This set of three proposals would diversify the OSMO currently used to support stOSMO liquidity in the community pool by:

• Withdrawing 50% of liquidity from the stOSMO/OSMO Stableswap pool
• Redeploying this into a more efficient stOSMO/OSMO Supercharged position
• Using the OSMO saved from this capital efficiency improvement to establish Supercharged positions of qOSMO and stkOSMO.

This proposal approves the use of 1.25M OSMO from the capital efficiency gains of concentrating the stOSMO/OSMO position to establish a Supercharged position of stkOSMO, if the stOSMO concentration proposal fails this proposal is automatically void. If this proposal fails the 1.25M OSMO surplus will be returned to the Community Pool.

Due to proposal length, the full text can be found on the forum post, with relevant sections added to each proposal of this set of three.

Background

stOSMO deployment

20M OSMO was allocated to the stOSMO/OSMO Stableswap pool in Proposal 641. This liquidity was instrumental in the adoption of stOSMO across the Osmosis ecosystem by providing robust underlying OSMO backing for the redemption rate of stOSMO.

Osmosis has previously supported alternative Liquid Staked Tokens (LSTs) ampOSMO and bOSMO through the funding of SAIL DAO in Proposal 708. With ampOSMO’s bribe system for delegations and pending deployment of slow burn arbitrage vaults, and bOSMO’s recent successful LAB streamswap, there has begun to be a variety of LSTs being bootstrapped by Community Pool liquidity.

stkOSMO

Developed by Persistence, stkOSMO utilizes an automated rating system to distribute the underlying staked OSMO to 75+ Osmosis validators and charges fees of 5% on staking rewards.

More details on stkOSMO can be found here.

Importance of Liquid Staking Diversity

Liquid Staking is a unique challenge for Proof of Stake chains, which require a bonding period. To encourage sufficient security to be provided through tokens, these often receive staking rewards in the form of inflationary emissions, transaction fees, or yield mechanisms.

This lack of flexibility is binary by default. Users can lock tokens to receive these rewards or attempt to beat the opportunity cost of those methods by using the unstaked token for alternative use cases such as liquidity provision or active trading.

Liquid-staked tokens provide additional options by removing the locking period in exchange for a fee from the staking rewards. The functionality of this lock removal relies on underlying liquidity for the LST to be sold into, allowing long-term restoration of any slippage incurred by the demand for this instant unstaking by arbitrageurs performing the unbonding period instead.

Liquid Staking centralization has been a contentious topic on Ethereum during the relatively recent move to Proof of Stake. Ethereum’s model requires a minimum staking deposit of 32 ETH, with each key needing to run its own Validation node. For the first two years of the Proof of Stake network, there was also no ability to unstake. These factors all led to a dominant market for custodial staking via liquid staking, which circumvented the minimum staking requirement, the technical barrier to participate, and the only trustless way for a staked position to be sold.

Liquid Staking providers require trust of custody and substantial liquidity to ensure minimal slippage when exiting the liquid staking. Ethereum's leading liquid staking providers quickly became popular Centralized Exchanges such as Coinbase, Kraken, and Binance, with the tokenized variety being dominated by Lido’s wstETH.

ETH Staking Distribution Source: https://dune.com/hildobby/eth2-staking

Lido has been close to controlling 33% of all Ethereum stake, allowing one provider to control which transactions are processed by the chain through obstruction. This centralization is the subject of much discussion on Ethereum, as Lido comprises 31 validators. Lido may not be viewed as a single entity for all actions as these actors may be split on a decision.

This alliance of validators is similar to the model of Liquid Staking appchains or DAOs typical in Cosmos. Here, the provider has checks and balances through decentralization, and there would need to be multiple actors with different goals to abuse this minority share. However, all validators running a specific liquid staking protocol naturally favor that protocol’s success as a whole, and most entities are likely to vote selfishly. This results in a soft bias toward decisions that are good or neutral for both groupings rather than independently good for the primary blockchain and potentially negative for the Liquid Staking Protocol.

Cosmos SDK chains, such as Osmosis, have a far lower barrier to non-custodial staking through the validator system. Validators perform the technical task of consensus on behalf of users and governance tasks alongside users. Users can also stake any quantity of the governance token by default rather than requiring a minimum amount.

This results in an initially lowered demand for liquid staking on Cosmos chains, only overcoming the opportunity cost for the unstaking period and the hurdle rate for unstaked assets. These may eventually lead to increased usage of LSTs, especially with the comparatively higher APR for staking on most Cosmos chains against the ~3.4% on Ethereum.

Liquid staking protocols add a layer of stake on top of validators, which includes a soft bias towards membership of their chosen delegation set and the potential for liquid staking protocols to vote using the underlying stake themselves. This means that the risk is not identical to the Ethereum conversations but is still relevant when talking about LST dominance on a chain.

Liquid Staking Layer

The current state of Liquid Staking on Osmosis is a minority of stake being controlled by these protocols. At the time of writing, there is a clear leader, with Stride having 25 million OSMO under management, 10 million of which are provided by the Osmosis community pool from Proposal 641.

State of Osmosis Liquid Staking vs Native Staking

There is a clear competitive advantage to being the incumbent liquid staking protocol as additional usage results in higher volumes through liquidity pools, resulting in higher reward APRs for liquidity, attracting more liquidity, and so making the liquid asset both more widely and deeply used as collateral or for purely liquid staking purposes.

Suppose Osmosis wishes to have a diversified liquid staking layer. In that case, actions must be taken to limit liquid staking protocol growth through increased fees for use or subsidizing alternative Liquid Staking protocols to encourage liquidity to redistribute to ones with less developed peg backing.

Mechanism

1.25M OSMO from the capital efficiency gains of concentrating the stOSMO/OSMO position will be placed in a 0.05% stkOSMO/OSMO supercharged liquidity pool at a range of 0.99 - 1.05

The position for stkOSMO comprises approximately one-third of the Liquid Staked asset, which will be acquired through a combination of purchase on Osmosis and Liquid Staking OSMO, according to which returns more of the LST.

The upper limits are all set to be the expected ratio of the LST to OSMO in approximately four months, meaning that this allocation to each LST is temporary and that the distribution of OSMO peg backing for all OSMO LSTs should be re-evaluated at that point based on a future governance proposal.

All positions will be returned to the Osmosis Community Pool for custody by the Osmosis DAO.

These tasks would be performed by the Osmosis Liquidity SubDAO, which is a 4/6 multisig comprised of

• CryptoAssassin (Validator)
• EffortCapital (Blockworks Research)
• Johnny Wyles (Osmosis Labs)
• NosNode (Validator)
• RoboMcGobo (Osmosis Grants Program)
• Trix (Independent)

This multisig has previously been used in Proposal 715 to deploy liquidity to stSTARS/STARS and in Proposal 756 to deploy AXL/OSMO to Astroport. This subDAO acts as an intermediary to perform multi-stage or time-dependent transactions, such as adding liquidity to a pool with a ratio of assets that will vary before a five-day Osmosis governance proposal is completed.

Forum Post: https://forum.osmosis.zone/t/re-evaluation-of-liquid-staked-osmo-held-by-the-community-pool/2654