▶️The Inefficiency of Proof-of-Stake Mechanism

Capital Inefficiency

The proof-of-stake (PoS) mechanism suffers from capital inefficiency. On average, only 5% of a delegator's assets actively contribute to providing effective security to the network, while 100% of their capital remains locked and illiquid. This limitation prevents asset holders from simultaneously participating in network security and leveraging their assets in decentralized finance (DeFi) activities, such as providing liquidity in decentralized exchanges (DEXes) or automated market makers (AMMs), lending, borrowing, and more.

Opportunity Cost and Unbonding

When the returns from DeFi products significantly exceed the returns from staking and outweigh the penalty incurred by unstaking one's assets, asset holders face a simple decision to unbond their security deposit in order to better utilize their capital. As a result, delegators may choose to unbond their assets and migrate them elsewhere in pursuit of better returns. This behavior can negatively impact network security.

Case Study: Osmosis Launch

In June 2021, the launch of Osmosis, an IBC-connected automated market maker protocol (AMM), provided evidence of this behavior. In the days following the Osmosis launch, over 2.5% of bonded ATOM (valued at $61.7M at the time) unbonded, leading to a significant outflow of previously staked capital from the Cosmos Hub. This reduction in staked assets materially decreased the network's security.

Implications

The capital inefficiency of the PoS mechanism and the opportunity cost associated with staking can lead to:

1. Reduced network security as asset holders unbond their stakes to seek better returns elsewhere.

2. Limited participation in DeFi activities, as asset holders must choose between staking for network security and leveraging their assets in other opportunities.

Addressing this inefficiency and finding ways to enable asset holders to simultaneously contribute to network security and participate in DeFi is crucial for the long-term sustainability and growth of PoS networks.