Building a stable passive income is a goal for many people. One way to achieve this is by staking crypto assets. Staking can be present in several forms and can be applied to a variety of Proof of Stake (PoS) blockchains.

In simple words, staking is where blockchain users put their crypto assets at the disposal of the network and thus maintain the blockchain. This helps secure the blockchain through the PoS consensus mechanism. More information on staking can be found in this journal.

This article provides a guide and comparison between Staking, Liquid Staking and Liquidity Mining. The focus here will be on the Kusama network with its native token KSM. Just as DOT is for Polkadot, KSM provides the elemental basis for Kusama. Tasks include: validate the network, nominate validators, bond parachains/parathreads, and vote on governance referenda.

In order to perform these tasks, the KSM tokens held must be staked. This has the advantage that you receive compensation in the form of staking rewards, but the tokens are also locked for a period of time.

To remedy this, Acala – winner of the first parachain auction – has designed the concept of the LKSM. The aim is to combine the advantages of staking – e.g. earning staking rewards – with the advantages of a non-staked token. LKSM, the liquid derivative of staked KSM, is a fully fungible token that can be used to participate in other network activities such as lending or as collaterals. Currently, some Kusama parachains are starting their liquidity mining programs, and LKSM is well suited for this purpose.

What actually is Kusama and what are the most important roles in this ecosystem?

A few words about it ???

Kusama and Nominated Proof of Stake

A chain that has attracted a lot of attention in recent weeks is the Kusama network. Kusama is called the “canary network” of Polkadot. Founded in 2019, it can be considered as the experimental version of Polkadot with nearly the same codebase and functionalities. Kusama should point out warning signals that might occur in the protocol. It operates completely independently from the Polkadot chain and has its own native token KSM. The consensus mechanism is Nominated Proof of Stake (NPoS). NPoS is the process of selecting validators to participate in the consensus protocol. It’s a variant of PoS and is used in substrate-based blockchains such as Kusama, Edgeware, or Polkadot.

There are two elementary roles here, the validators and the nominators.

The validators provide the infrastructure and maintenance of the network. They are responsible for producing new blocks, validating parachain blocks, ensuring finality, and ultimately the security of the network. They must be responsive at all times and operate a secure, reliable infrastructure. In addition, validators need tokens to support them, which provides an incentive for them to comply with the rules, otherwise, they could be stripped of some of those tokens (a concept known as “slashing”). For their services, validators are paid in the form of rewards denominated in the token of the underlying network – KSM on Kusama.

Nominators are token holders who contribute to the security of the network by economically supporting – nominating – up to 16 validators of their choice with their tokens. Nominators share a portion of the rewards earned by validators in the active set they nominate. It is important to note that the nominators are also subject to slashing in case of misbehavior of a validator they nominated

Staking KSM

Staking KSM works the same way as with the partner network DOT. A step-by-step guide to binding and nominating the KSM can be found here. A number of validators offer this service. They may charge fees for this and also differ in their reliability. Currently, there are 900 validators with over 6200 active nominators. These different staking providers can be compared right here on stakingrewards.com.

In the following figure, the possible Kusama staking rewards with $1,000 in KSM are shown. Here it was assumed that the value of KSM remains constant over a period of one year.

Figure 1 Kusama Staking Rewards:

Source: Staking R e wards 22.10.2021

With an average interest rate of 14.8 %, more than $148 could be earned. Both centralized and decentralized custodians have been included in this calculation. But beware, with a decrease in the price of KSM, this interest rate could also drop. In addition, the annual inflation of issued KSM must also be taken into account. All key metrics for Kusama can also be found on Staking Rewards.

Figure 2 Inflation of KSM:

x-axis: Proportion of KSM staked
y-axis: Inflation, annualized percentage
Blue line: Inflation rewards to stakers
Green line: Staker rate of return

Source: Web3 Foundation

Inflation

The inflation rate is dependent on the relative amount of KSM tokens that have been staked. As can be seen in the figure, the inflation rate decreases as the share of staked KSM increases.

At the time of writing (22.10.2021), approximately 44.2 % of all KSM tokens are staked. This results in an inflation rate of 7.3 %.

More detailed information, in particular the existence of parachains on the inflation rate, can be found here.

A measure with which the potential return can be better described is the adjusted return. It includes the inflation rate in the calculation of the return. According to the macroeconomic perspective, if demand remains the same and supply increases, the price of the goods falls.

Adjusted return = (1 + interest rate1 + inflation rate)-1

Adjusted return =(1 + 0.1481 + 0.073)-1 = 0.0698

In the case of staking KSM, this results in a value of 14.8 %. Deducting inflation, the nominator can expect an interest rate of 6.98 % per year in KSM.

Staking KSM		Assumptions
Interest Rate	14.8 %	Inflation has no impact on the KSM price
Adjusted Return	6.98 %	Inflation increases supply, causing KSM price to decline

Caution! By staking the KSM tokens will be locked on Kusama. During this time they cannot be moved or used for parachain slot auctions. Punishment in case of a validator found to be misbehaving (slashing) is also possible. There is a cooldown period of 7 days by unstaking. After this, the tokens are fungible again

Liquid Staking of KSM

Nominated Proof of Stake networks such as Polkadot and Kusama incentivize users and validators to stake DOT and KSM to improve security and consensus for the networks.

The staking of KSM has the consequence that the used funds are blocked for a period of at least seven days. In volatile markets, this represents a significant window of time. In addition, participants are penalized if they do not act in the spirit of the network. These mechanisms are widely used in Proof of Stake protocols. There are two key reasons for this:

Lock-Up periods: To make sure the network security is not threatened from immediate stake withdrawals in critical situations

Slashing: To make sure the validators behave in the interest of the network

However, a problem has come up: These staked assets do not provide benefits beyond staking earning rewards. DeFi users in particular, want more! They want to avoid both slashing as well as the lockening of their tokens. For most people, liquidity is a very important decision-making factor, if not the most important. Stakers want to be able to sell their tokens in critical situations.

Liquid Staking is the solution to this problem. It refers to tokenized staking positions – derivatives – that can be freely traded on the open market. Liquid Staking allows you to leverage your staked crypto assets in other trading or investment opportunities to get the best of both worlds – a reward for your staked assets as well as the returns from new trading/investment opportunities you identify.

Liquid Staking by Acala

“Acala is the decentralized finance network and liquidity hub of Polkadot. It’s a layer-1 smart contract platform that’s scalable, Ethereum-compatible, and optimized for DeFi with built-in liquidity and ready-made financial applications. With its trustless exchange, decentralized stablecoin (aUSD), DOT Liquid Staking (LDOT), and EVM+, Acala lets developers access the best of Ethereum and the full power of Substrate.”

Acala’s first Liquid Staking product is KSM Liquid Staking (LKSM), a product launched at Karura parachain that allows users to stake their KSM while accessing its liquidity.

When KSM is staked on Karura, users receive LKSM, a liquid, yield-generating token that not only represents the staked KSM value and is redeemable at any time but also contains the ever-increasing staking rewards.

Currently, anyone who stakes KSM for LKSM earns an indicative APR of ≈ 16 %, while benefiting from the advantage of LKSM being an unlocked token that grants access to its underlying KSM liquidity for other purposes in DeFi. The staking APR of LKSM is the compounded APR – aka APY – of staked KSM.

LKSM offers low minimum stakes starting from 0.1 KSM and no unbonding period for the underlying KSM, as users can unbond at any time for flexible fee on Karura. This flexible fee reflects the transaction fees (> 0.01$) on Karura parachain and can be paid in various available tokens – at the moment KSM, LKSM, KAR, kUSD, BNC, and vsKSM.

Figure 3 Karura Liquid Staking:

Source: Wiki Acala

Rewards

KSM staked via Karura Liquid Staking, receives a share of the LKSM account balance that entitles the owner to a likely increasing amount of underlying assets. These staked KSM are used to earn Kusama Nominator rewards. This means that earning staking rewards is as simple as holding an LKSM token, while LKSM can be used across chains and can be used to participate in other network activities, such as lending or as collateral for minting kUSD.

In this phase, the staking strategy is implemented by the Karura Council. They nominate the validators based on specific characteristics. The initial nomination strategies are as follows:

With an on-chain identity
No slash history
Validator history on Kusama
Commission Rate
Slash Cover (off-chain)
Prefer dedicated validators for LKSM

In summary, LKSM offers three basic advantages compared to the conventional staking of KSM:

No Lock-up Periods: It remains liquid and can be used in volatile and fast-changing market conditions

Additional Returns: It can be used in DeFi dApps. For example, as collateral for a kUSD stablecoin loan or as a liquidity provider in incentivized pools

Automated Staking: The staking rewards are automatically compounded and validators are nominated on an ongoing basis according to the criteria

Liquidity Mining with LKSM

In general: Liquidity mining is a network participation strategy in which users provide two-sided capital to a protocol and receive transaction fees and the protocol’s token in return.

Liquidity Mining promises the highest but also most volatile returns. With this approach, active asset management is necessary and a constant readjustment of the positions is a basic requirement. In particular, interacting with more complex contracts increases the risk level.

After the initial parachain auctions have been completed, teams can turn their attention to the next steps on the roadmap. These steps consist in achieving a certain market adaptation and attracting liquidity from users. This again creates new opportunities to participate in this success. As also seen in DeFi Summer 2020 on Ethereum, the first liquidity mining programs are now being launched in the Kusama ecosystem.

Karura, as a winner of the parachain auctions, also makes the start. One of the core products, minting of kUSD is already live, and users can thus use their KSM as collateral for this stablecoin.

In addition, KSM’s Liquid Staking is incentivized with the distribution of the protocol token Karura (KAR).

Figure 4 Karura Liquidity Mining Pool #2:

Source: Twitter

As an AMM, Karura is interested in providing as much liquidity as possible on its platform, thus enabling the lowest possible slippage for trades. For this reason, the platform incentivizes new liquidity with its Liquid Staking Splash program.

Part of this program is the KAR Reward Pool #2, which incentivizes providing liquidity for the LKSM/KSM pool. This pool is intended to enable low slippage trades from LKSM to KSM or vice versa at any time.

Returns, Inflation and Impermanent Loss

For a period of 4 months, 250,000 KAR will be spent. The incentive consists of two components:

30 % of the KAR serve as a base reward and can be claimed immediately
70 % of the KAR serve as a loyalty bonus and is paid out at the end of the four months to reward long-term liquidity providers

The following table shows the potential return on a $1000 investment in KSM. A possible impermanent loss, as well as inflation in KSM, are also taken into account.

Inflation here shows the dilution of KSM. The representation of a loss in $ creates a bias when prices are stable. The amount of KSM/LKSM held remains stable over the period.

The upper half shows the performance of the LP position after one year. Below, the returns resulting from participation in the liquidity mining program can be seen.

Table 1 Liquidity Mining:

APR 22.10.2021

Assuming that the program runs for one year and the interest rate would remain stable, an excess return could be achieved. A staker could make up to 54 % return on his LP position. An impermanent loss and the staking rewards are already included. Possible transaction fees have been neglected here.

KAR Liquidity Mining 54 % APR ? high return, moderate risk, highly liquid

LKSM Liquid Staking 16 % APR ? moderate return, low-moderate risk, highly liquid

KSM Staking 14.8 % APR ? moderate return, low risk, 7-day lock-up period (*compounded 16 % APY)

Delta

∆ ≈ 38-39 %

The delta arises from the increased risk factor when adding liquidity to a platform. Even though audits have been performed, unforeseen events can still happen that may result in a sudden outflow of funds. In addition, the assumptions of a stable price for KSM and KAR were made. In a dynamic crypto environment, this is a possible but unlikely condition.

Conclusion

The Kusama network remains in the early stages of its development. The first protocols and teams have rolled out their products. There are many opportunities for investors to participate in the success of the projects. The liquidity mining program by Karura shown in this article is just one example of several.

The article stated that staking can take different forms. Liquid Staking, as a new way of staking, enables many new applications. Especially in the dynamic crypto environment, it could lead to an acceleration of processes.

Care should also be taken to ensure that a diversity of validators prevails and that individual liquid staking products do not rely too heavily on single validators. Otherwise, systemic risks could arise that would have a serious impact on the networks.

Moreover, it has been demonstrated that it is possible to achieve excess returns with liquidity mining programs. They enable early participation in protocols and incentivize liquidity providers to take an active role in governance by holding the earned protocol tokens.

**This blog post is not investment advice and does not claim to be complete**

Sources:

https://www.stakingrewards.com/journal/2021-staking-ecosystem-report/

https://www.stakingrewards.com/journal/a-deep-dive-into-polkadot-kusama-parachain-slot-auctions/

https://stakingfac.medium.com/what-is-nominated-proof-of-stake-889fc22bef8f

https://guide.kusama.network/docs/learn-staking/#inflation

https://medium.com/acalanetwork/acala-launches-first-liquid-staking-product-for-polkadot-kusama-in-partnership-with-blockdaemon-5258546c2483

https://wiki.acala.network/karura/defi-hub/liquid-staking/lksm

Liquid Staking and Liquidity Mining with LKSM – More than Staking on Kusama