PolkaWorld Interview | StakeFi could be the next DeFi hot topic

Bifrost Finance
11 min readJun 1, 2022

Recently, PolkaWorld interviewed Bifrost Co-Founder Lurpis. The interview was about the role of Staking derivatives in the ecosystem, what stage of development its market is in, what actions it will take to achieve its goals and what derivative assets it plans to launch in the future. Read the interview to learn how to empower the StakeFi economy.

In the PoS network, users can obtain the benefits of Staking by pledging tokens in the network to provide security for the network itself. The problem is the assets in Staking cannot be used within a certain locking period. Staking derivatives can release the liquidity of Staking assets to improve their utilization.

On this issue, PolkaWorld interviewed Lurpis, the founder of the Polkadot ecosystem liquidity derivatives protocol, Bifrost. He believed that「StakeFi」, which combines Staking Derivatives with DeFi, is expected to become the next DeFi track worthy of attention, and Bifrost protocol, based on the Polkadot and Kusama ecosystem have some natural advantages.

- What is Staking derivatives and what problems can it solve?

Staking derivatives has the function to issue corresponding vouchers to the original tokens (such as DOT/KSM) staked in the platform. General users, who are holding this voucher, can obtain the benefits of Staking, while using the voucher to maximize their rewards. After the end of the Staking cycle, this voucher can be rigidly changed back with the original Token.
Staking derivatives mainly solve three problems.

The First One: Under the PoS consensus, benefits of DeFi and Staking are in conflict.

Here it is an example: We want to build a Dapp in the Polkadot ecosystem. Assuming it is a Lending protocol, users need to provide KSM to others for Lending, then the interest they provide must be at least higher than KSM’s own Staking reward (currently about 18% APY). Doing so, we can attract KSM for storage, because we have the best choice for our users. Therefore, there will be a lot of pressure on the loan agreement in the PoS network - to provide such a high income, the first thing to do is to get high subsidies, and the second is to charge higher interest from the KSM lender.

This is because the token itself can be used for Staking to generate revenue, which means that the token of the PoS network itself has a certain capital cost. DeFi must cover the capital cost to generate users and traffic, so DeFi and the bottom of the public chain are competing with each other.

In addition to ensuring that assets have the most basic rate of return, derivatives can also help solve this problem. When derivatives are used as assets in the Lending protocol, in fact, the derivatives borrowed by users contain the proceeds of Staking, and the additional proceeds are provided by the DeFi asset agreement.

At present, Ethereum 2.0 has not been launched, and there has not been a large-scale outbreak of DeFi under PoS networks such as Polkadot or Cosmos. However, with the development of the PoS consensus and the DeFi ecosystem on it, whether it is Polkadot or after Ethereum has been transformed into PoS consensus, this will become a more and more prominent problem.

The Second One: Cross chain costs.

Cross chain is certainly a development trend of blockchain in the future, but crossing the assets in the PoS chain means giving up the benefits of Staking. For example, if I want to cross Ethereum 2.0 assets into Polkadot ecosystem, my capital cost of crossing chain is the 4.2% annual Staking reward of Ethereum 2.0. Once I deposit my assets on the cross-chain bridge, my Ethereum will have no Staking reward, so my cross chain cost will be at least 4.2% annualized. If the other party’s cross chain application doesn’t cover this 4.2%, it’s not convenient to cross the chain, because it means users will lose money .

Derivatives can solve this problem of cross chain capital cost, in the process of cross chain itself. As long as users hold these derivatives, they can guarantee at least 4.2% of Ethereum 2.0 Staking return. At the same time, they can use it to participate in other cross chain DeFi protocol.

The Third One: The conflict between security and liquidity under the PoS consensus.

The pledge rate of Kusama is currently above 50%, which means that only half of KSM supply is in circulation. In other words, there are not so many assets available for the entire Kusama DeFi ecosystem. Although Staking lock up can capture more value for token, the negative impact is that the number and liquidity of tokens in the ecosystem may not be enough.

How can we ensure both the number of positions locked by Staking and the circulating liquidity?

This requires derivatives. Because if the income subsidy of DeFi is very high, users will unlock KSM/DOT in Staking to participate in DeFi, thus threatening the consensus security of Polkadot itself. If Staking has a high income, it will make it difficult for the DeFi protocols to get liquidity.

At this time, derivatives are used for DeFi, which not only ensures the high pledge rate of Staking but also the great asset liquidity of DeFi.

- The high proportion of PoS chain positions will lead to less liquidity, which seems to be a good thing for the Market. Will the emergence of Staking derivatives bring inflation?

Derivatives will not lead to more circulation, because the liquidity of derivatives and original assets is not the same thing, they are different.

I can give an example: The derivative of DOT is vDOT. Users may worry that if the price of DOT falls, some DOT in the lock up could not be operated, but now that there is a current vDOT, they can directly sell vDOT, causing the price of DOT to continue to fall. In fact, the probability of such a situation is quite low, because there is a discount before the maturity of derivatives.

It still needs 28 days for vDOT to accept and return the DOT in a 1:1 rigid manner. If selling the vDOT in advance, there is a capital cost, and there will be a discount between the unexpired vDOT and the DOT. If vDOT is sold 28 days before its maturity, its reasonable market price is about 98.75% of DOT. If a large number of vDOT are sold, the discount rate will further increase due to the increase in liquidity demand. Users can indeed cash out DOT by selling vDOT, but it means they need to pay liquidity costs, which is an act of adding leverage to funds. More DOT liquidity means higher liquidity costs, Therefore, it will only make limited DOT flow into the market due to supply and demand, and will not have an impact on the overall liquidity of DOT.

- How big is the market for Staking derivatives? What is the current development stage of Polkadot ecosystem Staking derivatives market?

A reasonable derivative should set the upper limit of casting quantity.
The current rule designed by Bifrost is that in order to ensure the consensus security of Polkadot and Kusama, the maximum casting amount of products for Polkadot and Kusama will not exceed 33% of their Staking amount (50%), that is, 16.5% of the total amount. According to this ratio, the total market value of the PoS chain is about $500 billion (data source: stakingrewards), so the Staking derivatives market has a market size of about $82.5 billion. We can see that many large TVL projects on Solana and Cosmos are Staking derivatives projects.

Even if the Staking derivatives are still in their infancy ,Polkadot’s Staking derivatives market is huge, because in addition to Polkadot and Kusama, each parachain also has the demand for derivatives.

- What opportunities will Staking derivatives bring?

First of all, it is the opportunity to track the Staking derivatives or StakeFi. This track will be an indispensable middleware, which will capture value from the underlying chain and other applications at the upper level. After the development of PoS network, the value of StakeFi agreement will be greater and greater. We will see that there are many projects in the StakeFi track with high TVL but low market value. For example, Lido, the largest protocol in Ethereum 2.0, has exceeded US $7 billion in TVL, but Lido’s market value has not yet ranked in the top 100, which also shows that the track has not attracted a lot of attention.

The second is the opportunity for users. Staking derivatives have brought new DeFi rules to users. After the DeFi Summer passed, we saw the Stablecoin and Lending trends but Staking derivatives have not been widely used in DeFi, yet.

An example is the arbitrage opportunities of derivatives. If there is a discount on derivatives, for a long-term currency holder, he can obtain higher profits by purchasing derivatives at this time than by directly purchasing cash. He can buy derivatives and redeem the original assets 1:1, so the discount is actually an arbitrage space with low risk and high return. In other words, if users are more proficient in the mechanism of derivatives, they will have the opportunity to earn higher profits in the ecosystem.

Third one: for the development of the whole Polkadot DeFi ecosystem, Staking derivatives bring the advantage of DeFi yield to the ecosystem itself. If Polkadot ecosystem will use derivatives for DeFi in the future, the basic DeFi yield combined with Staking derivatives will be higher than the ordinary DeFi yield. For example, it is known that the long-term stable yield of the Ethereum Top DeFi project can exceed 5%. However, if the DeFi and Staking derivatives are combined, the 5% interest plus 15% Staking reward, the DeFi product will have 20% long-term annual income, to attract more users to the ecosystem.

- How to promote a large-scale adoption of Staking derivatives?

I think there are three main points for Staking derivatives to be widely adopted. The first one is high security, the second one is good liquidity of derivatives, and the third point is high standardization of derivatives.

In terms of security, people are worried about the acceptability of derivatives. If the protocol is not safe, it may lead to the over issuance of derivatives or the loss of the assets pledged behind derivatives, resulting in the non-acceptance of derivatives and becoming worthless. Therefore, the security of the protocol itself should be assured to the users: On the one hand, we have the code security audit, and on the other hand, the consensus security of the chain itself. Both needs to be executed properly.

In terms of liquidity, a good liquidity of derivatives is the basis for it to become a mortgage asset or form a transaction pair. I think that the liquidity of the final derivatives may not be specifically provided to people with trading needs, but to Money Market, stable currency and other DeFi agreements. For example, if the vDOT of Bifrost wants to become the mortgage asset of Acala aUSD, the precondition is that the liquidity of vDOT is good enough to be liquidated in the event of a sharp fall in DOT. Therefore, the establishment of liquidity is also a difficulty for derivatives. Only with good liquidity can we carry the lending application above it, and derivatives can be used as much as possible.

Finally, the standardization of derivatives. At present, although many derivatives are deployed in multiple chains, they are not standardized.
For example, Lido deploys a contract in each chain. The biggest problem with this model is that its derivatives are not standardized. The casting and redemption methods of derivatives in each chain are different. Derivatives in each chain are difficult to cross the original chain, cannot be traded with each other, and liquidity cannot be shared. Therefore, a liquidity pool must be built independently for each chain.

Bifrost builds derivatives through XCM, which is standard. In this way, we hope to provide standardized derivatives for Polkadot/Kusama chains and parachains, including heterogeneous chains such as Ethereum 2.0 or Cosmos and its hub. They have a unified interface, a unified redemption method and an interest calculation method, which are forged by the same set of agreements. More importantly, each different derivative (such as vETH and vDOT) can be traded and can also generate loans to each other, Liquidity can be shared among them. Only standardized derivatives can be widely used by the DeFi application. Just as EVM developers need a set of standard interfaces to integrate assets at a lower cost.

I believe that security, liquidity and standardization are the prerequisites for the large-scale application of Staking derivatives.

- What specific actions will Bifrost do next to achieve these three goals?

First, security. At the coding level, Bifrost is implemented based on the technical framework of substrate and XCM, which is the premise for the casting of derivatives, and has completed the code audit by SlowMist and other audit institutions.

At the consensus level, Bifrost, as parachain, share the security of Polkadot.

At the agreement level, our derivatives are standard. We provide services for different derivatives through a set of agreements, and the security standards are unified. These three points ensure safety.

Then there is the liquidity aspect. How to establish mobility is arguably the biggest challenge for all DeFi applications. Bifrost makes full use of its derivatives and cross chain advantages to provide users with higher returns.

In DeFi, users usually get two parts of revenue, one is from the commission of transaction fees, and the other is from additional subsidies. And now we can provide two additional parts of revenue. How?

First of all, Bifrost, as a derivative agreement, provides users with basic Staking reward. Therefore, compared with the agreement without derivatives, we have advantages in income. Second, we use XCM cross chain interoperability to improve the asset utilization of parachains and generate additional benefits for users.

For example, the KSM that crosses the chain and enters the parachain is a shadow asset. The real KSM behind it is locked by the relay chain on the parachain address. The mechanism of Bifrost is that when users use shadow assets to provide LP in Bifrost, the parachain code will stake it corresponding to the real KSM, and the resulting Staking reward will be subsidized into the LP pool. This is a special way for us to establish liquidity - XCM improves the utilization rate of our own assets, thus providing a higher rate of return to quickly establish liquidity.

Finally, standardization. This cannot be achieved at the contractual level.
At present, compared with the existing technical framework, it is easier to achieve standardization on Polkadot, because standardized derivatives are based on common cross chain agreements and expandable technical frameworks, such as XCM or IBC, Substrate or Tendermint.
However, Cosmos, Tendermint and IBC cannot provide consensus security, it will encounter more obstacles on the road of standardization.

The standardization of derivatives on Polkadot depends on the progress of XCM. For example, we need to do the security derivatives of heterogeneous chains on the premise that the XCM bridge can be opened. Basically, Polkadot and Ethereum could interact through the XCM bridge. On this premise, we can do the derivatives of heterogeneous chains such as Ethereum, but right now, we only can make derivatives on Polkadot relay-chain and parachain with the help of XCM.

- After vKSM, what derivatives does Bifrost plan to launch next?

Our Polkadot parachain is being auctioned. When Bifrost Polkadot parachain goes online, we will successively launch vDOT and derivatives of such parachains as vGLMR, vMOVR, vPHA and vKILT. Interestingly, through Polkadot’s unique cross chain interoperability, we can enable derivatives with parachains to be directly cast and circulated in their own ecosystem.

For example, we will deploy an XCM SDK in Moonbeam. Moonbeam ecosystem’s users can directly use MetaMask to cast their GLMR into vGLMR, and can easily use and circulate vGLMR in Moonbeam ecosystem through MetaMask.

The mechanism behind this is actually a typical case of XCM cross chain interoperability. The user completes the process of GLMR cross chain to Bifrost through a MetaMask signature, casts the GLMR into vGLMR through the Bifrost SLP protocol, and again transfers the vGLMR cross chain back to Moonbeam.

The cross chain interoperability through the Bifrost XCM SDK not only ensures the convenience of the user but also the integrity of each parachain ecosystem.



Bifrost Finance

Bifrost Finance is a parachain designed for staking’s liquidity