An intro to Staking Derivatives I
By: Nicola Santoni
Tags: Derivatives, Cryptocurrency, Bitcoin, Staking, Blockchain

Staking derivatives by domain

The economic risk associated with staking has a multi-dimensional form. Depending on the particular interaction with the cryptonetwork, the stakeholder could incur different losses.

The following is a list of instruments in relation to each domain:

Security and Operability: instruments protecting from attacks and from losses due to network malfunctioning

instruments protecting from attacks and from losses due to network malfunctioning Economics: instruments preventing pure economic losses

instruments preventing pure economic losses Governance: instruments preventing losses from cryptonetwork mismanagement

instruments preventing losses from cryptonetwork mismanagement Network peculiarities: instrument protecting different kinds of losses, such as the right to perform a work for the network or to vote or participate in any kind of activity, peculiar to a network

Let’s now dive in each segment.

Staking derivatives by domain

Security and Operability

In a PoS cryptonetwork, security is possibly the most important property to achieve in order for the protocol to survive. This segment can be split into:

Liveness: Derivative products protecting token holders from a failure of the network, acting as an insurance for an attack to the blockchain. One could think of them as a life insurance for your tokens.

We refer to liveness as:

Availability

Consistency

Two important points to mention:

The distinction between liveness at network level and at individual node validator level. The latter being relatively insignificant in the context of network performance In terms of network design, there is often a decision on what to prioritize in case of network partition (availability vs consistency). Insurance products would therefore be one-sided as the network pre-determines how it will behave in adversarial situations

Operability: Emergency products issued by foundations to attract new validators when live nodes drop below a predefined threshold.

This would act as an additional stimulus to the dynamic inflation mechanism currently enforced by cryptonetworks like Cosmos or Ethereum 2.0.

These products could be a quicker, more effective tool in comparison to a change in the incentive structure (i.e. inflation). This is especially true since many of those decisions are currently made through elaborate off-chain governance processes.

A suitable and helpful parallel with traditional finance would be a quantitative easing policy.

For example, a government executing quantitative easing would translate into an on-chain crypto derivative issued by a foundation or by an emergency DAO.

This newly issued derivative would be more effective than a structural policy aimed to stimulate the economy from the ground up. In fact, the latter would produce tangible results only after years, if not decades. Alternatively, our instrument would produce immediate effects.

In conclusion, the line between security and operability is extremely thin and blurred. If a cryptonetwork security is threatened, its operability would be indistinguishably compromised.

Let’s revisit the parallels between a cryptonetwork and a city or state. A breach in its high-level security (e.g. a coup d’Etat or an enemy invasion) would also affect its operability (e.g. the public transportation would stop working). But on the other hand there is also a non-zero chance that the subway system in a city stops working without the state being attacked. Back to our PoS derivatives realm, the family of “operability derivatives” would address the single risk of operational failure. Either in a form of insurance (binary options) or in the form of futures or swaps, where the value of the product increases (or decreases) based on the likelihood of the failure occurrence.

The work on frontrunning (manipulating order of transaction on a decentralized exchanges) by Phil Daian is extremely inspirational. Frontrunning is an operability risk that could incur in losses. However, it would be very challenging today to create a product protecting these kinds of risks. Even more challenging would probably be collecting the data and prove that a certain behaviour has actually occurred and caused (you) economic losses.

Plausible example: A derivative product on Polkadot, issued by an emergency-DAO, offering X times higher validation staking returns (for a short, limited period) until the restoration of a minimum set of validators is completed (liveness).

Economics

Similarly to PoW mechanisms, PoS protocols are designed to incentivize miners (validators) to provide valuable resources to the network (such as security, block validation, storage) in exchange of staking rewards coming from newly minted tokens.

Staking rewards are doled out to validators in proportion to the amount of tokens staked in the network. Since PoS leads to some predictability of rewards, the affiliation with a traditional cash flow bearing instrument then becomes extremely intuitive.

Naturally, this is the area where one could foresee the vast majority of staking derivatives flourish.

A non-comprehensive list of those instruments includes:

Reward linked products: this is possibly the most popular. Those instruments would track exposures to staking rewards rate, fees, commission rates and validators uptime. We are not far away from having products hedging against a validator’s commission rate change in Cosmos, for example. A comprehensive list of risk/reward factors in the Cosmos network can be found here.

this is possibly the most popular. Those instruments would track exposures to staking rewards rate, fees, commission rates and validators uptime. We are not far away from having products hedging against a validator’s commission rate change in Cosmos, for example. A comprehensive list of risk/reward factors in the Cosmos network can be found here. Risk linked products: those instruments would offer insurance against economic losses resulting from slashing, unbonding or downtime. Taking Cosmos again as an example, one can imagine a derivative product providing protection against a validator being “jailed” or against a revision of its “minimum self-delegation”. However, during early conversations some doubts arose: this kind of protection could result in a net negative for network security. Validators could insure themselves against slashing and therefore be less incentivized to spend additional resources on securing themselves.

those instruments would offer insurance against economic losses resulting from slashing, unbonding or downtime. Taking Cosmos again as an example, one can imagine a derivative product providing protection against a validator being “jailed” or against a revision of its “minimum self-delegation”. However, during early conversations some doubts arose: this kind of protection could result in a net negative for network security. Validators could insure themselves against slashing and therefore be less incentivized to spend additional resources on securing themselves. Liquidity linked products: those instruments would facilitate liquidity for token holders who are obligated by the protocol to lock their tokens for a certain amount of time. In Cosmos, for example, the maximum threshold for slashing is currently set at 5%. That means that 95% of the tokens can not incur in any kind of slashing. One can envision a proliferation of derivatives products representing rights over a portion of locked, but secure, tokens. They would be basically used as collateral. In addition, for Layer 2, there is a whole uncovered field about renting liquidity to L2 hubs, like a lightning network or state channels network. The whole locking mechanism makes funds unusable, yet a hub earns some fees. One could consider this as a hub providing both liquidity and L2 payments routing. Akin to delegation in PoS networks, one could provide liquidity to an L2 hub in exchange for shared earnings. While in the PoS realm one casually sees yield, in lightning the rate of return is called Lightning Network Reference Rate. Consequently, one could wrap this into a derivative.

those instruments would facilitate liquidity for token holders who are obligated by the protocol to lock their tokens for a certain amount of time. In Cosmos, for example, the maximum threshold for slashing is currently set at 5%. That means that 95% of the tokens can not incur in any kind of slashing. One can envision a proliferation of derivatives products representing rights over a portion of locked, but secure, tokens. They would be basically used as collateral. In addition, for Layer 2, there is a whole uncovered field about renting liquidity to L2 hubs, like a lightning network or state channels network. The whole locking mechanism makes funds unusable, yet a hub earns some fees. One could consider this as a hub providing both liquidity and L2 payments routing. Akin to delegation in PoS networks, one could provide liquidity to an L2 hub in exchange for shared earnings. While in the PoS realm one casually sees yield, in lightning the rate of return is called Lightning Network Reference Rate. Consequently, one could wrap this into a derivative. DeFi linked products: This range of products, ideally swaps, would provide the holder a protection (exposure) to one or more “competition” protocols for the deployment of the same, locked asset. Taking ETH now as an example, imagine an asset representing a portion of your locked ETH in validation. Let’s call this new asset DETH. 1 DETH = 1/X ETH, with X dynamically set between 1,05 and 10 depending on risk parameters. A staking derivative product would algorithmically pick the most profitable decentralized protocol to autonomously deploy DETH (i.e. Maker vs Dharma vs Compound). The above example would only work if Maker, Dharma and Compound would accept DETH as a collateral asset.

Plausible examples:

Put option on Tezos staking rewards (Reward linked)

A Cosmos on-chain insurance-DAO derivative covering downtime slashing (Risk linked)

A staking provider or CEX backed liquidity certificate on locked ATOMs (Liquidity linked)

Off-chain interest rate swap on ETH locked in Compound vs Maker (DeFi linked)

Governance

This is possibly the most “futuristic” and exciting domain to explore. Governance, or a lack of it, has tremendous implications in a cryptonetwork, whether on or off-chain. However, the specs of the debate go far beyond the scope of this article.

What we are really interested in are the economic impacts of those implications. They will be more or less measurable and more or less “hedgeable”.

To this day, it is practically inconceivable to be able to measure the impact that a governance outcome would have on its primitive asset price. The ecosystem developing around decentralized predictions markets though, is evidence of this trend.

A “cryptogovernance” derivative sounds very far from the state-of-the-art blockchain ecosystem. Its abstractivity could feel overwhelming. However, Jesse Walden had previously compared cryptonetworks to cities while Joel Monegro associated governance to capital. The gap is narrowing and this trend will not likely stop.

Cryptonetworks like Tezos and Polkadot are creating mechanisms for a fair and open governance to insure a sound evolution of the cryptonetwork. The more decisions that are made on-chain, the more rational actors will have the opportunity to evaluate outcomes and assess risks. Governance processes will make decisions on fees, rates, upgrades and much more. As I stated before, risks bring uncertainty which leads to seeking protection.

Plausible example: Digital option on rental fees triggered by the positive or negative outcome of a Polkadot governance decision relative to an upgrade of validator’s dilution-fee.

Network peculiarities, hybrids and miscellaneous

In this segment I will include risks initiated by peculiar actions implemented within a cryptonetwork.

The above-mentioned risks do not necessarily need to incur in economic losses. On the contrary, they could relate more qualitatively to risk. A non-exhaustive list includes:

Right to operate: this range of products was inspired by the talk of Gavin Wood from Polkadot about its parachain auction mechanism. Polkadot will have a certain initially pre-defined number of slots available for its parachains. I found the model extremely interesting and I am confident this kind of mechanism will be a source of inspiration for designing staking derivatives.

Polkadot Parachain deployment — https://slides.com/paritytech/validating-in-polkadot#/15

Polkadot Parachain auction schedule — https://slides.com/paritytech/validating-in-polkadot#/20

One could see derivatives hedging the risk of losing the right to carry out work for the network.

Inter-protocol products: One can envision a multitude of specialized actors creating products and providing liquidity for them in a fully decentralized fashion. They would create new “markets” exploring opportunities across cryptonetworks. Teams are already creating infrastructures facilitating this. I also envision those products being collateralized by different cryptoassets. Consequently they will demand different requirements based on the collateralized asset volatility and liquidity parameters. However, they would be extremely hard to implement in a completely decentralized way. Therefore, centralized inter-protocol products will be much easier to create.

One can envision a multitude of specialized actors creating products and providing liquidity for them in a fully decentralized fashion. They would create new “markets” exploring opportunities across cryptonetworks. Teams are already creating infrastructures facilitating this. I also envision those products being collateralized by different cryptoassets. Consequently they will demand different requirements based on the collateralized asset volatility and liquidity parameters. However, they would be extremely hard to implement in a completely decentralized way. Therefore, centralized inter-protocol products will be much easier to create. Structured products (offering combination of payoffs)

(offering combination of payoffs) Regulatory insurance

Plausible examples:

An interest rate swap on Cosmos vs Polkadot validation (Inter-protocol product)

On-chain structure product long ETH staking rewards + a basket of call options on staking rewards for interoperability protocols (Structured product)

Off-chain OTC futures on a Polkadot parachain slot.

Many of those products could belong to two or more categories at the same time. A product tackling downtime, for example, could be seen with multiple lenses: purely economic, operational or for security.

The chart below summarizes interconnections across products and domains.