces counterparty risks as the security and reliability of these providers become critical. Users must carefully evaluate the reputation, security measures, and track record of the staking service providers to mitigate these risks.
- Potential network centralization: Liquid staking can impact the decentralization of blockchain networks. By relying on third-party service providers, there is a concentration of staked assets and decision-making power in a limited number of entities. This concentration introduces concerns about the overall network decentralization and potential centralization of control.
While liquid staking offers flexibility, liquidity, and access to additional financial products and services, users need to weigh these advantages against the potential challenges and risks associated with counterparty risks and their impact on network decentralization. In the next section, we will delve into DeFi staking and explore its unique characteristics compared to other staking methods.
In conclusion, the suitability of each staking method depends on the specific use case and individual preferences. PoS staking may suit individuals concerned about energy efficiency, network security, and long-term investment strategies. Liquid staking could appeal to those prioritizing liquidity, flexibility, and access to additional financial products and services. DeFi staking may be attractive to individuals seeking higher potential returns and inclusivity.
Ultimately, users should consider their risk tolerance, investment goals, desired level of control, and preferences for liquidity and accessibility when choosing a staking method. By carefully evaluating the features, strengths, weaknesses, and considerations of PoS, liquid, and DeFi staking, users can make informed decisions and select the most suitable staking method that aligns with their needs and preferences.
DISCLAIMER: This is not financial advice. Staking, delegation, and cryptocurrencies involve a high degree of risk, and there is always the possibility of loss, including the failure of all staked digital assets. Additionally, delegators are at risk of slashing in case of security or liveness faults on some protocols. We advise you to do your due diligence before choosing a validator.