Effects of Illiquidity
The proof-of-stake mechanism is capital inefficient. At most, five percent of a delegator's assets are at work, providing effective security to the network. However, 100% of their capital is locked and illiquid. Asset holders cannot simultaneously participate in network security and leverage their assets in decentralized finance (e.g., providing liquidity in DEXes or AMMs, lending, borrowing, etc.).
In cases where the return of such products is significantly greater than the return from staking and exceeds the penalty incurred by unstaking one's assets, it becomes a trivial decision for an asset holder to unbond their security deposit to better utilize their capital. In this case, we see delegators unbonding assets from securing the network to migrate them to other zones to seek better returns, thus negatively affecting network security.
We saw evidence of this behavior in June 2021 following the launch of Osmosis, an IBC-connected automated market maker protocol (AMM). In the days following the Osmosis launch, over 2.5% percent of the ATOM bonded, then valued at $61.7m, unbonded, causing a significant outflow of previously staked capital from the Cosmos Hub, reducing the security by a material amount.