This proposal reduces the inflationary subsidy of the revenue-based staking rewards from 3x to 1.5x, redirecting emitted OSMO tokens to the out-of-circulation community pool for optionality.

This change aims to shift Osmosis staking rewards another step towards being entirely reliant on real yield from sources such as taker fees and transaction fees while increasing the impact of burn mechanisms on net inflation, resulting in a sustainable and deflationary OSMO.

Current Status

Inflationary OSMO emissions have historically supplemented Osmosis staking rewards. This approach may have been suitable in the early growth and distribution phases but is now widely recognized as unsustainable.

As Osmosis changes phases from the OSMO distribution phase of inflation to participants and enters the sustainability phase, emissions should be reevaluated.

Inflation works well for distributing the token among participants who contribute to the blockchain. However, as inflation decreases, it becomes increasingly apparent as a subsidy for the real revenue that must eventually be the sole source of rewards for a token with a fixed maximum supply, such as Osmosis.

Osmosis is currently subsidizing this revenue output to staking rewards by 3x, a recent cut from 4x with the Thirdening in mid-June.

Staking rewards are primarily designed to ensure the continued security of the blockchain; however, the level of security required and the corresponding level of payment required for this are under question. Other Proof of Stake chains are grappling with this same issue:

• Celestia is debating moving to Proof of Governance to reduce inflation to 0.25%
• NEAR is debating cutting from 5% inflation to 2.5%
• SOL narrowly failed to pass an incremental inflation reduction due to the Supermajority requirement, and alternative versions are being redrafted.

This proposal initiates the process of determining the optimal level of revenue subsidy necessary to ensure the security that Osmosis requires through incremental reductions in emissions.

Security

To date, there have been no major security events recorded with Proof of Stake governance systems that have a relatively small liquidity level compared to the staking quantities required for a 51% attack.

The more significant theorized attacks are Long Range Attacks, which Osmosis aims to improve safeguards against by becoming a Bitcoin Secured Network, and vote centralization risks, which Osmosis opposes through having one of the most decentralized validator sets across the Cosmos ecosystem as well a high staking rate (45%) compared to liquidity (~3% across all exchanges).

Payment for security

Osmosis currently emits around 60,000 OSMO per day for security, valued at around $8,400 per day.

This value being transferred from non-stakers to stakers via inflation is likely too high for the security requirements of the Osmosis blockchain. These requirements are primarily designed to ensure that staking levels do not come too close to liquidity levels, which could facilitate consensus attacks through the purchase of OSMO on the market - a phenomenon that occurred with LUNA during the Terra collapse. Additionally, a diverse group of validators must control at least 67% of the voting power, which is indirectly incentivized by attracting a variety of stakers with differing validator preferences through an attractive headline APR and net yield.

Inflationary staking rewards primarily transfer value from users who have not staked to those who are willing to put their assets at risk during a bonding period and are subject to slashing. The users who remain unbonded must generate value to offset this value flow. This staking reward rate is often referred to as the opportunity cost or hurdle rate of not staking, and it is something that Liquid Staking protocols have attempted to mitigate by allowing users to access both staking rewards and DeFi uses simultaneously. When the value being transferred by inflation is too high compared to the value being generated by the unbonded stake, the unbonded stake has no incentive to remain in the system, resulting in lower value generation for the remaining unbonded stake, which perpetuates the effect.

Stakers face penalties from inflation, as staking rewards may carry tax implications. Consequently, the value staked does not retain its worth against inflation, even in a system where 100% of inflation benefits stakers. Therefore, it may be preferable not to inflate a token once the distribution phase is over, and to ensure that most rewards stem from the value appreciation of a fixed supply, giving stakers the option to avoid incurring a taxable event if relevant in their jurisdiction.

In addition to inflation, Osmosis currently generates an average of 2% in staking rewards per day, equivalent to approximately $2,800 from taker fees (30% of OSMO collected or bought back) and transaction fees. This payment is likely sufficient for its purpose alone, as evidenced by the many Cosmos blockchains that remain operational despite validators receiving lower payments exclusively from inflation.

Despite this, sudden changes to security allowances carry a risk. Therefore, this proposal represents the first step in an incremental reduction to measure the impact of reducing inflationary staking rewards on the level of OSMO staked for security, aiming to find a sustainable level of inflationary reward against revenue.

Proposed Change

Staking rewards today represent the single largest recurring issuance of OSMO. Halving these rewards by redirecting the emissions to the out-of-circulation community pool helps:

• Maintain the staking rewards’ net yield after accounting for inflation.
• Reduce overall inflation, thereby preserving the value of staked OSMO and enhancing the staking experience.
• Preserve optionality for governance to decide the future use of these tokens.

The proposed change is as follows:

• Reduce the token distribution allocated to Staking Rewards from 50% to 25% by redirecting to the Community Pool.
• These tokens do not enter circulation unless accessed through a further governance proposal. They can, therefore, be considered a soft burn, as they are held outside the circulating supply while maintaining the one billion OSMO minting cap, as expected by holders.
• Governance can choose to complete the burn of these tokens, for example, if the community pool is too large relative to OSMO liquidity.

Impact of inflation reduction

This reduction to the incentive allocation effectively reduces the revenue subsidy of staking from around 3x to around 1.5x. The recent Thirdening event reduced this from 4x in mid-June, and the impact on staked OSMO to the active set has been minimal. Recent unbondings have either been typical or resulted from unbondings of delegations to jailed validators. Chart 1: Osmosis Staking APR composition by day with projected change

Chart 2: % OSMO Supply Staked. Source: SmartStake

Risks & Considerations

Headline APRs

Some validators or stakers may view this as a reduction in passive income. However, the resulting reduction in inflation may offset this by improving OSMO’s price dynamics. An 8% APR is poor when compared to a 70% loss in deposit value over the year, with OSMO’s inflation currently outpacing the burn being cited as a tokenomics issue to address.

As this change is performed by modifying the distribution parameters of Osmosis, it can be easily reverted in part or entirely if security levels drop excessively.

Other Cosmos chains, such as the Cosmos Hub and Kava, have already reduced or eliminated inflation without experiencing security issues. The Hub, for example, capped inflation at 10%, resulting in a drop of staked ATOM from 66% to a low of 54.5%. Kava has transitioned to a 0% inflation with the subsidy paid via the community pool instead. Kava’s staking rate is a lower 11.2%, but a large portion of their supply (35%) is in the community pool, resulting in lower liquidity levels as well.

Both remain stable and well-functioning. Osmosis can take a similar, cautious path.

This change will be monitored by tracking the % of OSMO staked over a minimum of 21 days following this proposal before any further reductions are proposed. With the current 45% staked, there is little risk of a security event. If adverse effects are observed, such as rapid unbonding, governance can revisit or adjust the distribution parameters accordingly.

Community Pool OSMO

Care must be taken not to treat the redirected emissions as free capital for low-impact initiatives. Character Count Reached, See the forum for the end of the Community Pool Section

Forum Post: https://forum.osmosis.zone/t/halve-staking-inflation-to-reduce-the-revenue-subsidy-3x-to-1-5x/3791