In a PoS network, users can receive Staking revenue by pledging tokens in the network to provide security for the network, but the assets in Staking are not available for a certain lock-in period. Staking derivatives can free up the liquidity of Staking assets and improve asset utilization.
In this episode, PolkaWorld interviews Lurpis, founder of Bifrost, a liquidity derivatives protocol in the Polkadot ecosystem. He believes that “StakeFi”, which combines Staking derivatives and DeFi, is expected to be the next DeFi track to watch, and that such a protocol built on the Polkadot ecosystem has some natural advantages.
What is the Staking derivative and what problem does it solve?
The essence of Staking derivatives is to issue a corresponding credential to the native token (e.g. DOT/KSM) that participates in Staking, and by holding this credential, you can get the benefits of Staking, and after the Staking cycle is over, this credential can be rigidly accepted back to the native token.
Staking derivatives solve three main problems.
The first problem is that DeFi revenue and Staking revenue are in conflict under PoS consensus.For example, if we are going to start a DeFi application in the Polkadot ecosystem, let’s say， a Lending protocol, and I need users to provide KSMs for others to Lend, then the interest rate I offer must be at least higher than the Staking yield of the KSM (currently about 18% annualized), otherwise there is no way to attract KSMs because users have better options. So there is a lot of pressure on the lending protocol in the PoS network. To offer such a high yield, you have to ,frislty, provide a high subsidy；secondly，charge the KSM lender a higher interest rate.
This is due to the fact that tokens can be used as stacking to generate revenue, which is equivalent to the token of the POS network with a certain capital cost. Defi must cover the capital cost，then to generate users and traffic, which means that defi and the public chain are competing with each other.
In addition to ensuring a minimum yield on the asset, derivatives can help solve this problem. When using derivatives as assets inside a Lending Agreement, the user actually borrows derivatives that include the Staking proceeds, with the additional proceeds provided by the DeFi Asset Agreement.
Now Ether 2.0 is not yet online, and DeFi under PoS networks such as PoC or Cosmos has not yet exploded on a large scale, but with the development of PoS consensus, and the development of the DeFi ecosystem built on it, whether it is Polkadot or after Ethererum is transformed into PoS consensus, this will be a problem that more and more prominent.
The second issue is the cost of cross-chain.
Cross-chain is definitely a future trend of blockchain, but cross-chain assets in PoS chain means giving up the Staking revenue. For example, if I want to cross Ethereum 2.0 assets to the PoS network, then the capital cost of my cross-chain is the annualized 4.2% Staking revenue of Ethereum 2.0 Staking. Once I deposit my assets on the cross-chain bridge, there is no Staking gain for my Ethereum, so my cross-chain cost is at least 4.2% annualized. If the cross-chain application does not cover the 4.2% annual revenue for me, I am not willing to cross my asset because I will lose money
Derivatives can also solve the cross-chain capital cost problem, that is to say, I can turn it into a derivative for you in the process of cross-chain, and this derivative can guarantee at least 4.2% annualization of Ethereum 2.0 Staking as long as you hold it, and you can also use it to participate in other cross-chain DeFi.
The third problem is the conflict between security and liquidity issues under PoS consensus.
For example, Kusama’s pledge rate is currently above 50%, which means that only half of the KSM is in circulation. This means that the entire Kusama DeFi ecosystem does not really have so many assets available. Although Staking lockups can capture more value for tokens, the downside is that the number of tokens and liquidity in the ecosystem may not be enough.
How to ensure both the number of Staking lockups and liquidity? That’s where derivatives come in. If DeFi is highly subsidized, it will cause people to unlock the KSM/DOT in Staking to participate in DeFi, thus threatening the consensus security of Polkadot. And if the Staking revenue is high, it will make it hard for DeFi to get liquidity. This is where using derivatives for DeFi guarantees both a high pledge rate for Staking and good enough liquidity for the assets in DeFi.
A high percentage of PoS chain lockups will lead to less liquidity, which seems to be a good thing for the market. Will the emergence of Staking derivatives lead to inflation?
Derivatives will not lead to more liquidity because the liquidity of derivatives and primary assets are not shared, they have different liquidity.
For example, the derivative of DOT is vDOT. People may worry that if the price of DOT falls, a portion of DOT that was in a locked position would not be able to operate, but now that there is liquid vDOT, they can go directly to sell vDOT, causing the price of DOT to continue to fall. But in reality, the probability is very low, because there is a discount before the derivative expires.
If vDOT wants to 1:1 rigid acceptance back to DOT, it still needs to wait for 28 days, if you want to sell vDOT in advance, there is a capital cost, and the outstanding vDOT will have a discount compared to DOT. vDOT is sold 28 days before maturity, its reasonable market price is about 98.75% of DOT, if vDOT is sold in large quantities, the discount rate will increase due to the liquidity demand. Users can indeed sell vDOT to cash out DOT in time, but it means they need to pay liquidity cost, which is a kind of leveraging behavior for funds.
How big is the market for Staking derivatives? What is the current stage of development of the Polkadot Staking derivatives market?
A reasonable derivative should have a cap on the amount of casting. We at Bifrost have now designed the rule that the maximum minting volume for Polkadot and Kusama oriented products will not exceed 33% of their Staking volume (50%), or 16.5% of the total, in order to safeguard the consensus of Polkadot and Kusama. At this rate, the total market cap of PoS chains is roughly $500 billion (source stakingrewards), so the Staking derivatives market has a market size of roughly $82.5 billion. We see that many of the bigger TVL projects on Solana and Cosmos are Staking derivatives projects.
Polkadot Ecosystem Staking derivatives are still in their infancy. But the market for Staking derivatives in Polkadot is huge because there is demand for derivatives in every parachain except Polkadot and Kusama.
What opportunities will Staking derivatives bring?
First is the opportunity for the Staking derivative or StakeFi track. This track will exist as an essential middleware that will capture value from the underlying chain, and other applications in the upper layers. As the Pos network grows, the value of the StakeFi protocol will grow. We will see many projects in the StakeFi that currently have high TVLs but not high market capitalization themselves. For example, Lido, the largest project in Ethereum 2.0, has a TVL of over $7 billion, but Lido is not in the top 100. This also shows that this track has not attracted much attention yet.
The second is the opportunity for users. The Staking spinoff brings a new way to play DeFi. After DeFi Summer passed, we saw these plays with stablecoin and Lending. But because the three aforementioned contradictory issues are not yet obvious, Staking derivatives have not yet been used on a large scale in DeFi.
One example is the arbitrage opportunity for derivatives. If a derivative generates a discount, for a long-term holder, he can make a higher profit by going to buy the derivative at this time than by buying the spot directly. He can buy the derivative and then redeem the original asset at 1:1, so the discount is actually a low-risk, high-yield arbitrage. In other words, if the user is more proficient in the mechanism of the derivative itself, he has the opportunity to earn a higher return in the ecology.
The third is that for the development of DeFi, Staking derivatives bring the advantage of DeFi yield to the ecosystem. If the future of the Polkadot ecosystem uses derivatives to make DeFi, the DeFi yield combined with Staking derivatives will be higher than the normal DeFi yield without considering the project subsidy due to the existence of the basic Staking yield. For example, the long-term stable yield of DeFi project in the head of Eth is very good if it can exceed 5%, but if DeFi is combined with Staking derivatives, with 5% interest plus 15% Staking yield, this DeFi product will have 20% long-term stable annualized yield, which will attract more users to the ecology.
How to promote a large-scale adoption of stacking derivatives?
I think there are three main points for stacking derivatives to be widely adopted. The first is high security, the second is good liquidity of derivatives, and the third is high standardization of derivatives.
In terms of security, people will worry about the acceptability of derivatives. If the agreement is not safe, it may lead to the over issuance of derivatives, or the loss of the assets pledged behind derivatives, resulting in the non acceptance of derivatives and becoming a pile of air. Therefore, the security of the protocol itself should be done well. On the one hand, the code security audit should be done well, and on the other hand, the consensus security of the chain itself should be done well.
In terms of liquidity, the good liquidity of derivatives is the basis for it to become a mortgage asset or form a transaction pair. I think that the liquidity of the final derivatives may not be specifically provided to people with trading needs, but to money market, stable currency and other defi agreements. For example, if the VDOT of Bifrost wants to become the mortgage asset of ACALA ausd, the precondition is that the liquidity of VDOT is good enough to be liquidated in the event of a sharp fall in dot. Therefore, the establishment of liquidity is also a difficulty for derivatives. Only with good liquidity can we carry the lending application above it, and derivatives can give full play to its maximum utilization.
Finally, the standardization of derivatives. At present, although many derivatives are deployed in multiple chains, they are not standardized. For example, Lido deploys a contract in each chain. The biggest problem with this model is that its derivatives are not standardized. The casting and redemption methods of derivatives in each chain are different. Derivatives in each chain are difficult to cross the original chain, cannot be traded with each other, and liquidity cannot be shared. Therefore, a liquidity pool must be built independently for each chain.
Bifrost builds derivatives through XCM, which is more standardized. In this way, we hope to provide standardized derivatives for Polkadot /kusama trunk chains and parallel chains, including heterogeneous chains such as Ethereum 2.0, cosmos and its hub. They have a unified interface, a unified redemption method and an interest calculation method, which are forged by the same set of agreements. More importantly, each different derivative (such as Vth and VDOT) can be traded and can also generate loans to each other, Liquidity can be shared among them.
Only standardized derivatives can be widely used by the defi application. Just as EVM developers need a set of standard interfaces to integrate assets at a lower cost.
In general, I believe that security, liquidity and standardization are the prerequisites for the large-scale application of staking derivatives.
What are the next concrete actions Bifrost will take to achieve these three goals?
First of all, security. At the code level, since Bifrost is based on the technical framework of Substrate and XCM, we use this as the premise for casting derivatives and have completed code audits by SlowMist and other auditing organizations, which is the security at the code level; at the consensus level, since we are a parachain, we share the security of Polka, so our security at the consensus level is the same as that of Polkadot; at the protocol level, our derivatives are standardized. At the protocol level, our derivatives are standardized, and the security standard is unified through a set of protocols to provide services for different derivatives. These three points ensure security.
Then comes the liquidity aspect. How to build liquidity is arguably one of the biggest challenges for all DeFi applications. Bifrost leverages its derivatives and cross-chain advantages to provide users with higher returns.
In DeFi, users usually get two parts of revenue, one is the commission from transaction fees and the other is the additional subsidy. And we can now provide two additional parts of revenue, how do they come about?
First, Bifrost as a derivative protocol, we provide users with the basic Staking revenue, so we have an advantage in terms of revenue compared to protocols that do not use derivatives; second, we use the XCM cross-chain interoperability feature to improve the asset utilization of parachains, which generates additional revenue for users.
For example, the KSM on top of the cross-chain into the parachain is a shadow asset, and the real KSM behind it is a locked position on the para chain address by the relay chain. the mechanism of Bifrost is that when the user uses the shadow asset to provide LP here in Bifrost, the para system code will take it corresponding to the real KSM to do staking, and the generated staking revenue will then be subsidized to the LP pool. This is a special way for us to build liquidity — by increasing the utilization of our own assets through XCM, thus providing higher yields to build liquidity quickly.
Finally, there is the standardization aspect. This is something that cannot be achieved at the contract level, and at the moment, it is easier to do so on Polkadot than on the existing technical framework. Because standardized derivatives have to be based on common cross-chain protocols and scalable technical frameworks, such as XCM or IBC, Substrate or Tendermint, but Cosmos Tendermint and IBC cannot provide consensus security and will encounter more obstacles on the road to standardization.
For example, if we want to do the security derivatives of heterogeneous chains, the prerequisite is that the XCM bridge can be opened, for example, Polka dotand Ether eum can interact with each other through the XCM bridge, and only under this prerequisite can we do the derivatives of heterogeneous chains like Ethereum. But at present, we can already make derivatives of Polkadot relay chain and para chain with XCM.
After vksm, what derivatives does Bifrost plan to launch next?
Our Polkadot parachain is in the process of bidding. When Bifrost Polkadot parachain goes online, we will launch VDOT and derivatives of vglmr, vmovr, vpha and vkilt. Interestingly, through Polkadot’s unique cross chain interoperability, we can make derivatives with parachains cast and circulated directly in their own ecosystem.
For example, we will deploy an xcm SDK in moonbeam. Moonbeam users can directly use metamask to cast their glmr into vglmr, and can easily use and circulate vglmr in moonbeam ecology through metamask.
The mechanism behind this is actually a typical case of XCM cross chain interoperability. The user completes the process of glmr cross chain to Bifrost through a metamask signature, casts the glmr into vglmr through the Bifrost SLP protocol, and again transfers the vglmr cross chain back to moonbeam. The cross chain interoperability through the Bifrost XCM SDK not only ensures the convenience of the user, but also ensures the integrity of each parachain ecosystem.
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