Assessing Staking Risks: Illiquidity and Price Volatility

May 16, 2022

 

Staking has grown dramatically over the last couple of years and established itself as a DeFi solution allowing institutions and retail investors to generate additional returns on their digital assets. Conversely to holding tokens, staking pledges them to operate Proof of Stake blockchains, critical to secure and govern networks.

There are different ways of putting digital assets at work to generate passive income. Lending protocols, like Aave and Cream, offer users a way to participate in a lending pool by depositing or borrowing tokens. Lenders are being rewarded proportionally with interest on the tokens borrowed. Liquidity pools instead make use of Automated Market Maker (AMM) protocols, like Uniswap, Sushiswap, or Curve Finance, allowing digital assets to be traded automatically and permissionless compared to traditional exchanges. Liquidity providers (LPs) can stake tokens to provide liquidity to trading pairs and earn trading fees in return. A more complex staking strategy is yield farming, in which users shift their assets around between multiple high-yield marketplaces and protocols to maximize returns.

Understanding and differentiating these types of DeFi products is essential to accurately assess risks and establish effective short- and long-term investment strategies. Institutions that are gradually opening themselves to these alternative forms of investment are mostly attracted by the high returns offered compared to TradFi instruments. However, each of the above staking solutions carries different risk profiles that investors should take into consideration. Here are some of the most common risks.

Impermanent loss (IL)

Impermanent loss (IL) represents a loss of funds in a liquidity pool and is a risk affecting most liquidity providers (LPs) in AMM protocols. IL is defined by the opportunity costs between holding tokens in an AMM versus holding them in a wallet, which crypto investors call HODL. The higher the price change relative to holding the token, the higher the IL. It’s worth considering that IL only occurs once tokens are withdrawn from the liquidity pool. A liquidity pool has to maintain a given ratio in the value of the token’s pairs, like 50/50 ETH/USDC. When depositing into a pool, investors must also put an equal amount in value for both tokens.

The price of these tokens in the liquidity pool is defined by the ratio between them and not the prices on external exchanges. Therefore, it might result in higher price volatility which increases the likeability of IL. A greater change in the ratio of the pool will result in a larger amount of impermanent loss. The risk of IL can be furthermore impacted by the different tokens in the liquidity pool. Trading pairs with less volatile tokens, such as ETH/USDC, typically lower IL risks than those trading newer and more unstable cryptocurrencies.

Example:

  1. An investor deposits liquidity into the pair ETH/DAI liquidity pool on Uniswap with a 50/50 ratio of the liquidity pool. The investor decides to provide 1 ETH and 100 DAI into the liquidity pool (with 1 ETH worth $100 and 1 DAI $1) for a total investment of $200. Based on the AMM formula the total liquidity in the pool is $10,000 (10 ETH x 1,000 DAI).
  2. A week after, the price of 1 ETH increases to $200 (or 200 DAI), generating an imbalance between the market price and the liquidity pool exchange price, which in turn creates an arbitrage opportunity.
  3. Arbitrage will buy ETH from the liquidity pool at 50% less than external exchanges, decreasing ETH reserve in the liquidity pool and increasing DAI one. This will continue until 1 ETH price reaches 200 DAI, creating a new liquidity pool ratio (7 ETH and 1,400 DAI).
  4. If the investor decides to cash out, he will get 0.707 ETH and 141.42 DAI at the new market price totaling $282.82.
  5. If the investor would have held the initial 1 ETH and 100 DAI, the value of the assets at the new market price would be $300. The impermanent loss in this example can be calculated by subtracting $282.82 from $300, equal to $17.17.

Smart Contract and Oracles Risks 

Smart contract bugs and hackings are a widespread risk in liquidity and lending protocols. These DeFi solutions are managed and controlled through smart contracts, a fault in their system might open breaches for hackers to control funds as well as shut down the whole network. Auditing networks’ smart contracts can reinforce security levels preventing, or at least mitigating this type of risk. However, code vulnerabilities still imply a certain degree of residual risk that can’t be circumvented.

Liquidity and lending protocols also rely on oracles to provide on chain price data. Oracles, that are used to connect real-world data to the blockchain, might fail or can be wrongly misused, exposing LPs funds to significant investment risks. An example is Compound, one of the largest DeFi platforms that allow users to lend cryptocurrencies by putting up collateral that exceeds the amount borrowed. At the end of 2020 Compound, which oracles are pegged to Coinbase’s pricing data, had to liquidate millions of dollars worth of tokens due to DAI price increases on Coinbase Pro.

Counterparty and Validator Risk

The way digital assets are delegated plays a crucial role in assessing overall staking risks. These include reward and capital custody risks: the first, refers to who is controlling and distributing delegators’ staking rewards, whereas the second only considers the management and custody of the principal staked asset. Investors can opt for several types of custody based on their own personal criteria: they can choose to self-manage their own asset or delegate it to a centralized exchange or a validator.

When delegating assets to a validator, several aspects must be taken into consideration to prevent loss of funds. One of the safest ways would be self-managing assets in a non-custodial manner using a cold wallet like Ledger. Ledger is a hardware wallet allowing token holders to stake their assets while maintaining control over the private keys.

Being users of Centralized Exchanges (CEXs) instead implies a certain degree of risk as this means not holding control over the staked assets, thus being furthermore exposed to possible exchange hacks and security breaches. At the same time, as a centralized authority, the exchange can block users from accessing and withdrawing their funds. Between 2020 and 2021 DEX started to play a more predominant part allowing users to bypass unnecessary intermediaries as CEXs have.

Unbonding Periods

Staking durations are a crucial aspect affecting risk, reward, and liquidity. It is typically defined as lockup or unbonding period, which varies depending on the network ranging from 1 day to nearly a month. The risk with unbonding time is that it drastically limits capital efficiency and, to a certain extent, might result in a liquidity crisis.

Staking is also used as a strategy to hedge against the high price volatility of cryptocurrencies; a locked asset, however, makes it hard to timely respond to sudden token price movement. Therefore, staking duration risks might differ significantly depending on the preferred investment strategy and delegators’ objective.

Generally: the shorter the delegation time, the lesser the rewards and liquidity risks involved. Conversely, the longer the delegation, the higher the rewards and consequent risk of illiquidity. A key metric to estimate the overall capital efficiency and illiquidity risks is the total locked value (TLV). TLV compound the value of all tokens deposited in DeFi instruments like staking, lending, and liquidity pools. To date, nearly 81% of staked ETH is illiquid.

Slashing Risks

PoS networks rely on reward mechanisms and penalties to discourage validators’ malicious behavior. These penalties, known as slashing, affect both validators and token holders. Slashing occurs when validators do not sign transactions on the blockchain over a defined period due to a node being offline or not synced with the chain; this is known as downtime. A second and more severe infraction is double signing happening when a node signs two blocks at the same height. The severity of these penalties typically varies depending on the networks, implying a partial or entire loss of the staked assets and/or validator’s temporary suspension from the active set.

Rug Pulls

A Rug Pull is a crypto exit scam typically involving the team of a project and affecting whoever invested in the project. A Rug Pull usually occurs in liquidity and lending and involves a development team creating a new crypto project, raising money from investors, and pumping up the native token price. There are various rug pull strategies and methodologies, each leading to the same painful outcome.

In liquidity stealing, once bad actors reach the desired token value, they suddenly withdraw all the tokens from the liquidity pool running away with the money as the native token price drops close to zero. In dumping strategies instead, scammers quickly sell off their token, typically the largest supply, hence driving the token price down, which leaves token holders with a worthless asset.

Regardless of the exit strategy used, there are no safe ways to avoid rug pool scams. Relying on an external audit and having a proven background check of the developer team behind a project is crucial to safeguard any time of DeFi and crypto investments. More advanced rug pool scams include limiting selling orders; this implies developers code in a way that restricts the selling ability of certain investors and not others. Such restrictions can be identified only by checking and analyzing code and, therefore can be hard to spot.

How Figment Mitigates Risks

As a much less risky option, Figment only supports protocol staking, in which risks are restricted to slashing, bonding periods, and validator risks. Our goal is to restlessly work towards mitigating, and, where possible, removing these types of risks completely. We rely on a redundant staking infrastructure that is fully insured through three layers of on chain and off chain staking coverage. Figment has never been slashed, ranking amongst top validators across the most prominent PoS networks. We also provide non-custodial staking service, allowing our institutional clients to maintain full control and custody of their keys. Our goal is to ensure long-term involvement in Web 3 by providing institutional-grade staking solutions that safeguard and optimize our clients’ investments.

SHARE POST

Meet with us

Bring the Complete Staking Solution to Your Organization

Figment respects your privacy. By submitting this form, you are acknowledging that you have read and agree to our Privacy Policy, which details how we collect and use your information.