In recent times, the decentralized finance (DeFi) space has witnessed remarkable growth, achieving its intended objective of improving financial inclusion and operational efficiency. DeFi provides many opportunities for participants in the space to earn returns on their investments. Common examples include DeFi lending, trading, and staking.
With the evolution of the decentralized finance space, DeFi staking has become rather prevalent. This activity rewards users for their short-term investment of tokens without requiring them to engage in any form of trade.
This article explores DeFi staking in detail, with a brief glance at yield farming, another popular form of DeFi investing. We’ll also look at the DeFi staking protocol models and the risks associated with DeFi staking.
What is DeFi Staking?
DeFi staking encompasses a range of activities that reward users who lock their crypto assets in a smart contract to earn returns after a predefined period. The term refers to decentralized activities that involve depositing tokens into a pool for a period to earn passive income.
Investors engage in DeFi staking mainly to generate passive income. In some DeFi staking protocols, users may need to deposit their tokens into a pool to get rewards. For example, DeFi Staking Aggregators search for DeFi protocols with the highest payouts and invest the assets of their users in them.
The DeFi staking protocol determines the rewards that users earn from this activity. It is important to note that the Annual Percentage Yield (APY) returns may vary over time.
Types of DeFi Staking Activities
Crypto enthusiasts can participate in different DeFi staking activities, some of which are discussed below.
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Staking
This is a popular activity that pays participants who lock in a specific number of tokens. Crypto enthusiasts can often delegate their crypto assets to a validator, who binds the token to the network. Staking is only possible in proof-of-stake networks and variants. Staking is currently not supported on Proof-of-Work platforms.
Validators are incentivized to validate transactions that occur in the network. Validators tend to share their rewards with stakeholders.
Similarly, if a validator is penalized for failing to perform its duties, the stakers may also be punished. Penalties may include slashing the erring validator’s tokens.
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Yield Farming
Yield farming is another DeFi staking activity that involves individuals injecting their tokens into a liquidity pool to earn rewards. In some circumstances, the user is rewarded in the form of transaction fees or a liquidity pool token. Yield farmers often move from one DeFi staking platform to the next in search of higher yields. This can be done manually or with the help of a DeFi staking aggregator.
Tokens deposited in a pool can be used for trading or lending. If they are utilized to provide trading services, they are classified as decentralized exchanges. If they are utilized for lending, they are categorized as DeFi lending platforms.
Models of DeFi Staking Protocols
Different DeFi staking platforms operate using distinct models.
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Synthetic Asset Staking Protocol
This type of protocol provides synthetic assets that are representations of underlying assets. Staking Proof-of-Stake (PoS) tokens, for example, can result in illiquidity for users. When users bind their tokens to the network while staking, that token is removed from circulation for the duration of the staking period.
During that time, the user is unable to access their assets or utilize the tokens to trade or engage in other transactions. This is a problem that the StaFi Protocol synthetic asset staking platform seeks to solve. StaFi introduced the concept of liquid staking, which means that users can stake while still having access to synthetic assets for other transactions.
StaFi users can stake their PoS tokens on the network and gain access to synthetic assets in the form of rTokens.
They earn rewards on the underlying tokens they stake while also retaining the option to exchange or lend their synthetic tokens. Eventually, they swap the rTokens for the underlying tokens staked, as well as their returns. One of the numerous synthetic asset staking protocols is StaFi. The Synthetix platform is another example.
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Stablecoin Staking Protocols
This type of platform allows users to borrow stablecoins in exchange for other popular cryptocurrencies such as Bitcoin, Ether, Litecoin, Ripple, and others.
Stablecoins are available for use during the borrowing stage in the DeFi staking protocols that offer this feature. Two examples are Compound and dYdX.
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DeFi Staking Aggregators
This type of platform focuses on pooling the crypto assets of multiple users and investing them in high-yielding protocols. A DeFi staking aggregator’s job is to steer a user’s cash to the protocol with the highest payout available at the time. They sift through many DeFi staking protocols before deciding on the best ones for their users. Zapper and Plasma.Finance are two examples of DeFi Staking Aggregators.
Risks of DeFi Staking
Though DeFi staking offers users the opportunity to earn returns on their idle assets, there are inherent risks involved that must not be overlooked. These dangers may result in the loss of cryptocurrency assets.
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Risk of attack
Hackers have repeatedly targeted decentralized finance protocols. The news of DeFi protocols being hacked circulates throughout the crypto industry regularly. Hackers may attempt to drain funds by exploiting vulnerabilities or bugs in the smart contract’s code. Smart contracts govern the operation of DeFi protocols, and if an attacker gains an unfair advantage in the coding, it could result in a loss of funds.
When users perform a DeFi staking activity, they must inject their tokens into a pool, especially when it is liquidity mining. This means that the smart contract has control over the funds. If the smart contract is not attacked, the system could be manipulated or a flash loan attack may be used.
For instance, Inverse Finance, a decentralized platform for creating, lending, and borrowing synthetic assets, lost $15 million to an attack.
The DeFi protocol announced via their Twitter page, “This morning, Inverse Finance’s money market, Anchor, was subject to a capital-intensive manipulation of the INV/ETH price oracle on Sushiswap, resulting in a sharp rise in the price of INV, which subsequently enabled the attacker to borrow $15.6 million in DOLA, ETH, WBTC, and YFI.”
The manipulation was not a flash loan attack and was unrelated to Inverse’s smart contract or front end code.”
In the case of Ola Finance, they lost approximately $5 million to a re-entrancy attack.
In the past, there have been several reports of DeFi protocols being hacked. In some cases, the platform refunds its users in full or in part.
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Impermanent loss
Because of the mechanism that controls liquidity pools, the value of tokens in a pool may differ both within the pool and in the crypto market. This means that if a user withdraws tokens from a pool, they may do so at a loss. Some DeFi protocols provide features or rewards to reduce the likelihood of this happening.
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Gas fees
The rewards for staking may be substantial depending on the DeFi protocol used, especially if the platform is new.
Leaving aside the aforementioned, exorbitant gas fees could erode the enjoyment of the benefits of these returns.
This is quite common with platforms based on blockchains that have scalability issues. Profits may be affected as a result of this.
For example, Ethereum 1.0 has scalability issues, made evident by the high gas fees. Several DeFi protocols on Ethereum leverage scaling solutions to incentivize DeFi stakers.
In Conclusion,
- DeFi staking is the process of locking up one’s funds to earn returns on a DeFi platform.
- The locked funds may be used in decentralized lending or trading activities.
- The benefits that accrue to users of this type of platform are a passive stream of income.
- There are different models of DeFi staking platforms.
- Though there are benefits accrued from this activity, there are risks that should be considered.
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