Do staking and lock-ups for liquidity pools need to change to see mass crypto adoption?

The recent downturn in the broader crypto landscape has exposed several flaws inherent in Proof-of-Stake (PoS) networks and Web3 protocols. Mechanisms such as bonding/unbonding and lock-up periods have been architected into many PoS networks and liquidity pools to mitigate a total bank run and encourage decentralization. However, the inability to withdraw funds quickly has become a reason many are losing money, including some of the most well-known crypto companies.

At their most basic level, PoS networks like Polkadot, Solana, and hapless Terra rely on validators that verify transactions while securing the blockchain by keeping it decentralized. Similarly, liquidity providers of different protocols offer liquidity across the network and improve the speed of the respective cryptocurrency – i.e. the rate at which the tokens are exchanged through the crypto rail.

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In its forthcoming report, Web3: The Next Form of the Internet, Cointelegraph Research discusses the issues facing decentralized finance (DeFi) in the current economic backdrop and assesses how the market will perform.

The unstable stable

The collapse of Terra raised many questions about the sustainability of crypto lending protocols and, more importantly, the security of the assets deposited by the platforms’ users. In particular, crypto lending protocol Anchor, the heart of Terra’s ecosystem, has struggled to cope with the deprecation of TerraUSD (UST), Terra’s algorithmic stablecoin. This caused users to lose billions of dollars. Prior to Depeg, the Anchor Protocol was valued at more than $17 billion. As of June 28, it is just under $1.8 million.

Assets deposited with Anchor have a three-week hold period. As a result, many users were unable to exit their LUNA — which has since been renamed Luna Classic (LUNC) — and UST positions at higher prices to mitigate their losses during the crash. When the Anchor protocol collapsed, his team decided to burn the locked deposits, increasing the liquidity outflow from the Terra ecosystem to $30 billion, which subsequently caused the total TVL on Ethereum to drop by 36%.

While several factors led to Terra’s collapse – including UST withdrawals and volatile market conditions – it is clear that the inability to quickly remove funds from the platform represents a significant risk and barrier to entry for some users.

Drop Celsius

The current bear market has already shown that even curated investment decisions, carefully evaluated and made by the leading market participants, are a game of chance due to lock-up periods.

Unfortunately, even the most thoughtful, calculated investments are not immune to shocks. The stETH token is minted by Lido when Ether (ETH) is staked on its platform and gives users access to a 1:1 Ether-backed token that they can continue to use in DeFi while their ETH is staked. Lending protocol Celsius provided 409,000 stETH as collateral for Aave, another lending protocol, to borrow $303.84 million in stablecoins.

However, as stETH broke away from Ether and the price of ETH fell amid the market downturn, the value of the collateral also started falling, raising suspicions that stETH was liquidated by Celsius and the company is facing bankruptcy.

Given that there are 481,000 stETH available on Curve, the second largest DeFi lending protocol, liquidating this position would subsequently lead to extreme token price volatility and further stETH depeging. As such, lending protocol lockdown periods not only pose an additional risk factor for an individual investor, but can sometimes trigger an unpredictable chain of events that impact the broader DeFi market.

3AC in trouble

Three Arrows Capital is also at risk as the ETH price drop reportedly led to the liquidation of 212,000 ETH used as collateral for its $183 million stablecoin debt and pushed the venture fund to the brink of bankruptcy.

Additionally, the lending protocols’ inability to negate the liquidations has recently prompted Solend, the most prominent lending protocol on Solana, to step in and propose to take over a whale’s wallet “so that the liquidation can be done over-the-counter and Solana not pushed to its limits.” device”. In particular, the liquidation of the $21 million position could lead to cascading liquidations if SOL’s price fell too low. The first vote was won by another whale wallet, which contributed 95.1% of the total votes. Although a second vote reversed that decision, the fact that the developers violated core principles of decentralization and revealed their lack thereof alarmed many in the crypto community.

Ultimately, a lack of flexibility in bonding/unbonding and locked liquidity pools may discourage future contributors from joining Web3 unless they have a strong understanding of DeFi design and an appropriate level of risk. This is exacerbated by the collapse of too big to fail protocols like Terra and uncertainty surrounding hybrid venture capital firms/hedge funds like Three Arrows Capital. It might be time to explore some alternative lock-up solutions to enable sustainable returns and true mass adoption.

This article is for informational purposes only and does not constitute investment advice, investment analysis or a solicitation to buy or sell any financial instrument. In particular, the document does not serve as a substitute for individual investment or other advice.

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