👾 Cross-chain liquid staking and the risks no one is talking about — Steven Walbroehl

What do the 2008 global financial crisis and DeFi markets have in common? Steven Walbroehl, co-founder and CTO of Halborn, had warned developers about the potential money bubble scenarios involving derivatives, wrapped tokens, and cross-chain liquid staking. He compared CeFi and DeFi worlds and pointed out the real problem that no one is talking about. We summarized the key points from his talk in this post. Enjoy!

Intro

I am a co-founder and CTO of Halborn a cybersecurity company. Unfortunately, we are not the builders we are cross-chain breakers. We are working with many projects presented

on this meetup like Aurora and deBridge.

On the plane right over here from Miami, I was thinking what the hell am I going to talk about? I want to discuss something that impacts everybody here. Has anybody seen the Big Short? This is about the 2008 financial crisis. I want to talk about some similarities that are bothering me and some risks around bridges.

«Your scientists were so preoccupied with whether they could, they didn’t stop to think if they should» — Ian, Jurassic Park. There are a lot of patterns that are occurring again and again. We should think about the long-term effects of what we are doing in order that this ecosystem thrives.

Staking, liquidity staking, crashing staking

This is the big stake. And talking about the staking there are not only technical risks but also financial risks. We are going now from staking to liquid staking, but it is going to be crashing staking instead of liquid staking. Especially in case if users are staking and locking assets in an unreleased system with no launch date. In the case of liquid staking, we create a derivative of the staked asset to earn money while the actual staked asset is also earning some profit. Now we have a new level — the cross-chain liquid staking where we are going to mint a derivative of the derivative to earn money while the actual staked asset is also earning some profit and the other derivative is locked in a bridge on another network.

There are different levels of risk involved into these staking things. We start with the medium risk of the staking and talk about slashing. This means that validators (like in ETH 2.0) have the risk of staking penalties, with up to 100% of staked funds if validators fail. And it can happen again and again. That is why we put money into centralized systems to stake for us, and they know how to manage infrastructure, but they do not know how to manage financial risks sometimes. There is really no guarantee that ETH 2.0 or any other staking-based smart contract has been developed error-free. Any vulnerability inherent brings with it slashing risk. And there was this discussion on GitHub on some ETh1 to ETh2 topics. My translation is: «don’t worry… We’ll figure out a secure way to withdraw and move the staked ETH later. Merge it!». This is unproven or yet-to-be-developed protocol logic. But maybe we should think about these things before we put money into them.

What is liquidity staking?

It allows the owner of the locked or staked asset to «unstake» it and use that asset elsewhere, just in some other protocol. Users can transfer that derivative liquid staking token through a bridge into another blockchain system for a wrapped token

We can make some money with this. But what are the long-term problems? Liquid staking is done through the issuance of a tokenized version of the staked native asset — aka a derivative. It can be transferred and stored, stored, spent, or traded as a regular token. But there are usually some issues with derivatives.

Here we have an architecture of the liquid staking. There are the proof-of-chain level, smart contracts and liquidity pools, liquid staking derivative assets, DeFi protocols, and markets. So this is kinda doubling free money which is similar to the situation during the 2008 world financial crisis.

What is cross-chain liquidity staking?

It also allows the owner of the locked or staked asset to «unstake» it and use that asset elsewhere, just in some other protocol. Users can transfer that derivative liquid staking token through a bridge into another blockchain system for a wrapped token and use it while their staking token is locked in a bridge vault.

The process involves the introduction of wrapped assets based on the liquid staking derivative token, which is usually minted by a bridge integrated smart contract on another chain.

For example, users can put their stETH into smart contracts on blockchain to create wrapped stETH. This means that users staking ETH will continue to receive their staking rewards, while being able to use their stETH to lock in a bridge vault for new trading opportunities on another chain with a wrapped version.

We can imagine the derivatives as a kind of onion with a native token in the core. Then it is wrapped into a liquid staking token (locked) and finally we have the wrapped liquid staking token. But I think that atomic swaps and native assets are the best combination.

Derivatives vs the 2008 financial crisis

The 2008 financial crisis was caused by many factors, derivatives being a major part of it, specifically «mortgage-backed securities» (MBSs). It is like Jenga puzzle with very shitty assets inside there and many ways of speculation. The complexity combined with the interdependency of market players, combined with leverage combined with synthetic assets for speculation and hedging lead to a financial meltdown. There were also big leverages and loans.

During the financial crisis in early March 2008, a wave of deleveraging hit the markets. This created liquidity problems in high yield corporate debt and in both prime and non-prime US housing related paper derivatives.

Counterparty risk became extraordinary intense and dealers in mortgage-backed securities and in over-the-counter (OTC) derivatives started asking for more collateral; or risk a margin default. Since dealers finance themselves in the repo markets they abruptly withdrew from providing liquidity to make markets so the ability for anyone to exit derivatives positions or collect collateral co cover margin vanished.

This can compare to the sudden bridge’s collapse or there is a flaw in a contract in DeFi. And after the days of customer outflows. Shrinking capital and collateral lockout, the troubled banks were bailed out with the help of an arrangement by which the Federal Reserve would lend up to $30 billion in order to finance the portfolio of troubled securities.

What risks do we have?

We have a long link of processes — wrapped tokens and locked assets — so if something goes wrong we will lose connection to the native token. But we think it can be done safely. But everyone wants to develop things fast. When we move fast we cause situations when users lose their money. What is the long term effect of building fast and making a lot of money? We were burned many timed with Terra and Celsius.

We can compare the DeFi complex financial models and the complexity is the enemy of security. I like complexity. It can be amazing architecture and controlled chaos. But it is awful and unstable for the security side. In DeFi are the same instruments: synthetic assets are the wrapped tokens and liquid staking assets; the leverage is margin use on exchanges; and the volatile collateral are the always volatile tokens + unrealistic APY.

There is a big price risk because the staking asset can become lower at one moment on the crypto market. This makes arbitrage and risk-free market making impossible.

Arbitrage risk. The value of a liquid staking token is build around the staking rewards associated with the native asset. For example: ETH on the Ethereum Beacon chain and if ETH 2.0 fail to reach required levels of adoption there could be extreme significant fluctuations in the value of ETH and stETH, causing cascading financial implosions.

I don’t want this world financial crisis scenario to repeat in DeFi, actually. But I have a question: who will bail the cross-chain bridges and liquid staking platforms with liquidity troubles and uses access to native assets when they can’t unwind their positions? I think we should think about things we are building from a long perspective.

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