Tapping-The-Untapped: DeFi to unlock staked crypto assets

With the emergence of a new computing paradigm, there is a significant amount of uncertainty on how it can be most effectively utilized. Blockchain is no different. It is important to acknowledge that during the early phases of the technology’s introduction, the universe of possibilities is not completely familiar. As we move towards extreme utilization conditions, a growing number of issues are being realized, such as transaction speed, wastage of resources, interpretability, etc.

If you know Bitcoin, you may also be familiar with the concept of Proof-of-work consensus and the role of miners. Mining involves the process of solving complex mathematical puzzles, the first to solve wins the right to add a new block to the blockchain. These blocks contain transactions and the process ensures correct transaction records get added to the blockchain. This mechanism is known as Proof-Of-Work. Since it consumes a lot of computer resources, it is a costly process. To know more about Bitcoin mathematical puzzles, read here.

Proof-Of-Stake protocols on the rise and along with it staking of assets

Proof-Of-Stake is an alternative to the Proof-Of-Work system. Instead of consuming resources (electricity), Proof-of-Stake requires validators (alternative to miners) to stake a fixed amount in the wallet (lock capital). Instead of competing to solve puzzles, validators get randomly selected on the basis of the amount they stake. Once selected, they propose a block to be added to the blockchain.

As the validators ecosystem in PoS protocols expands, so is the competition. Therefore, to increase the chances of selection, validators pool their stake together. A staking pool allows multiple stakeholders (or bagholders) to unite their stakes to increase their chances of earning the block rewards.

Today many blockchain protocols are considering Proof-Of-Stake as the underlying mechanism for consensus. Examples – Cosmos, NEAR, Harmony, Elrond, Solana, etc. As of August 2020, 50% to 60% of Proof-Of-Stake protocol’s market capitalization is lock-in staking nodes i.e. more than $16.8 billion. Source: StakingRewards. Few experts estimate that by the year 2023 this value lock can grow to up to $75 billion.

While increasing the staking rate ensures the stability of the network (prevents long-range attack), it introduces a new challenge – the liquidity of assets.

Challenge: ‘Liquidity of assets’

Liquidity is the probability that an asset can be converted into an expected amount of value within an expected amount of time. Any token claiming as ‘money’ should be liquid. If cryptocurrencies fail to provide easy liquidity, then they fail as mediums of exchange, one of the principal roles of money.

Today the market capitalization of crypto-assets remains small relative to the global financial system, at around $270 billion as of 1 July 2020, about 0.9 % of the market capitalization of the S&P Index 500 and 2.8 % of the global value of gold. The impact of the crypto-assets market is therefore still low and crypto-assets are so far not yet widely in use for financial transactions.

As businesses in this area are just starting to emerge and consolidation still has to take place, the impact at the global level remains limited, but could soon change given the rapid evolution of DeFi protocols.

DeFi – Tap-the-Untapped capital

Decentralized Finance (Defi) offers a compelling value proposition to solve crypto liquidity challenges. DeFi protocols bring financial primitives for crypto users whereby users can easily and quickly access and exchange capital without the need for a trusted intermediary.

Much of the consideration to build a Defi protocol has been on the Ethereum Network allowing ERC20 crypto-asset holders (stable coins, ETH, WBTC, etc) to participate and benefit from financial primitives like lending/borrowing protocols and earn interest by providing liquidity for trade-pairs in the DEX.

The DeFi products can expand their protocol use for non-ERC20 staking crypto tokens, enabling users to maximize their leveraged positions.

The following article theorizes how new financial primitives can be added for Non-ERC20 staked crypto assets in Ethereum based DeFi protocols. The rise of cross-chain interoperability solutions makes this possible in the following 3 stages.

1st stage: Bringing liquid capital (non-ERC20 assets) to the Ethereum network

It starts with creating staking wallets (or nodes) for a given protocol. Users deposit their tokens in these wallets and receive an I-OWE-YOU token (wrapped token). This process is governed by underlying smart contracts in these wallets. These IOU tokens represent 1:1 peg of your stake amount and are transferable. Smart contracts also ensure the distribution of stake rewards at regular intervals to addresses holding IOU tokens.

Users at any time can redeem these IOU tokens for the real token by interacting with the wallet’s smart contract. Smart contracts enforce these conditions and eliminate third-party intervention. Additionally, to ensure no single person has access to the capital staked in the wallet, multi-signature wallets are used – ‘no single ownership’ of keys.

2nd stage: Moving non-ERC20 assets to Ethereum wallets

To transfer the IOU token to the Ethereum address, users use a gateway (or cross-chain bridge) that creates an equivalent ERC-20 native IOU token and is deposited to the user’s ETH address. Gateways are decentralize-custodian that fluidly mints and burns non-ERC20 digital assets 1:1 to ERC20 crypto assets.

Since users have moved their IOU tokens from the original blockchain wallet, the distribution of stake rewards now happens in the Ethereum wallet address. A parallel smart contract on Ethereum distributes stake rewards to addresses that hold ERC-20 based IOU tokens.

This way users are able to create liquid capital in Ethereum and inject in the DeFi system.

3rd stage: Creation of new financial primitives

Once users convert their non-ERC20 to an ERC20 crypto asset, they can inject it in the decentralized Finance (Defi) protocol to easily and quickly access borrowing capital without the need for a trusted intermediary.

In this setup, lenders add their stable coins (DAI, USDC, etc) to the pool. A user in need of a loan can deposit their IOU assets as collateral. Following the deposit, 50% of the asset value is given as a loan amount. As long as the collateral ratio (value of collateral/ loan amount) is above the liquidation minimum, borrowers have time to repay loans. In case the collateral ratio falls below a certain threshold, the collateral is liquidated and repaid to lenders. This setup ensures that lenders don’t lose money when borrowers default.

“Keepers” govern this liquidation process. Keepers are competing individuals and organizations that receive incentives to absorb risky debt. For each successful liquidation, keepers get incentives.

Closing thoughts

The opportunity to create financial primitives based on stake tokens could expand DeFi usage and improve the liquidity of PoS assets. RAMP DeFi and Stafi protocols are among the early innovators in this space. The functionality could vary from protocol to protocol, but the base design remains the same as explained above (3 stages).

NOTE: Users do need to take into account the complex nature of these protocols as it requires using several smart contracts and connecting different protocols. This increases the probability of code errors (smart contracts bugs), jeopardizing user funds. For investors, they should take into account the long-time horizon to developing such protocols. A lot can change from now to then.