Why Cosmos Liquid Staking is Poised for Explosive Growth in 2023

Can the upcoming Liquid Staking Module (LSM) unlock the potential of Cosmos DeFi?

May 29, 2023

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Introduction

Liquid staking plays a pivotal role in DeFi, enabling stakers to participate in the blockchain’s economic security while also engaging in DeFi activities. By issuing a derivative token that represents the underlying stake, liquid staking facilitates access to previously locked liquidity. The derivative tokens’ composability reduces the opportunity cost of staking and opens up opportunities including lending, trading, LP farming and collateralization.

Due to their high inflation emissions, many chains on Cosmos maintain a high staking ratio (bonded ratio). The Cosmos Hub and Osmosis, for example, have a bonded ratio (percent of token staked on the network) of 68% and 43% respectively. Ethereum staking ratio is about 15% for context. The impact of liquid staking on Ethereum is much belabored. While the liquid staking ecosystem on Ethereum has thrived, the same cannot be said for the Cosmos universe so far.

As of the end of last year, about $5 billion were staked across the 46 IBC-connected chains within the Cosmos ecosystem, with an average bonded ratio of about 60%. Take ATOM, Cosmos Hub’s native token, as an example. Despite the total staked value of ATOM being $2.6 billion, the market capture of liquid staked ATOM is only about 1%.

The growth of liquid staking in the Cosmos ecosystem is a potential multi-billion-dollar market yet to be fully tapped. In this memo we seek to cover the following topics:

Recap on Cosmos: What are IBC, ICA, ICQ, ICS
Overview of Liquid Staking Protocols on Cosmos (Stride, pStake, QuickSilver)
Comparison of top Cosmos liquid staking protocols
What is Liquid Staking Module (LSM) and its impact on Cosmos DeFi?
Challenges for Cosmos liquid staking to take off
Catalysts ahead & Conclusion

Recap on Cosmos: What are IBC, ICA, ICQ, ICS?

The Cosmos network constitutes an interconnected ecosystem of about 50 sovereign Layer 1 blockchains known as “zones”. Each zone is constructed using the Cosmos SDK, customized to meet application-specific needs. Osmosis, an automated market maker (AMM), for instance, operates on its own blockchain. The communication and exchange between these various zones is made possible by the Inter-Blockchain Communication (IBC) protocol. IBC ensures secure transfer of assets and data between chains within the ecosystem, forming the backbone of Cosmos' interoperability.

Among these zones, Cosmos Hub stands as the largest, with its native ATOM token having the highest market capitalization in the ecosystem. However, unlike many other Layer 1 blockchains, Cosmos Hub does not directly enable ATOM liquid staking. This is primarily due to its adherence to 'Hub Minimalism', a design principle emphasizing security and a lean feature set to minimize potential vulnerabilities.

Cosmos Hub's rejection of Proposal 69 in May 2022, which intended to introduce CosmWasm, a platform that allows developers to program smart contracts in Rust, further illustrates this conservative approach. Although the proposal aimed to expand the functionalities of Cosmos Hub, it was ultimately rejected due to preference for maximum security.

Given these design constraints, Interchain Accounts (ICA) have emerged as a crucial element in the Cosmos ecosystem. ICA offers a way for one chain to control an address on another, allowing for transactions to be executed across chains without requiring local private keys. Interchain Queries (ICQs) further enhances the ecosystem's interconnectedness. It allows developers to securely retrieve data from remote zones, accessing raw data and Merkle proofs from the storage of other blockchains.

Finally, Cosmos' Interchain Security (ICS) plays a crucial role in improving the ecosystem's integrity, as detailed in the ATOM 2.0 Blog post. Here, the concept of Replicated Security stands out. Replicated security allows a blockchain (consumer chain) to lease security from another blockchain (provider chain), such as the Cosmos Hub, by having their blocks produced by the provider chain's validator set.

Developed under the Interchain Foundation (ICF) Funding Program, this model allows smaller chains to 'borrow' security from more established chains. The first implementation of this innovative approach will happen on the Neutron chain. And as we will explore later, liquid staking zones such as Stride are also exploring the implementation of interchain security.

Liquid Staking Protocols on Cosmos

The introduction of ICA has had a significant impact on the Cosmos ecosystem, particularly with regards to liquid staking. ICAs allow providers to circumvent the need for smart contracts on host-chains. When users liquid stake ATOM with providers like Stride, pStake, or Quicksilver, the ATOM is transferred to an ICA on the Cosmos Hub, controlled by the liquid staking provider. In this section we provide an overview of the top liquid staking protocols on Cosmos.

I. Stride Protocol

Founded in early 2022, Stride Labs quickly established itself as a front runner in Cosmos liquid staking. After raising $6.7 million, they began supporting liquid staking for a wide array of Cosmos tokens. Stride's users deposit their tokens into the protocol, which stakes them on the host chain, Stride then issues stTOKEN to users that can be freely traded or redeemed. It is currently the largest liquid staking protocol on Cosmos with over $35M in TVL. It also supported the most number of Cosmos tokens, including Cosmos Hub, Osmosis, Juno, Stargaze, EVMOS, Terra 2.0, and Injective.

STRD is the protocol token of Stride Protocol used for governance and staking. 50.2% of the total STRD supply will be distributed to the communities Stride serves, through airdrops and staking rewards. The STRD token is used to vote on decisions regarding the network and is staked to secure the network.

The Stride protocol collects 10% of the staking rewards of all liquid staked tokens as a fee for liquid staking, and this revenue is shared with STRD stakers. This means that as a STRD staker, you will receive the STRD inflation rewards from its initial token allocation as well as the fees collected on the staking rewards as real yield in the forms of stATOM, stOSMO and other liquid staking tokens.

II. pStake

pStake, hosted on the Persistence blockchain, is the second largest liquid staking protocol in the Cosmos ecosystem, with approximately $4.4 million worth of ATOM staked. The protocol enables users to liquid stake their ATOM on Cosmos through a non-custodial interchain solution built with modules deployed on the Persistence chain. With this arrangement, users immediately receive stkATOM tokens upon liquid staking through pStake, and their assets are natively staked on the Cosmos chain.

Rewards are compounded daily using ICA and IBC features of the Cosmos SDK, with ICQ added as necessary to maximize yields through auto-compounding of rewards. Delegation to validators for staking takes place every epoch (about every day), while unstaking requests are sent on a 4-day epoch to abide by the 7 unbonding events limit per 21 days on Cosmos chains.

Its governance token $PSTAKE allows users to vote on proposals. It is also used to incentivize users to participate in protocol security and to provide grants to contributors of the protocol.

With regards to rewards and fees, 95% of staking rewards go to stkATOM holders, while 5% go to the protocol for supporting long-term development like hackathons, grants, and bug bounties. The 5% fee is charged on the auto-compounding of rewards, not on other steps like staking, unstaking, or claim. There is also a nominal 0.5% charge for the "Redeem Instantly" feature.

III. Quicksilver

Quicksilver Protocol is a liquid staking zone for the Cosmos ecosystem that was founded in late 2021. It has a total value locked (TVL) of approximately $2.3 million. The Quicksilver Protocol is hosted on its own blockchain and supports ATOM, STARS, OSMO, and REGEN.

Users can stake their Cosmos assets with their preferred validator and receive liquid staked assets, called qASSETs (e.g., qATOM, qOSMO), which can be used for swapping, pooling, lending, and more, all while their original stake continues to earn staking APY from securing the network.

The protocol employs a fee model that charges 3.5% on staking rewards. These fees are collected at the end of each epoch, when the protocol auto-compounds rewards. The fees are charged in the native token of the chain where the staking occurs, such as ATOM for Cosmos or STARS for Stargaze. QCK, the native token of Quicksilver, has three primary roles: governance, security, and payment of on-chain fees. By staking QCK, holders can receive ongoing rewards in denominations of the chains that Quicksilver integrates.

Comparison of Cosmos liquid staking protocols

This following section provides an comparisons of the protocols such focusing on 4 dimensions:

Economic security
Host chain validator selection
Smart contract functionality
Liquid staking governance

Economic Security

Crypto-economic security in the context of a proof of stake (PoS) chain refers to the level of security provided by the economic incentives built into the blockchain protocol. Validators, who maintain the security of the network, must stake their crypto as collateral, which is locked up in a smart contract. The more token they stake, the more incentive they have to act in the best interest of the network. This principle of economic security is fundamental to the Cosmos liquid staking protocols.

Stride, pStake, Quicksilver, are currently governed and secured by their native tokens and validator sets. However, the capacity to safely scale these protocols with demand is constrained. For instance, ATOM staked through the Stride protocol (atATOM) is technically secured by the economic security of STRD stakers. At present, this implies a security of $27Mn safeguarding a total value secured (TVS) of $35Mn. While the current TVS/Economic security of 1.3x is not a significant red flag (Ethereum for example has and TVS/Economics security ration of 11x), the setup does not bode well for long term growth.

Recently, Stride proposed to join the ATOM Economic Zone and adopt the Interchain Security (ICS). This move signifies a notable shift away from its existing security model. Stride is the first liquid staking zones that has proposed to switch to interchain security. Under this proposal, Stride would share its various revenues with Cosmos Hub as follows:

15% of liquid staking rewards
15% of STRD inflationary staking rewards
15% of maximal extractible value (MEV) revenue
15% of transaction fees

Stride is the first to adopt the ICS model and Quicksilver has stated interests in exploring this route as well.

Host-chain Validator Selection

The selection of host-chain validators is a crucial aspect of Cosmos' liquid staking protocols, with different protocols adopting unique strategies to this end. Stride select its validators through on-chain governance. This selection process begins with an advisory council of independent experts, who elect a set of validators. However, the final authority would rest with STRD stakers, who have the power to approve or deny the elected validator set. pStake's approach is similarly based on governance but revolves around a predefined set of criteria for selecting validators.

Quicksilver, on the other hand, plans to give users the autonomy to choose their validators through intent signalling. Despite the appeal of user empowerment, this strategy may be vulnerable to various attack vectors. For instance, a malicious entity could set up a validator with no self-bond (refers to the amount of ATOM tokens that a validator bonds to their own node) and attract delegations from a liquid staking provider. After securing delegations, the malicious entity could open a short position on the liquid staking token and intentionally misbehave. This misbehavior would trigger a slashing of the liquid staking provider’s funds, causing a depreciation of the liquid staking token's value, in line with the slash.

General vs. narrow purpose zone

As mentioned, chain minimalism is a philosophy that stresses the importance of code minimalism to reduce potential risks and attack surfaces. Stride employs a minimalist design with just the core liquid staking protocol, focusing on security over functionality. Quicksilver and pStake, however, intend to include smart contracts and DeFi applications on their blockchains, providing greater functionality at the potential expense of security.

Liquid staked token governance

Stride is working on a way to allow holders of Stride stTOKEN to exercise the voting power of the underlying tokens, which can be called liquid governance. Holders of Stride’s stATOM currently cannot vote in Cosmos Hub governance currently, once liquid governance is available they will be able to. Like Stride, Quicksilver is also exploring qTOKEN holders to use the voting power of underlying tokens. Quicksilver’s implementation is called “governance by proxy”, and is under development.

Here is a summary comparison:

Token Comparison:

*Note: Data from CoinMarketCap, CoinGecko, blockchain explorers as of 21 May 23*

Staking Yield Comparison:

*Note: Data from protocol websites of 21 May 2023*

What is Liquid Staking Module (LSM) and its impact on Cosmos DeFi?

The Cosmos Liquid Staking Module (LSM) is a proposed upgrade to the Cosmos Hub that aims to replace the existing staking, distribution, and slashing modules with variants that regulate liquid staking. The LSM is designed to provide greater liquidity and flexibility for ATOM token holders, allowing them to liquid-stake their already staked tokens without needing to wait for a 21-day unbonding period.

This solves a major pain point for liquid staking adoption. Currently users need to unstake their already staked ATOM on Cosmos Hub and sacrifice yield for 21 days to then stake them through liquid staking providers. This is a major hassle and roadblock for existing stakers. LSM addresses this straight on and current stakers can deploy to liquid staking protocols much more easily.

The LSM also introduces safety features to mitigate potential liquid staking risks. It limits the total amount of ATOM that can be liquid staked to 25% of all staked ATOM. This cap on liquid staked ATOM is enforced by limiting the total number of tokens that can be staked via interchain accounts and tokenized using the LSM on the Cosmos Hub. Once the cap is reached, the LSM prevents interchain accounts from staking any more ATOM. According to the proposer, this is a key safety feature as it would prevent liquid staking providers from collectively controlling more than ⅓ of the total staked ATOM supply, which is the threshold at which a group of bad actors could halt block production.

While a 25% limit might seem restrictive, let’s view it from a broader perspective. As of now, only 1.4% of the $2.5Bn staked ATOM is through liquid staking providers, which translates to $35Mn. Therefore, a 25% cap still leaves room for substantial growth – up to 18-fold. This limit can be seen as a prudent measure for an initial implementation, with potential for adjustments as the ecosystem evolves.

For comparison, around 42% of all staked ETH currently participate in liquid staking pools. As the validator selection criteria for liquid staking protocols become rigorously tested and decentralized this cap could be revised. Therefore it isn't a permanent restriction but rather a cautious starting point that can be reassessed.

Challenges for Cosmos liquid staking

Several challenges and risks still exist for liquid staking on Cosmos to take off.

The first is regarding composability, which means the ability of liquid staking derivatives to move seamlessly between protocols. For Cosmos, although IBC solves the cross-chain issue for native assets like ATOM, it doesn't fully resolve the cross-chain problem for liquid staking assets. For example, a user staking ATOM through Stride receives the staking derivative stATOM. However, to provide liquidity for the ATOM-stATOM liquidity pool on Osmosis, this stATOM also needs to be transferred cross-chain. This leads to a rather cumbersome and unpleasant user experience.

It's worth noting that non-"minimalist" chains like Quicksilver will not be plagued by this issue as much, as they plan to have built-in DeFi protocols that can meet the needs of the qATOM application directly on its app chain. This presents a dilemma for Cosmos liquid staking zones chains, where they must negotiate between "minimalism" and composability, and between non-"minimalism" and security.

In any case, beyond LP farming on Osmosis, options for using these derivative tokens remain limited right now. Liquid staking tokens within Cosmos currently lack depth and it highlights a need to develop diverse applications for these assets to enhance their value proposition.

Catalysts Ahead

Adoption of Interchain Security

Replicated security in Cosmos is crucial for the growth of liquid staking. It allows individual chains to leverage the security of the Cosmos Hub, which has a much larger market cap and validator set, providing a higher level of security and confidence for users and developers.

This increased security can help drive the adoption of liquid staking tokens and contribute to the growth of the Cosmos DeFi ecosystem. Proposal #794 is already passed on Cosmos Hub and Stride is poised to implement Interchain Security and join the ATOM Economic Zone.

This move is expected to encourage other protocols to follow suit, further strengthening the Cosmos ecosystem. The adoption of replicated security by Stride and potentially other protocols will create a strong synergy with the Cosmos Hub, extending it to the ATOM Economic Zone and beyond to the broader Interchain.

Soon-to-be-launched Cosmos DeFi chains

The imminent launch of several Cosmos-based DeFi chains and protocols could act as a catalyst for Cosmos liquid staking by providing fresh avenues for liquid staking tokens. One example is Sei Network, which has already partnered with Stride to launch the stSEI token, enabling users to stake their SEI tokens in exchange for stSEI. Another chain is Berachain, a DeFi-centric EVM compatible layer 1 built on the Cosmos SDK. The chain will have a DEX and perpetual exchange built in along with a Proof-of-liquidity consensus mechanism that allows users to stake multiple assets (like ETH, BTC, or stablecoins) to a validator. Meanwhile, the Inter Protocol seeks to become the MakerDAO of Cosmos and issues a stablecoin called Inter Stable Token (IST). IST is a fully collateralized decentralized stablecoin on the Agoric chain. Inter Protocol is planning to launch their “Vaults” product which allows overcollateralized minting of IST with ATOM tokens. They could accept stATOM as collateral in the future which will vastly expand the utility of Cosmos liquid staked tokens.

These projects are likely to bolster the Cosmos Liquid Staking ecosystem by offering new opportunities for users to stake their liquid taking tokens and engage in DeFi activities chains.

Conclusion

Cosmos hasn't kept pace with Ethereum in liquid staking, largely because it wasn't designed as a comprehensive smart contract platform bustling with dapps. Yet, it has established a robust interchain infrastructure with the implementation of ICA, ICQ, and Interchain Security. This infrastructure is key in spurring growth of liquid staking zones.

Given the under-utilized potential in Cosmos' liquid staking, there's a substantial opportunity in sight. Among the top protocols, Stride has shown promising growth, leading the sector in terms of TVL as well as roadmap. The impending introduction of the Liquid Staking Module (LSM) could redefine the landscape, accelerating the broader acceptance of Cosmos' liquid staked tokens.

As the narrative evolves with the imminent launch of new DeFi app chains, we could witness the ushering in of an era for Cosmos.

Note: Other Cosmos liquid staking providers not mentioned above include StakeEasy, Stafi, Prism, Eris

References

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