Nov 30, 2021
Proof of Stake yield uniquely offers certainty, longevity, and scalability
The growth of blockchain and blockchain applications has created many opportunities for earning yield, which vary greatly in magnitude, duration, and risk. While “yield farmers” seek out the highest yields while they last, institutional investors seek yield that is reliable, scalable, and safe. This article asserts that yield from staking offers institutional investors what crypto-yield sources cannot — certainty, longevity, and scalability.
The nature of blockchain creates many sources of yield
Blockchain functions because everyone plays their part, and everyone plays their part because they are incentivized to do so. People’s use of blockchain networks is enabled by the activities of others, who earn a reward in the process. Let’s refer to the reward-earners as “Alice”, and the network users as “Bob”. Today there are more opportunities than ever for Alice to support the function of a blockchain and earn a yield — let’s examine these yield opportunities, and assess their risk, return, and stability.
Yield from trading fees — decentralized finance
The yield most spoken about recently is the yield from decentralized finance (DeFi) applications, which run on top of blockchains like Ethereum and have different requirements and incentives for Alice. For example, in order for a decentralized exchange (DEX) to support Bob’s buying and selling, Alice locks up her assets in a liquidity pool and earns trading fees in the process.
It is not hard for Alice to find yields in the hundreds of percent annualized, but these yields change in a matter of days or even hours, as the demand changes for trading of those particular assets. As assets rise and fall in popularity, Alice will have to move her capital from one pool of assets to another in order to continue to earn attractive rates (which is called “yield farming”).
The risk here is smart contract risk, where an exploit might be found that allows a hacker to steal funds from the protocol. These protocols are complex software performing novel functions in a relatively untested environment, written by teams often lacking the expertise to employ robust development practices. Exploits have allowed hackers to steal $285m via exploits in DeFi platforms, either via finding exploits in the protocol’s code or otherwise manipulating the assets on the periphery in order to achieve an unexpected behavior from the protocol.
Yield from interest — decentralized finance
A straightforward source of yield is from lending assets, where Alice is paid interest for allowing Bob to take out loans. Lenders contribute to a “pool”, which borrowers can borrow from, and the interest rate is set algorithmically depending on the balance of borrowing and lending. Loans are overcollateralized, and the protocol liquidates borrowers whose debt becomes equal to the amount of collateral they’ve put up.
Like the yield from earning trading fees, returns from lending are good but vary significantly, depending on the changing demand for loans. Again, Alice will likely engage in yield farming to continuously earn attractive yields.
The risk faced by a lender, like on other decentralized applications, is protocol risk, where an exploit might be found that allows a hacker to steal funds from the protocol governing the application. Because all of the lending is overcollateralized, there is no credit risk, but lenders do rely on the protocol to liquidate borrowers before they become bankrupt. Should the price of an asset suffer a liquidity crisis, or a stablecoin losses its peg, lending protocols may begin liquidating positions that were otherwise properly overcollateralized. (This happened in November 2020, when DAI reached $1.30 on Coinbase, triggering over $88m in liquidations on Compound protocol).
Yield from validating transactions — mining
The first-ever opportunity for Alice was Bitcoin mining, whereby she would perform the computation to assert the validity of blockchain transactions via “Proof of Work”. For each block of transactions she verified, she earned some newly created bitcoin. Today, bitcoin mining generates tens of millions of dollars daily and has spawned several publicly traded companies.
The profitability of a miner depends on their cost of electricity, the efficiency of their machines, the total amount of mining happening on the network, and of course the price of bitcoin in the marketplace. Mining can certainly be a profitable business, but that profitability changes over time, according to these factors. Today, entering the mining business requires high capital expenditures and is not without risk.
Yield from validating transactions — staking
More modern blockchains no longer rely on Proof of Work to verify transactions, instead, Proof of Stake has become the dominant method for verifying transactions. As explained in a previous blog post, Alice can put her blockchain tokens “at stake” in order to assert the validity of blockchain transactions, earning a reward of newly created tokens in the process. This removes the high capital expenditure required to enter the mining business, allowing investors of any size to earn a yield on their blockchain tokens.
The yield varies from blockchain to blockchain, with stakers currently earning an average real yield of 6.4%. (Source: Staked) On a given blockchain, the staking rate will adjust in order to incentivize or disincentivize token-holders from staking. The blockchain does this because it wants a certain percentage of the total supply of tokens to be staked — too few tokens being staked means the network is less secure, while too many means that people are holding the tokens instead of using them to transact and trade. As shown in the graphic, the target percentage for Polkadot is 75% — if less than 75% of the supply is staked, the yield rate increases, and if too many tokens are staked the yield rate decreases. (Note that Alice will also receive some small, additional income from transactions fees paid by the users like Bob).
The only risk of loss associated with staking is due to the event of a “slashing” penalty, which would be carried out if the staking infrastructure is run poorly or if attempts are made to insert malicious transactions into the blockchain. However, allowing tokens to be staked by third-party validators, the risk of slashing is very low. Figment, for example, uses Hardware Security Modules (HSM) to secure private keys and prevent double sign faults and has multi on-premise and off-premise secure server backup and redundancy. Blockdaemon, uses protocol-specific failover strategies to eliminate the risk of double-signing and is confident enough to insure any losses due to slashing. Chorus One, directly works with developer teams to ensure that there are no vulnerabilities in the underlying protocols. (They are even offering a $2m bug bounty for Lido for Solana).
Staking is crypto’s most reliable and scalable source of yield
As outlined above, there are several opportunities to earn yield in crypto, but it’s hard to find rates that don’t undergo large fluctuations or last for a short amount of time. We’ve discussed in the previous section that staking yields change but will not drop below the “worst-case” rate — this gives investors a level of certainty that they will not find with Defi yields.
In searching for a predictable, long-term source of yield in crypto, it makes sense that this could be collected in return for performing a service that blockchains will always need: helping to verify transactions. Since every blockchain needs to continuously achieve consensus to remain operational, staking yield from new supply will continue indefinitely, regardless of the demand on that blockchain.
Additionally, staking is a scalable source of yield. Adding more capital is just a matter of buying more tokens, and staking them with validators. According to stakingrewards.com, there are already $143b locked in staking. Compare this to the $47b locked in decentralized lending, or the $30b locked in decentralized exchanges, and it’s clear that bringing tens of billions of dollars to staking would make much less of an impact than it would in DeFi.
While staking might sound great on paper, achieving optimal staking rates and avoiding loss requires technical expertise, which is worth discussing.
Staking is still a technical challenge
If staking gives a relatively predictable yield with indefinite duration, scales with large amounts of capital, and doesn’t take on huge risks, what’s the catch? Is it just a way of printing free money? Well, no, staking is a reward for undertaking the verification of transactions on the blockchain, which is no easy task. It requires running secure, constant up-time infrastructure, with very little room for error, making sure to adhere to the rules of the blockchain network.
Each protocol has its own rules surrounding staking, requiring validators to adapt in order to earn yield safely and efficiently. A few examples: Some protocols define a maximum amount of tokens that can be staked on one node, requiring validators to spin up many nodes to stake large amounts of capital. Some protocols do not compound staking rewards automatically, which some require the validator to manually stake the newly earned rewards. If an investor wishes to remove tokens, “unstaking” may require waiting for a specific amount of time. These are a few of the issues that validators have to deal with, aside from making sure that their infrastructure stays online at all times and they never accidentally verify the same transaction twice.
These technical challenges, and the requirement to lock up tokens while they are being staked, have prevented the large majority of crypto exchange-traded products (ETPs) from including staking yield in their products, providing investors with anytime liquidity but not the chance to counteract supply inflation of their tokens. The limitations and opportunities in this space are becoming clear, and validators are playing an ever-larger role in the crypto ecosystem.
Validators are increasingly important
These days, there are plenty of highly competent validators with great track records, who will undertake the technical exercise of staking in exchange for a share of the reward. Validators can stake tokens without needing to take custody of them, meaning that investors can safely stake their assets with a validator from inside the account of a custodian.
The value that validators offer is evidenced by their growth. The first sign this year was in January when Coinbase acquired Bison Trails for around $80m. This fall, Blockdaemon, one of Finoa’s partner validators, officially became a unicorn after raising a $155 series B at a $1.26b valuation. The three staking providers that Finoa works with all have many billions of dollars worth of digital assets being staked on their infrastructure: Blockdaemon reports on their website staking over $10b of assets, Chorus One reports staking $3.9b, and Figment reported in August staking $7b.
Institutional investors need to participate in blockchain networks
As institutional capital becomes more interested in the yield opportunities within crypto, asset managers will have to learn how to put their assets to work by participating in blockchain networks. Incentive mechanisms are a key tenet of crypto — yield opportunities exist only for those who are willing to contribute to the health and security of the ecosystem. Due to the certainty and longevity it provides, staking may be the future of institutional yield generation in crypto, but that capital will have to work hand-in-hand with validators to ensure that staking is happening in a secure and efficient way.
At Finoa, we’re proud to work with industry-leading validators to provide our clients with an unrivaled level of transparency and choice when it comes to staking their digital assets. We’ve worked closely with blockchain developer teams and staking validators to ensure day-1 custody and staking support for MINA, NEAR, FLOW, ROSE, and SKL, and continue to play a critical role in the success and growth of emerging PoS blockchain protocols.
About Finoa
Finoa is a regulated custodian for digital assets, servicing professional investors with custody and staking. The platform enables its users to securely store and manage their crypto-assets, while providing a directly accessible, highly intuitive, and unique user experience, enabling seamless access to the ecosystem of Decentralized Finance (DeFi). Reference customers include the world’s most renowned Venture Capital firms, large corporations, and financial institutions. Finoa was founded in Berlin in 2018, has received a preliminary crypto custody license (§64y Para. 1 KWG), and is supervised by the German Federal Financial Supervisory Authority (BaFin).
