Oct 27, 2020 09:45 PM | Joe Wang

As the fervor around DeFi grows, Ethereum-based DeFi projects have congested the entire network. As a result, transaction fees on the Ethereum blockchain have risen sharply. 

Could an existing Proof of Stake network offer a better alternative for DeFi applications? So far, many PoS projects are failing to capitalize on the DeFi hype. But there may be a systemic reason for that. 

While PoW (Proof of Work) blockchains lock up hardware to achieve consensus, PoS (Proof of Stake) chains lock up capital. Theoretically, 100% of the tokens on a PoS chain could be staked, but that would be sacrificing liquidity — crucial to DeFi projects — for security.

For example, according to data from MINTSCAN, the percentage of tokens staked on Cosmos is 64%, which means that only 36% of tokens are in circulation. That’s not much liquidity. 

Moreover, it takes 21 days to unlock staked tokens from the Cosmos network. During that time, fluctuations in the secondary market could lead to stakers taking a loss. This is meant to incentivize staking, but it also disincentivizes liquidity.


The Solution: Shadow Tokens

To release the liquidity of staked tokens, developer communities have proposed PoS projects issue a staking voucher, similar to a bond, and provide that to stakers to ease anxiety during the “lock-up period" and secure profits for the demand-side. This approach is described as a "shadow token” in the article "The bAsset Protocol" by South Korean blockchain developer Ryan Park et al.

In the paper "Why Stake When You Can Borrow" by Tarun Chitra and Alex Evans, similar new products — staking derivatives and Lien Tokens — are further explored. The goal of these products is to integrate DeFi products into other PoS public chains to create an incentive ecosystem and unlock more liquidity for heavily-staked assets.

Here is an example:


Polkadot is currently the largest PoS blockchain by market cap, with a valuation of nearly US$3 billion. According to data on StakingRewards as of September 25, 60% of all DOT is staked on the network.

Imagine that Polkadot's validators were allowed to borrow 75% of their staked tokens in the form of a synthetic asset. We’ll call this hypothetical asset sDOT.

In order to strike a balance between income and expenditure, the validator wants to withdraw their tokens and block rewards. sDOT could be equivalent to the value of the staked DOT and its interest earned, giving the validator access to liquidity even as their tokens are staked. This kind of synthetic asset is called a "staking derivative".

This hypothetical, synthesized sDOT is a lien token: it represents proof of holding the token and earning interest at a specified date in the future. This approach can be actively integrated into various DeFi applications, and could greatly improve the liquidity of smart contract platforms using PoS consensus.

The pros & cons of staking derivatives mechanism

Well-designed staking derivatives products are beneficial to both node validators and end users. Validators can access liquidity earlier to enhance capital efficiency, and end users are able to gain exposure to the underlying assets and yields without mastering technical concepts like staking, delegation, etc.

In other words: this approach is mutually beneficial for end-users and validators alike, and it could improve the ecosystems of existing PoS chains. 

The article "What PoS and DeFi can learn from mortgage-backed securities" proposed a model similar to mortgage-backed securities to illustrate this financial model on PoS networks.

At present, a common design in DeFi lending protocols is to issue stablecoins by staking digital assets. If the staker cannot pay back what they borrowed, they will be liquidated. Similarly, staking derivatives allow nodes to obtain a loan certificate via staked assets. If many validators borrow simultaneously, the security of the entire PoS network will be tied to the probability of those validators defaulting


Simply put, if a PoS public chain gains liquidity via a large amount of staking derivatives, it is injecting leverage into the system. The advantage is that validators can increase their capital utilization, but if the network's lending threshold is too low, defaults can trigger liquidations and could severely reduce the security of the PoS network.

Therefore, in the design of such protocols, it is necessary to carefully design the pricing functions of derivatives, and strike a balance between liquidity and network security. Also, one must think carefully about how much validators who want to gain liquidity can borrow.

Real-World Projects

Currently, projects focusing on this field are mainly concentrated in China, the United States, and South Korea. Many proposals for staking derivatives come from PoS node validators, such as the Wetez team, Liebi Pool, Chorus One, etc. These teams have accumulated experience in the PoS field and have realized the necessity of innovation to balance the security of blockchains with the activity of ecosystems.

Chorus.One, a well-known PoS-based basic layer service provider, separates “staking derivatives" into four categories:

1.Native — Tokenized representations of staked tokens that are  themselves part of the core protocol

2.Non-native — Tokenized representations of staked tokens that exist on a secondary on-chain protocol

3.Synthetic — Tokenized financial agreements that mirror the flow of staked tokens;

4.Custodial — Tokenized representations of staked tokens issued by the custodial entity that is holding those staked tokens.

From the perspective of protocol design, in addition to the centralized custodians, the designs of decentralized staking liquidity protocols can be divided into two main types:

1. Native design in pursuit of ease-of-use and retaining governance rights for token holders;

2. Non-native design in pursuit of cross-PoS network functionality (but that may require stricter risk control for security.)

A delegation voucher is a design based on the native chain. Sunny, a developer and researcher from the Cosmos community, and Chorus.One have put forward a lot of research and proposals on this design. The Matic Network team is also working on its own implementation.

However, many new development teams are more focused on the design of "non-native" staking derivatives with incentive mechanisms.

For example, there are teams like Stafi and Bifrost using Substrate-based staking derivative protocols. Stafi has launched its governance token and will release a series of synthetic tokens (rTokens) in Q4. Bifrost has also recently released a testnet for its own incentive program (Asgard) for staking validators, which attracted more than one hundred nodes in just three hours.

In terms of the team, Stafi founder Liam Young has accumulated many years of industry experience. Unlike other projects, Stafi cooperates with a centralized trading platform for fundraising, which has accelerated its adoption.

Recently Stafi ran StakingDrop, a staking incentive campaign that ended on August 31 with  a total of 1,700+ addresses binding 200 million USD worth of staked assets to the network.

Stafi Protocol recently released its roadmap for Q4. It is going to launch an ERC20 bridge that can move assets across the Ethereum blockchain, convert FIS or rTokens into Ethereum tokens, and circulate on Ethereum DEXes such as Uniswap. The rToken will be also introduced to Polkadot/Cosmos and other mainstream PoS blockchains’ ecosystems. rToken will first be implemented on FIS — rFIS is scheduled to go online at the end of November. After stable operation, the development of rDOT and rKSM will begin in December.

Unlike the Stafi team, which focuses on DeFi and multi-chain diversification, Bifrost focuses on the construction of the Polkadot ecosystem. Its founder Lupris is the winner of the third prize of the 2019 Polkadot Shanghai Hackathon. Before Bifrost turned to Substrate, the team participated in the EOS and IOST communities. In the validator competition that ended in August, the exchange volume of EOS-vEOS exceeded 8 million.

Bifrost attaches great importance to incentivizing the community. Its testnet has been tested for half a year, from the PoC2 node testnet incentives in early 2020 to the two consecutive Asgard node contests. During that period, it has also held many activities that helped it gain a large user base. These activities included a faucet campaign in the developer community, and airdrops to the Polkadot community in sync with third-party integration entities like multi-chain wallets, to teach potential stakers how to leverage vToken to use the PoS network more efficiently.

At present, Bifrost has officially launched its third round of testnet incentives, distributing a total of 18,000 BNC (its utility token) as rewards covering 3 modules: the number of blocks produced by the validator, interoperability, and vToken exchange. After the release of the new version of the node client, its testnet gained more than 100 nodes. Bifrost has said it will continue to integrate other well-known PoS public chain ecosystems in addition to Polkadot/Cosmos to provide liquidity.

With the approach of Ethereum Phase 0 and the launch of various PoS chains (Celo/Solana/Near, etc.), we have seen increasing interest in models designed for staking economics, which can help facilitate ecosystem activity for PoS public chains. 

The staking economy and DeFi have evolved from spaghetti code to being a billion dollar financial business just in the last three years. Hopefully we’ll see even more innovation aimed at moving the token economy towards mass adoption. 

This article was sponsored by Stafi and Bifrost.

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