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Two significant events define the growth of crypto and the broader blockchain-powered industries. The first is the emergence of decentralized finance (DeFi), underpinned by blockchain-based digital assets.
DeFi quickly became an alternate financial system that facilitates global accessibility and superior financial infrastructure. And today, this new financial system has over four million unique users and is worth over $200 billion.
The second defining event is the transition from proof-of-work (PoW) to proof-of-stake (PoS) blockchains. PoS as a consensus provides an energy-efficient and practical way of securing the blockchain. It is also more scalable when compared to PoW.
But a more significant reason for its popularity is that it provides a way for users to put their digital assets to use. By simply locking up their digital assets in PoS protocols, users earn a guaranteed yield, which is generally significantly higher than yields in traditional financial systems.
However, with DeFi growing both in value and number of users by the day, the long staking period for assets on PoS protocols leads to pools of idle liquidity that are now crippling the domain’s growth.
DeFi’s idle liquidity problem
The total market cap of PoS assets hit an all-time high of $594 billion in 2021. The projected rewards earned by staking these assets are also set to hit $18 billion soon. Additionally, the total volume of assets locked in DeFi protocols is $214 billion currently. While all these numbers seem impressive on the surface, they actually hide more than they reveal.
Most of this liquidity is fragmented, underutilized and inaccessible. This is because assets locked in PoS protocols lose their usability for a long period of time and are siloed away in their individual networks.
Although these staked assets acquire interest over time, their usability in the larger DeFi framework becomes limited. Moreover, this contributes to the indecomposable nature of DeFi, making it hard for networks to exchange value efficiently.
Thus, to fully access DeFi’s liquidity, protocols in the industry are now creating tokenized derivatives of PoS assets through a process called liquid staking. But for DeFi to achieve true composability, the industry also needs to focus on creating real utility for these tokenized derivatives.
Creating utility for underused liquidity
For the uninitiated, liquid staking is a process of issuing to users derivatives of PoS assets. This means that the liquidity of the underlying asset is unlocked without unlocking the asset itself. So, users – while reaping the staking rewards for the locked asset – can still put the asset to use on various other protocols in the ecosystem.
For instance, a user staking asset X on a PoS protocol will earn a yield of about seven percent annually and will also receive a tokenized derivative of the asset – say, tX. Then, if the user provides liquidity to a tX-ETH pair on a protocol that earns an annual yield of about nine percent, at the end of the year the user earns a total yield of 16% on a single asset.
This way, PoS assets, while being used for the consensus to secure blockchain networks, can still be used across other protocols, facilitating full access to DeFi’s liquidity.
However, while liquid staking protocols are growing in number, the industry still lags behind on creating proper utility for these newly minted derivatives of PoS assets. Without realistic use cases, the industry is once again left with liquidity that is underutilized.
So, the need of the hour in DeFi is to create protocols that make use of this newly unlocked liquidity in the right way. There are a few networks that are already taking strides in this direction.
Such innovations will finally allow DeFi’s liquidity to be accessed fully and also facilitate the exchange of value between protocols and networks to make the industry composable.
Making DeFi capital-efficient
The first iteration of DeFi, with its innovative nature and global accessibility, brought a significant inflow of capital and liquidity into the industry. However, with the transition toward DeFi 2.0 taking shape, the industry is now focused on creating financial products and protocols that allow for this liquidity to be properly accessed and used.
In this regard, liquid staking brings a world of new opportunities into DeFi. Combined with proper utility for staked derivatives, this can catapult DeFi’s success and make it a capital-efficient industry in the near future.
Tushar Aggarwal is a Forbes 30U30 recipient and the founder and CEO of Persistence.
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