Read the blockchain, oracle machine and DeFi's equity pledge mechanism in one article

This article will discuss in depth the fundamental logic, operating mechanism and application scenarios in blockchain and DeFi ecology of equity pledge

Written by: Chainlink

Staking usually refers to locking cryptocurrency as collateral to ensure the security of a certain blockchain network or smart contract agreement. Cryptocurrency assets pledged by equity are usually linked to DeFi liquidity, income rewards and governance rights. Use Cryptocurrency to pledge rights and interests, that is: lock the pass in a certain blockchain network or protocol to obtain returns; and these pass will be used to provide key services to users.

This article will discuss in depth the fundamental logic, operating mechanism and application scenarios in blockchain and DeFi ecology of cryptocurrency equity pledge. In addition, this article will also compare the difference between the equity pledge mechanism of the oracle network and the existing blockchain network.

Blockchain equity pledge mechanism

To ensure security and a high level of Byzantine fault tolerance in the blockchain, an anti-Sybil attack mechanism must be established to prevent a small group of nodes from attacking the network. If the anti-sybil attack capability of the blockchain is relatively weak, it may suffer from 51% attacks. A 51% attack is when a small group of nodes conspire to launch malicious attacks, such as rewriting blockchain history or manipulating users.

A block contains a group of user transactions, which will be jointly verified by nodes during the update process of the blockchain ledger. Each block will not only contain this new set of transaction data, but also contain the hash value of the previous block, and connect all the blocks in chronological order through encryption technology, so it is named blockchain (ie: a chain connected by blocks). Validators/miners are responsible for creating blocks and submitting them to the blockchain network. The blocks submitted by them will be added to the ledger if they are deemed valid by the majority of validators/miners and full nodes.

Proof of Stake (PoS) is an anti-Sybil attack mechanism on the blockchain. Verification nodes must pledge tokens in the network to have the opportunity to add new blocks to the chain. On the PoS blockchain, anyone who pledges a certain amount of native tokens can join the network to become a verification node (staker) and produce blocks. The amount of tokens staked by a validator or the number of validators run by a user usually determines its probability of being selected as a block producer. In other words, the more tokens you pledge, or the more verification nodes you control, the more likely you are to be selected as a block producer.

Validators typically receive staking rewards from the protocol, as well as a portion of user transaction fees, when they successfully create valid blocks. In order to reduce malicious behavior, the PoS blockchain often adopts a penalty mechanism. Under this mechanism, if the verification node violates the protocol rules, some or all of the pledged tokens will be confiscated. In some PoS blockchains, if the node goes offline or the block producing node fails to produce a block normally, the pledged pass will also be confiscated.

Three types of blockchain equity pledge: Proof of Work (PoW), Proof of Stake (PoS) and Delegated Proof of Stake (DPoS)

The anti-sybil attack mechanism of the PoW blockchain requires miners to compete with each other by solving computational problems, which is also the mechanism adopted by the Bitcoin blockchain. That is, the miner needs to generate a valid hash based on the information in a certain block. The first miner who solves the calculation problem, submits a valid block and obtains the consensus of the blockchain network will be rewarded. The Bitcoin blockchain will automatically adjust the difficulty of the calculation problem every 2016 blocks (note: about every two weeks), and its goal is to ensure that a block is generated every 10 minutes on average. The difficulty is usually adjusted based on the number of people participating in the miner (that is, computing power). If the number of miners increases, the difficulty will increase accordingly to maintain the decentralization level of the network.

In the PoW mechanism, the probability of becoming a block node is proportional to the computing power consumed by the node. Therefore, although the PoW blockchain does not have an explicit pledge mechanism (note: the explicit pledge mechanism means that the user locks the cryptocurrency in the smart contract, and the money will be confiscated if the violation occurs), such blockchains do have an implicit pledge mechanism, because nodes will not only hold the network’s native certificates, but usually spend money on expensive hardware equipment to expand computing power in order to gain opportunities for block rewards, and usually these hardware cannot be used between chains. If miners cannot generate income through mining rewards, then the cost they spend on equipment and electricity is wasted. If network security cannot be guaranteed, the market value of mining equipment and native assets will also drop, which will indirectly lead to economic losses.

*Although Bitcoin does not have a traditional pledge mechanism, it uses some kind of implicit pledge mechanism. Miners must work hard to maintain network security so that Bitcoin can maintain a high value and achieve profitability. *

The anti-sybil attack mechanism of the PoS blockchain replaces the hash calculation with the pledge of cryptocurrency rights and interests. In other words, miners in the PoW mechanism compete for computing power, while verification nodes in the PoS mechanism compete for funds. One notable difference is that in PoW blockchains, all miners have the opportunity to create blocks in each round, while PoS blockchains usually assign validators in turn to create blocks based on a stake-weighted random number. Ethereum is currently launching the "Merge" plan (The Merge), transforming from PoW to PoS.

*The PoS blockchain uses an explicit pledge mechanism, and the verification node pledges a certain amount of tokens as a deposit. If the node violates the protocol rules, the deposit will be confiscated. *

There is a subcategory of PoS called Delegated PoS (DPoS), which allows token holders to delegate tokens to validators, thus separating token stakers and validators. Doing so allows token holders to participate in the block creation process, so they can also share the block rewards instead of being monopolized by validators. However, there is a flaw in this mechanism, that is, the number of verification nodes will be less than that of traditional PoS networks. Because in a PoS network, every staker must run their own validator client.

Stake Rewards

Stakers in a blockchain network are economically incentivized to create valid blocks, and nodes receive transaction fees for each transaction as well as block rewards. That is, validators who successfully create blocks or validate blocks receive newly issued cryptocurrencies.

Different protocols will calculate equity pledge rewards in different ways, usually considering factors including the number of tokens pledged by each verification node, the duration of the verification node pledge, the total number of tokens pledged in the network, and the circulation of tokens as a percentage of the total supply ratio etc. PoS blockchains will use different methods to determine the proportion of reward distribution, but generally speaking, the rate of return will be determined according to the total amount of tokens pledged in the network.

In some PoS systems, token holders can pool their resources (that is, staking assets) together to increase the chances of being selected and winning staking rewards. If the equity pledge threshold is set in the network, even if the number of tokens in the hands of users does not reach the minimum threshold, they can participate in the PoS blockchain through the equity pledge fund pool. Rewards will be distributed proportionally to stakers and the operation team of the fund pool.

Staking equity in DeFi

Staking is also common in decentralized finance (DeFi) protocols. The pledge of rights and interests in DeFi is not to ensure the security of block chain generation, but to lock the token in the DeFi protocol to achieve a specific goal. Although the term "equity pledge" deviates from its original meaning in this case, it has become a conventional term because it is commonly used in the industry.

The following are some examples of equity pledge in DeFi:

• Provide insurance for the agreement- Decentralized lending agreements such as Aave use the equity pledge mechanism to stimulate liquidity. AAVE token holders can pledge their tokens in the security module of the agreement. Provides additional security and insurance to depositors in the event of a swan event. Users who pledge tokens can get rewards from the agreement.
• **Governance—**Decentralized trading platform (DEX) Curve adopts the equity pledge mechanism to coordinate the long-term economic incentives of liquidity providers and governance participants. CRV token holders can "vote-lock" the CRV in their hands, and get voting entrusted CRV (ie: veCRV). The longer the user locks up, the more veCRV they will get. Token holders can vote on the agreement proposal through voting lock, determine the CRV rate of return in a certain liquidity pool, and share part of the transaction fee income of the agreement.
• Provide Liquidity—— Decentralized liquidity protocol Synthetix adopts the equity pledge mechanism to provide collateral for synthetic assets. Synthetic assets anchor the price of an off-chain asset and are mortgaged by pledged SNX. Users who pledge SNX will receive economic incentives, provide liquidity for the protocol, and receive equity pledge rewards and transaction fees generated by dApps such as Kwenta that use the Synthetix protocol.
• **Token Issuance—**DeFi protocols such as Alchemix use the equity pledge mechanism to issue tokens to the community and stimulate liquidity in the decentralized ecosystem. Users can obtain LCX tokens by staking tokens in the Staking Pools contract.

Comparison of equity pledge mechanism between blockchain network and oracle network

The role of the equity pledge mechanism in the decentralized oracle network is fundamentally different from that in the blockchain network. As stated in the Chainlink 2.0 white paper: "The transaction verification on the blockchain is essentially to ensure the consistency on the chain, while the oracle report is to verify the data off the chain." To further understand the specific differences between the blockchain and the oracle, please Read "Understanding the similarities and differences between blockchain and oracle machines and their synergistic effects in one article".

In general, the blockchain provides a service (ie: block verification) that follows a set of predefined and widely recognized rules. Therefore, the blockchain adopts this equity pledge mechanism to ensure the security of the entire network. In contrast, Chainlink’s decentralized oracle network provides a range of different services, including external data, off-chain computation, cross-chain interoperability, and data output to legacy systems, each of which can be flexibly Customized to meet the specific needs of users in terms of performance, budget and trust assumptions. Therefore, the oracle machine needs to establish a very flexible equity pledge mechanism to meet the specific needs of different users to verify external data and events.

The PoS blockchain uses a stake pledge mechanism to motivate honest nodes to reach a consensus on the validity of the block and pass a series of transactions. Penalty mechanisms for verification nodes include but are not limited to:

• **Encryption technology——**A verification node generates two different blocks at the same block height, and repeats the signature (for example: repeats the signature for multiple blocks).
• **Internal state——**The generated block contains invalid transactions, and the transaction amount does not exist in the account (such as: double-spending transactions).
• **Internal rules of the network-**The block created by the verification node violates the protocol rules (such as: the number of tokens minted exceeds the upper limit of block rewards).

In the decentralized oracle network, the significance of the equity pledge mechanism is not to ensure the creation of valid blocks, but to ensure that reliable and tamper-proof oracle reports can be generated, and the reports can accurately reflect the state of the external world. Since the off-chain world itself is full of variables and uncertainties, different users may have different punishment mechanisms for oracle nodes, and in addition to the encryption technology, internal state, and internal rules mentioned above, it is necessary to establish other penalty mechanism. An on-chain service level agreement (SLA) will be signed between the oracle machine user and the oracle network, which stipulates the penalty conditions, reward and punishment mechanism, and which verification scheme to use to trigger the penalty mechanism.

*The blockchain verifies and reaches a consensus on the block where the transaction is located, while the oracle network reaches a consensus on external data and off-chain calculations. *

Chainlink currently supports more than 800 oracle networks distributed across various services and blockchains. Chainlink is working hard to develop explicit staking mechanisms, which cover various customized fine mechanisms, reward and punishment mechanisms, and verification schemes, and are compatible with various blockchains. Therefore, Chainlink’s explicit staking mechanism can incentivize honest oracle node operators and allow flexibility to customize various Chainlink oracle networks and services.

*Chainlink combines implicit and explicit staking mechanisms. The implicit staking mechanism includes the reputation system of the oracle node and future fee income opportunities; while in the explicit staking mechanism, the node needs to pledge the deposit according to the terms in the service level agreement smart contract. If the terms are violated, the deposit will be confiscated. *

It is worth noting that the equity pledge mechanisms of blockchain, DeFi, and oracle networks have one thing in common, that is, users who pledge tokens to ensure the normal development of services can share a portion of user transaction fees. As the number of protocol users continues to grow, stakers can share more and more transaction fees.

Future development prospects of equity pledge

The encrypted economic model of equity pledge is becoming more and more mainstream in the smart contract ecosystem, and can be directly applied to the oracle network. The original purpose of equity pledge is to ensure the security and economic sustainability of the blockchain, and it is now widely used in DeFi protocols to manage liquidity and protocol governance. In addition, the Chainlink oracle network will also further enhance security by adopting a stake pledge mechanism.