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Networks that offer liquid staking generally see greater decentralization and increased security. Since liquid staking incentivizes users to begin staking at the point of purchase, or by default, networks see greater participation across large and small value holders. While this doesn’t work to lower transaction times, every amount of staked crypto helps improve network security while increasing decentralization. Oftentimes, stakeable assets will also come with governance privileges, which help encourage more active participation around the health of a network from a broader swath of the community. Where staking initially lowered the bar to participate in a network’s functioning, liquid staking basically dissolved it. However, this isn’t to say liquid staking is not without its potential drawbacks.
The deep end of liquid staking
Much like any financial endeavor, it’s paramount to always conduct extensive research before making purchases or entering into unfamiliar instruments or agreements. However, when so much of the crypto ecosystem is being built in real-time, it can be difficult to determine which new opportunities have the potential to turn hazardous. This double-edged sword of risk and reward is most on display in some new innovations cropping up around liquid staking: yield farming and crypto-backed loans.
Yield farming
By freeing up assets for increased movement across the crypto ecosystem, liquid staking has opened doors to many new developments in experimental valuation. Yield farming is one such practice that involves staking the proxies of staked assets on other protocols to earn rewards across multiple networks. This essentially allows traders to earn simultaneous yields on what amounts to copies of the same assets. While it’s human nature to want more of a good thing, yield farming can open traders up to pitfalls should the markets shift dramatically when assets are spread akimbo.
Imagine you have multiple tokenizations of the same asset spread across several different protocols. As long as these networks remain stable, the rewards can prove favorable. But when the markets inevitably shift, this can create a domino effect and collapse the house of proxies. Since each proxy is a stand-in for a staked asset, any proxy can be used to redeem an original of that coin or token. Should an entire community respond to a downward shift and attempt to liquidate their assets, this can result in what’s called a run. In turn, this frenetic activity on an exchange can destabilize the price, causing the events to snowball across the ecosystem. When we’ve seen examples of exchanges and assets that have faced total liquidation in 24-hour periods, animal instinct can override the measured calm that long-term investing requires. But sometimes, that nagging urge to run is right.
If an exchange dips into an unstable loan-to-collateralization ratio, it can default on its holdings, and put the existence of countless assets into jeopardy. When traders choose to tangle their assets up in a nesting doll of derivatives to practice aggressive yield farming, it can be difficult to extricate funds during a time of crisis without risking a loss of investment cash or crypto. This ultimately makes yield farming a cautionary tale: only take on as much risk as you can safely absorb. Otherwise, you could get stuck holding the bag.
Crypto-backed loans
Compared to yield farming, crypto-backed loans are a much more straightforward concept to grasp. However, the pitfalls can be strikingly similar. A warning to those who’ve played Monopoly at all recently and fell into the trap of mortgaging to buy new properties: this may cause flashbacks.
When opportunities suddenly arise within the crypto ecosystem, it can feel advantageous to move assets around to unlock liquidity. In these high-pressure situations, it can be tempting to sell crypto to obtain quick cash to complete the transaction. Crypto-backed loans offer an alternative tactic for traders looking to retain their crypto without sacrificing the accessible funds. In this scenario, a trader could receive a crypto-backed loan using a liquid staking protocol. Here traders receive a tokenized version of their assets in the form of proxies, that can then be converted into the fiat currency of their choosing. While this can be a useful approach for those in a tight squeeze, the risks should be apparent.
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