Liquid Staking Derivatives (LSD) and Decentralized Validator Technology (DVT) are two of the most exciting and innovative developments in the cryptocurrency world. They are two distinct concepts poised to revolutionize how investors interact with blockchain networks. These concepts have emerged as a result of the popular proof-of-stake consensus mechanism on blockchain networks. As a result, a discussion of what LSDs and DVT would be incomplete without the word ‘Staking’.
Staking is a process by which investors can earn rewards by holding and maintaining a certain amount of cryptocurrency on a network. It offers several benefits to investors. Also, it provides an opportunity to earn passive income by holding a certain amount of cryptocurrency on a network. Additionally, staking rewards are generally higher than traditional savings accounts and can provide a significant boost to an investor's portfolio. However, there are also risks associated with staking, including market volatility and the possibility of network downtime.
This article will explore the benefits and risks of staking, an in-depth look into Liquid Staking Derivatives and Decentralized Validator Technology, as well as the risks and challenges associated with both concepts for investors.
Brief Overview
Ever since Ethereum moved from a proof-of-work consensus mechanism to a proof-of-stake consensus mechanism, there have been several upgrades and improvements on the blockchain. Asides from these upgrades, investors on the blockchain have found ways to make the most benefit and profit from The Merge.
Naturally, with Ethereum’s transition to a proof-of-stake (PoS) consensus mechanism. There has been an emergence of several staking processes such as self-staking and exchange staking. However, these different staking processes come with different levels of reward, risks, and benefits.
What this means is that innovation came to play and concepts like LSD and technology like DVT came into existence to offer investors the best that they can have access to.
Worthy of note is the fact that many chains and blockchain ecosystems use staking to ensure the security of their chain. These include Ethereum, Solana, Cardano, Avalanche, Polygon, etc. However, among all, Ethereum tops them all with the highest staking cap of about $29 billion. Hence, Ethereum and ETH would be used to explain the concepts.
Staking: Benefits and Risks for Investors
Cryptocurrencies and blockchains that allow staking use a consensus mechanism called proof-of-stake. This consensus mechanism allows participants to make decisions according to the number of tokens that they have staked. Staking, in its simplest terms, is a way of earning rewards while holding on to the cryptocurrencies that you own. While you stake, you earn rewards and also benefit as being a validator establishing which block is valid thereby increasing the security of the blockchain the token staked is built upon.
Everyone talks about passive income. Staking is one way to earn passive income. Also, you can earn cryptocurrency through crypto staking by leveraging your current holdings to vouch for blockchain network transactions.
Because crypto is a volatile currency, holding it for long period has heightened risks. For example, you could stake a $1.00 token that pays a 10% annual yield. When compared to a standard bank account, this is a fantastic rate of return. However, the price of the token can fluctuate from $1.00, affecting the overall yield. It could have moved dramatically up or down a year later. You should be aware of this, as well as the potential risk if the price falls.
There's also a high liquidity risk if you stake a token that hardly has any liquidity on the major exchanges. This means that in the long run, you might be unable to sell your accumulated assets. In addition, more tokens have to be locked up for a long period—this period is sometimes always unknown.
Staking Processes
The Merge launched staking on Ethereum and consequently popularized the different staking processes that are available and provided an opportunity to explore alternatives for maximum profits and lesser risks. The two most popular such staking processes are self staking and exchange staking.
Self-staking, just as the name suggests, happens when users stake their ETH token into the Ethereum Deposit contract to secure the network. With self-staking, users can not unstake their ETH until the Shanghai upgrade-an upgrade that allows staked ETH to be unstaked and is also slated to launch around March 2023. However, from the look of things, it might take some users years before they can get back their staked ETH.
Exchange staking on the other hand allows users to stake tokens through a centralized exchange service. Unlike self-staking, exchange staking allows users to stake and unstake their tokens at any time, and withdraw rewards. Despite this, this staking process has its risk in that its reward rate is significantly lower than that of self-staking.
Importantly, a minimum of 32 ETH is required to stake on Ethereum 2.0 to become a complete validator; anything less will place you in a staking pool. This already poses a problem for investors who cannot own or stake 32 ETH for an unknown period. For exchange staking also, exchanges have to deposit 60% of users' deposit before allowing users to withdraw their staked ETH.
LSD: Liquid Staking Derivatives
An understanding of liquid staking is necessary to understand what Liquid Staking Derivatives are. Liquid staking emerged as an alternative to risks associated with self-staking and exchange staking. With liquid staking, users are allowed to stake and unstake their ETH at any time.
Here’s how it works; Users who want to stake their ETH on the Ethereum ecosystem and earn rewards with minimal risk would deposit their ETH into a third-party application. The application then deposits the user’s ETH into the Ethereum Deposit contract using its validators. The app in turn issues a derivative token that can be transferred, stored, and spent like a regular token. This token allows users to transfer their ETH wherever and whenever they like. One major upside to this staking process is that users still earn staking rewards through all of these.
Liquid Staking Derivatives (LSD) are what these derivative tokens are generally called. They are receipt tokens for staking ETH with a third-party provider. Hence, DeFi applications act as third-party applications for users who prefer liquid staking and issue derivative tokens as they see fit.
Lido Finance
Lido Finance(LDO), issues a token called stETH in exchange for staked ETH. What makes Lido preferable includes the advantage of over $5.8 billion in total value locked across chains and 240,000 unique stakers with $250 million in rewards paid.
Staked Ether (stETH) is a token that you receive in a 1:1 ratio when you stake with Lido. stETH represents your staked ETH, and you can use it to earn yields and lending rewards just like regular ETH.
Your stETH balance is updated daily and is calculated as follows: initial deposit + staking rewards - penalties.
Rocket Pool
Rocket Pool (RPL) only requires a minimum of 16 ETH for node operators which is half of what is normally required. However, stakers need to have a minimum deposit of 0.01 ETH and no maximum deposit. Stakers receive rETH in exchange.
The Rocket Pool protocol is primarily composed of 3 main elements, smart contracts, the Smart Node Network, and Minipool Validators.
Also, the smart contracts accept ETH deposits, assigning them to node operators with staking commission rates based on current node operator demand, and also issuing and tracking various tokens. The Smart Node Network is a decentralized network of special Ethereum nodes that run our Smart Node software. They feature custom background processes that allow them to communicate with the protocol's smart contracts, and just as importantly, provide the network consensus (validation) required by the Beacon Chain.
FraxFinance
Frax Finance issues frxETH. StaFi issues rETH. All of these derivative tokens issued in exchange for ETH staked are called liquid staking derivatives. frxETH is a stablecoin that is loosely linked to ETH, and users can exchange frxETH for sfrxETH to increase their staking yields. Moreover, the platform's validators are managed by Frax Finance's in-house team, which comes with some of the inherent risks of centralization.
However, ETH staked through Frax Finance yields up to a 10% return, which is significantly higher than the returns offered by other liquid staking protocols. The higher yield is due to its significant CRV/CVX treasury holdings. Frax Finance takes a 10% commission on staking rewards. In addition, the insurance pool receives 20% of the fee, while veFXS holders receive the remaining 80%.
Ankr
Ankr's decentralized web3 platform facilitates the creation of decentralized apps (DApps). It operates with the ANKR utility token. This token is used for governance, Ankr service payment, and staking. Staking assets on Ankr in exchange for ankrETH allows stakers to earn farming rewards. These bonuses are in addition to the ones offered by liquid staking derivatives. A compounding effect is created by staking the farmed rewards.
DVT: Distributor Validator Technology
Nothing is perfect, so is the new Ethereum PoS protocol. Like every significant change or move, there are always flaws and room for improvement.
One fundamental flaw that came with The Merge was the threat of power concentration within the network. The proof-of-stake consensus mechanism rewards stakers based on their position and the amount of ETH they have staked. Consequently, there stands the risk of power being disproportionately allocated among stakes.
Asides from the threat of centralization, there is also the threat of single points of failure. Before becoming a validator, you're required to create two pairs of cryptographic keys; one private and one public.
However, the Ethereum protocol requires that a validator signs both keys from a single machine. The vulnerability from this is higher for validators. A single attack on a validator's computer can cause serious losses.
DVT also seeks to solve some other major issues such as the validator liveness check—where validators are checked for activity and penalized for a lack of activity, private key custody—stakers are required to entrust their private keys to the staking service operator fully, and forking penalties—penalties accruing to a validator appearing offline because the Beacon node the validator is connected to develops a fault.
With the different problems and risks associated with the PoS system listed above, the need for a lasting solution is necessary. Luckily, the Distributor Validator Technology addresses the problems associated with the risk of centralization. In every blockchain network, there are participants, also known as nodes responsible for validating and proposing new blocks on the chain. PoS allows stakers to be responsible for validating and proposing the addition of new blocks.
With the use of threshold cryptography, Distributed Validator Technology (DVT), a decentralized open-source protocol, enables the distribution of a validator's responsibilities among several nodes rather than a single machine. DVT is a decentralized staking layer on Ethereum that enables anyone to build and distribute validators across several fault-tolerant machines so that the validator can continue to function even if one node is down or malfunctioning. A system's ability to function despite errors or malfunctions is known as fault tolerance.
A description of threshold cryptography from the Panther blog
Source: Panther Protocol Blog
DVT offers an additional layer of fault tolerance for Ethereum validators, eliminating the chance of redundancies like a single point of failure, centralization problems, etc. Hence, it is a validation process that eliminates the need for central authorities in a blockchain network.
By combining distributed key generation, multi-party computation, Shamir's secret sharing, and Byzantine fault-tolerant algorithms. Distributed Validator Technology enables validator responsibilities to be distributed across multiple nodes while remaining compliant with Ethereum's staking regulations. In the sections that follow, we'll learn more about these algorithms and how they affect DVT.
In addition to spreading out a single validator's responsibilities among numerous computers, distributed validator technology also "distributes" its private keys. Keep in mind that to create or sign messages with its private keys on a single computer, Ethereum needs a validator. DVT avoids the single point of failure, as we will see below, by dividing shares of the private key among various nodes and using a distributed key generation mechanism.
DVT is a multi-signature system, but rather than confirming transactions, it is used to carry out the blockchain's consensus-required validator functions.
A distributed key generation (DKG) scheme is the first and one of the essential parts of DVT. DKGs entail sharing a private key that is calculated by several parties so that no one member has complete control over the secret key. The participants each receive a portion of the encrypted private key.
The private key can then be divided using Shamir's secret sharing such that each validator client that participates only has a portion of the private key, and no one share is enough to sign messages. Shamir's secret sharing uses a threshold that is typically predefined rather than requiring everyone to be present to reform the secret or sign messages. This allows the validator client to stay online even if there is a flawed or malicious member.
Risks And Challenges of Liquid Staking Derivatives (LSD)
LSD, or Liquid Staking Derivatives, are a new type of financial instrument that allows investors to earn rewards by staking their cryptocurrency holdings. LSDs, like any other financial product, has risks and challenges that investors should be aware of.
The volatility of the cryptocurrency market is one of the main risks associated with LSD. Cryptocurrency values can fluctuate rapidly, resulting in significant gains or losses for investors. Furthermore, the staking process involves locking up a certain amount of cryptocurrency for a set period, making it difficult for investors to liquidate their holdings during this time.
Another issue with LSDs is the possibility of fraud and scams. Because the cryptocurrency market is decentralized, there is no regulatory oversight, making it easier for scammers to operate. When investing in LSDs, investors must exercise caution and thoroughly research the project and the team behind it.
Furthermore, investors' lack of understanding of the technology and its associated risks can be a significant challenge. This is due to the staking process requiring complex technical knowledge that many investors may lack. As a result, before investing in LSDs, investors should educate themselves on the technology.
Risks and Challenges of Distributed Validator Technology (DVT)
Distributed Validator Technology (DVT) is a game-changing technology that is increasingly being used by corporations and businesses to build trustless and decentralized networks. It has the potential to do away with the need for intermediaries, resulting in a more secure and transparent system. However, there are some risks and difficulties associated with DVT that must be addressed.
One of the most serious risks associated with DVT is the possibility of malicious actors exploiting system vulnerabilities. As with any new technology, there are bound to be bugs and weaknesses in the code that hackers could exploit. According to a McAfee Labs report, the number of cyber attacks on blockchain-based systems increased by 400% in the first quarter of 2018. This emphasizes the requirement for strong security measures to defend DVT-based networks from intrusion.
Scalability is an additional problem that DVT faces. The need for processing power and bandwidth will rise as more companies switch to DVT-based networks, possibly resulting in congestion and longer transaction times. For businesses that need quick and effective transactions, this might be a serious issue.
In addition, regulatory compliance might be a hurdle. DVT-based networks might not comply with the rules as they are now written because they are decentralized and trustless. Businesses wishing to embrace this technology may face uncertainty because governments and regulatory agencies are still debating how to regulate DVT-based systems.
Conclusion
From our findings, LSD and DVT are needful in ensuring that Ethereum transition to the PoS consensus mechanism is successful and enticing to the investors. Without these two, Ethereum might not have been able to imagine the transition talk more of actually transitioning.
Importantly, LSD and DVT are groundbreaking technologies not yet been fully explored and are still in the initial phases. One thing that is certain for investors is that nothing is certain. As ironic as this may sound, with these technologies, the safest way to make the most out of it all is to stay on the edge of it all by bracing for the uncertainty and investing carefully after thorough research. This however does not take away the place of risks in investing as investing in itself is a risk.
In conclusion, LSD offers an intriguing new opportunity for investors to profit from their investments in cryptocurrencies, but they also have several risks and difficulties that investors need to carefully evaluate. Before investing, potential investors must conduct a comprehensive investigation of the LSD project, team, technology, and dangers.
Without a doubt, DVT has the potential to completely change how we conduct business, but some serious risks and obstacles need to be dealt with. To ensure the success and wide acceptance of DVT-based networks, businesses, and developers must place a high priority on security and scalability.
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