---
title: 3.6 Staking
description: Defining and understanding liquidity in DeFi
---

# 3.6 All Roads Lead to Liquidity, and Liquid Staking

The elephant in the room when discussing the principles of decentralized finance, is the practical liquidity needs that an ecosystem as a whole needs, in order to sustain continuous development of different DeFi, NFT, Gaming, Metaverse, and financial protocols. The reason this topic remains an elephant in the room is because builders and teams are usually only focused on their specific product or protocol, and are unaware of how the aggregate state of liquidity in an ecosystem can determine the success of future products. 

**_Defining Liquidity: From the highest level, liquidity refers to the ease with which an asset can be bought or sold on a market without affecting the price. A liquid market is one where there are many buyers and sellers, and the asset can be traded quickly and easily. Meanwhile, an illiquid market is one where there are few buyers or sellers, and the asset may be difficult to trade._**

With this in mind, we can ask the most essential question on the topic: _Which products or dApps, require liquidity in crypto?_ Upon scrutinizing this question we find the following: 



* All decentralized marketplaces and lending protocols, require liquidity as a basis for executing loans or trades (AMMs/Orderbooks/etc.). 
* All NFT marketplaces require liquidity and volume, in order to sustain user confidence and price discovery in the underlying asset that is being purchased. 
* All marketplaces for game items, widgets, and characters, requires liquidity insofar as users are incentivized or are confident in their ability to re-sell their rewards / purchase in-game perks. 
* Any digital metaverse, with land, object, or user purchases. 

The underlying principle from these points, is that when we are not dealing with centralized entities, that can pool liquidity in siloes or hide liquidity shortages, or ultimately receive loans and credit injections when needed (think Repo markets in mainstream finance), we are faced with a very serious and new problem: _Open-source systems, and decentralized protocols, require liquidity in order to function both at their inception and at scale_. The idea of an open-source value imbued system, is one that is sustained by the collective of participants. Put another way, if we wish to create an internet where users have ownership of their money, data, and identity, then in order for different markets to function properly, it is up to the users to collectively pool their resources into these protocols! There is no central bank or federal reserve capable of bailing out these systems. 

## The Liquidity Solar System

To pull all of these topics under a single heading, we refer to the concept of a _liquidity solar system_ as it is illustrative of the role that liquidity plays in an ecosystem. The total value locked in an ecosystem, is much like the sun - the different protocols and dApps are like planets orbiting the sun. 

The concept is simple: So long as liquidity can move around the different protocols and dApps, and there are net _inflows_ into the ecosystem in question, virtually any future dApp or protocol has the capacity to steal liquidity from other protocols as they gain in popularity. This increase in popularity, usually triggers further liquidity inflows from either outside of crypto, or other ecosystems, and the process then repeats itself. 

Instead of looking at the Total Value Locked (TVL) if each individual protocol, if one takes a step back and looks at [the TVL of an entire ecosystem,](https://defillama.com/chains) it becomes crystal clear that the ecosystems with the most TVL also tend to be (1) The strongest in terms of price of token, (2) the largest in terms of active users, (3) the most innovative in terms of dApps being launched and new designs being pioneered, (4) The ones that attract the largest communities over time (exceptions include Tron - which is largely concentrated in China / East Asia). 


![](@site/static/img/bootcamp/mod-em-3.6.1.png)


[https://defillama.com/chains](https://defillama.com/chains)

There are two fundamental dynamics that any ecosystem should prioritize when thinking about long-term growth in liquidity: 



1. **Liquidity Inflows:** Why is there an interest from users and institutions, in bringing liquidity into an ecosystem, and how concretely is this done? What kind of ‘bridge’ is used? Is the bridge decentralized? What catalysts trigger the movement of value across the bridge? 
2. **Ecosystem Generated Value:** Refers to new value, natively created inside of the ecosystem. The implicit premise of ecosystem generated value, is that if it is _valuable_ it will require a pair with some form of stable coin or other token in order to be traded. As such there is a direct correlation between the amount of ecosystem generated value, and the demand for liquidity inflows to support markets for that newly minted value (could be fungible, non-fungible value). 

## Composability and Liquidity: Two Sides of the Same Coin?

We have mentioned before, the fundamental innovation of crypto centering upon the notion of _composability_. The idea that value can flow and speak with each other, in a way that lowers transaction costs, and enhances user-choice. 

Liquidity should be understood, as a necessary precondition for composability in the following manner: In order for different types of value, to flow between and among other types of value, there must be an existing market or automatic swap mechanism that is willing to substitute one type of value for another. 

Concretely we can think of this through a number of examples:


* I cannot loan out my NFT, unless there is a counterparty willing to accept the value of it, in exchange for credit (in stables or something other unit of value). Set value of my NFT is only possible through established price as through market discoverability (i.e. liquidity in the market). 
* I cannot create a market for exogenous value of things like DNA, Carbon Credits, or Art, without sufficient liquidity to trade against these items - regardless of whether they are fungible or non-fungible. 
* I cannot bring tokenized assets on-chain for a synthetic market, unless each asset that is mirrored on-chain has sufficient liquidity to trade on its own. 

Liquidity works very much like the blood of a crypto-ecosystem: It allows value to move between products and protocols, while also grounding new products that may emerge. A lack of liquidity in an ecosystem, risks limiting the growth of the ecosystem as a whole, due to limited capacity for markets to emerge, price-discovery to be set for particular assets, and users to convert assets across dApps. 

Interestingly, there is a common currency that can help facilitate the flow of liquidity within an ecosystem, and that happens to be the L1 mother token. 

## Liquid Staking

For any L1 ecosystem that exists, the native token of the blockchain is commonly used in proof of stake systems to be locked up within a node on the network. The tradeoff for the L1 ecosystem in question is the following: If more and more of the genesis token supply is locked on the network, then less and less of the token is available for liquidity pairing with other ecosystem tokens. In other words, the value in the ecosystem is fractured between securing the blockchain itself, and being used to stimulate value transfer within the ecosystem. 

Liquid staking solves this problem in the following manner: 

_“Liquid staking solves the illiquidity problem. A liquid staking provider takes token deposits, stakes those tokens, and gives the depositor a receipt which is redeemable for the staked tokens. The receipt is a representation of those staked tokens that can be traded or used as collateral elsewhere. For this reason, liquid staking tokens are sometimes referred to as liquid staking derivatives.” ([Finoa](https://www.finoa.io/blog/guide-liquid-staking/#what-is-liquid-staking-and-how-does-it-work))_

In other words, a node on the network can issue ‘staked NEAR’ or ‘staked ETH’ out to any delegator who wishes to deposit their real NEAR or real ETH into the node, to be secured on the network. The delegator can then use this ‘staked token’ as open liquidity in the ecosystem, while still being able to earn rewards from securing the network. 

This helps alleviate the original problem of limited liquidity from the blockchain base token, but in itself it is not sufficient to guarantee ecosystem wide liquidity across pairs. 

## A Need For Better Liquidity Incentives?

Liquidity incentives have traditionally been designed in two ways: 

1. To directly reward liquidity providers by offering them a percentage return on the amount of value they have put into a liquidity pool - usually as the mother token of the protocol, or a basket of tokens in an ecosystem. This leads to what is known as _liquidity farming_. 

2. To entice liquidity providers and users to actively engage with the protocol with the understanding that at a later point in time there will be a ‘snapshot’ of the active accounts and a resultant airdrop in which the protocols native token will launch, and all of the users up until this point will be eligible to receive free money. DYDX is an example of this strategy. 

Neither of these strategies have been wildly successful in their own right, however the first strategy has been successful insofar as the original LP tokens that were released did maintain much of their value, due to the first-mover nature of many of the protocols (Compound for example and the COMP token), and as a result significant amounts of liquidity have remained in the protocols. Suffice is to say, there is plenty of room for innovation in playing with liquidity incentives as a method of attracting long-term and sustainable liquidity providers into a protocol or ecosystem. 

## How Early On Is The ‘Liquidity’ Game?

On a historical note, it was these types of yield farming strategies that jump started DeFi summer in 2020, and from which launched the bull market of 2020-2022. Until 2020, there was minimal liquidity inside of crypto - yet from that time, liquidity has grown significantly:

As of December 2, 2018:


![](@site/static/img/bootcamp/mod-em-3.6.2.png)


As of November 2022: 


![](@site/static/img/bootcamp/mod-em-3.6.3.png)


In terms of ecosystems breakdown, Ethereum has led the way, followed by Binance Smart Chain (BSC): 


![](@site/static/img/bootcamp/mod-em-3.6.4.png)


## Open Questions For Addressing Liquidity In The Future

The rapid collapse of FTX prompted a direct withdrawal of liquidity from the Solana ecosystem, dropping it from around 3.9 billion TVL at its peak, to less than 250mm TVL by December of 2022. Meanwhile, in spite of the contagion prompted from FTX, Ethereum’s liquidity dropped by barely 15% in the same timeframe. This begs a number of important questions when looking at liquidity in an ecosystem:


* To what extent does institutional capital, centralized exchanges, and custodial on-ramps play a role in improving the TVL of an ecosystem? 
* To what extent do original, innovative products attract sticky liquidity? 
* What additional incentives can be coordinated on a protocol wide level so as to attract liquidity in the ecosystem over a long-period of time? 
* Can an ecosystem survive without liquidity? Is composability possible without liquidity?