This article was compiled and organized by BlockWeeks
Just like traditional finance, credit is the cornerstone of DeFi. It serves as a liquidity hub, powering the growth of the entire on-chain economy. However, discussions in the on-chain world mostly focus on speed and transactions, habitually using throughput and execution efficiency as measures, while overlooking the core that truly supports real-world financial markets: credit.
Without robust credit applications, decentralized finance would become hollow, just as the traditional financial system would shrink dramatically without banks, credit unions, and other lending institutions. The key point is that credit markets with liquidity and scalability cannot be purely "engineered" into existence. Unlike decentralized exchanges (DEXs)—which perform best on chains with superior performance and can operate with thin liquidity—lending protocols typically require deep liquidity and high-quality assets to function optimally. No amount of throughput or block space can replace this.
Ethereum is the best example: despite being one of the slowest and historically most expensive blockchains to use, it hosts the largest and most resilient lending market because it brings together the full spectrum from high-quality assets to ample liquidity.
Staking and Lending: Structural Tension in L1 Economics
An important but underappreciated structural constraint in on-chain lending markets comes from the network's native staking. High staking rates reduce the available supply of the network's base asset, which can limit the depth and bootstrapping capacity of on-chain lending markets. This article explores the subtle yet powerful relationship between staking dynamics and the development of the credit layer, and why it constrains credit applications more severely than other DeFi sectors.
For proof-of-stake (PoS) L1 tokens such as ETH and SOL, there are two main, competing sources of yield: first, core protocol participation, i.e., staking; second, financial market participation, i.e., DeFi.
Over-leaning toward one side can "starve" the other. However, liquid staking tokens (LST) provide a workaround, allowing users to participate in both staking and DeFi simultaneously.
Historically, many users have preferred staking, often at the expense of DeFi liquidity. This is natural: staking is available immediately at the chain's launch, unconstrained by scalability (theoretically, a chain's entire token supply can be staked), is a more passive activity with lower immediate risk, and offers more stable, more predictable yields. In contrast, the DeFi ecosystem takes time to scale and carries market-level and application-level risks. Therefore, for some users, staking often provides a better risk-adjusted source of yield, typically being the heavier end of the "DeFi—staking" barbell relationship.
How High Staking Rates Squeeze High-Quality Collateral
The core issue of this dynamic in the context of credit markets is that a scalable and competitive lending market needs to be built on deep, cohesive liquidity resting on a large and diverse base of high-quality assets. For an L1 chain, these assets are primarily its native token, liquid staking derivatives (such as Ethereum's ETH and stETH, Solana's SOL and jitoSOL), and other synthetic assets built on top of them.
When a chain's native asset is heavily staked—yet not enough of it exists in the form of LSTs or other liquid synthetic assets—the available supply of high-quality collateral becomes constrained, thereby stifling the liquidity and high-quality collateral base that supports the chain's lending market. A shortage of high-quality assets may force lending applications to:
- A. Move down the collateral risk curve (e.g., introducing meme coins and DAO tokens) to fuel the market;
- B. Import collateral from other chains (such as wrapped bitcoin) or from off-chain;
- C. Tighten market parameters, thereby limiting the efficiency and role of the chain's native asset and other asset types as collateral.
In either case, obtaining high-quality collateral and scaling credit applications becomes an uphill battle.
Causes of Over-Leaning Toward Staking
Over-leaning toward staking can arise for multiple reasons. On a newly launched, still-immature network, users default to staking because the chain's native asset does not have many other uses. A chain's staking design—for example, the differences between delegated PoS and Ethereum's validator-based PoS, or between instant staking/unstaking and queued designs—may naturally promote or hinder LST adoption and limit access to the underlying staked asset. Staking yields and other benefits attached to staking (such as airdrops and fee discounts) may be so high that DeFi applications struggle to compete in absolute returns. These factors can compound one another, amplifying or mitigating the negative impact of staking on credit markets.
Conversely, in an environment with constrained collateral quality and liquidity, lending applications are often forced into one of the following suboptimal combinations:
- Adopting siloed designs as risk protection, further fragmenting already-thin liquidity and weakening network effects;
- Setting stricter parameters to balance "lower-quality" collateral, thereby capping the efficiency and scalability ceiling of the assets they attract;
- Compensating liquidity providers (LPs), especially stablecoin LPs, to create incentives for some users to turn to DeFi for passive yield rather than staking.
Ethereum's First-Mover Advantage: The Deep Embedding of wrapped BTC
Ethereum has a multi-year first-mover advantage in integrating wrapped bitcoin as collateral for its lending markets, and this early adoption has brought structural advantages that compound over time.
When wrapped BTC products began to gain substantial traction in 2019–2020, Ethereum was the dominant smart contract platform, with very limited competition for BTC holders looking to deploy their assets into DeFi. Although other L1 platforms such as EOS, Cardano, Tron, and NEO were marketed as "Ethereum killers" in 2017–2018, by 2019–2020 none of them had delivered on their promises or developed meaningful lending infrastructure. EOS and Tron launched early DeFi ecosystems with basic lending protocols in late 2019, but at a scale far smaller than the established applications on Ethereum, such as Sky (then MakerDAO), Aave, and Compound. Moreover, new chains launching in 2020 and beyond also had to compete with Ethereum's Lindy effect and the first-mover advantage it accumulated during the 2017–2018 "Ethereum killer" cycle.
Ethereum's position was further reinforced by infrastructure advantages. By 2019–2020, Ethereum had more mature wallet infrastructure (MetaMask, hardware wallets) and established channels for onboarding users from centralized exchanges, making it easy for Bitcoin holders to bridge across chains and interact with DeFi protocols. Competing chains lacked this ecosystem maturity, and the resulting friction further tilted the competitive balance toward Ethereum.
This early integration allowed Ethereum to deeply embed wrapped BTC into its credit infrastructure before competitors established viable alternatives. By the time other L1 chains matured enough in 2021 and beyond to support complex lending markets, billions of dollars of wrapped BTC were already locked in the Ethereum ecosystem and integrated into dozens of protocols. Challenging this deeply entrenched position is by no means easy.
Conclusion
For credit applications, staking is not just a competing source of yield, but a structural constraint—because it limits the scarce resource on which lending markets depend: ample, high-quality collateral. This also means that emerging chains seeking to cultivate their own credit layer must make trade-offs among staking design, the LST ecosystem, and DeFi incentives; otherwise, the gap in high-quality collateral will continue to suppress the depth and scalability of their lending markets.
