Why Institutions Should Have a Stake in the Future of Ethereum
Ethereum is the second largest blockchain by market cap, but is the first blockchain to combine trusted, immutable transaction records with programmable contracts. This combination enables developers to deploy smart contracts, which are digital agreements that automatically execute once predetermined conditions are met. These smart contracts are transforming transactions among counterparties in the finance, gaming, legal, real estate, and healthcare industries. They’re also changing how businesses are administered with the rise of decentralized autonomous organizations (DAOs). The programmable nature of Ethereum means there is more to the value of this blockchain than just the price of Eth tokens.
What is the future for Ethereum?
While Ethereum could be the future for computing across industries, it’s not without its problems. This includes high transaction costs, known as gas fees, which are often cost prohibitive for users. Transaction times can be long and often take several minutes. Users are accustomed to the immediacy of typical internet transactions, so this is a major barrier to adoption. Significant costs also exist for network node operators or “miners”, who validate transactions on ethereum.
Ethereum uses a “proof of work” consensus mechanism to ensure the validity of transactions. Proof of work pits miners against one another in a race to solve mathematical puzzles. Winners are awarded Eth for successfully creating the newest block to be added to the chain. While solving puzzles to validate Eth transactions is an effective consensus and security mechanism, it’s also a massive waste of energy. Many countries are scrutinizing proof of work blockchains and considering bans due to the energy required and its environmental impact.
ETH2 staking to the rescue
To address these challenges, the Ethereum Foundation has built a new blockchain with a more efficient consensus mechanism. The new blockchain, Ethereum 2.0 or Eth2, will merge with Eth to create a single Ethereum chain. This upgrade has the potential to expand Ethereum’s dominance among developers and users. Eth2, in its final form, will be much faster, increasing from 30 transactions per second to nearly 100,000. Most importantly Eth2 uses “proof of stake” rather than proof of work to validate transactions.
Proof of stake also uses a distributed network of node operators but instead of a race among miners, consensus is reached by a collaborative group of validators holding Eth. To be a validator, participants must lock at least 32 Eth in a smart contract, in a process called staking. The staked Eth is the collateral that ensures validators participate and behave appropriately. Validators simply participate in the blockchain to receive interest on their staked Eth. Proof of stake encourages and rewards participation by all validators. This system also eliminates the huge energy cost that comes with proof of work. Validators are currently making 4.8% interest (APR) on their staked Eth.
However, this is not a risk free rate of return. When validators go offline or validate incorrect transactions, they are penalized by “slashing.” Slashing occurs when a validator is punished by losing some or all their staked Eth. Staked Eth is locked, and cannot be withdrawn until some time after the merge is completed. Once the merge is complete, the price of Eth may fall as validators are permitted to withdraw their Eth. Conversely, as more Eth is staked, the rate of return will fall. While the Ethereum merge is set for somewhere around September 15th, 2022, this date has changed several times, and may change again. Lastly, validators need to stake at least 32 Eth, which is approximately $54,400 today.
Institutional approaches for Eth2 staking
There are two options for institutions considering Eth staking. The first is solo staking. Solo staking means running your own validator node, and a significant investment in both knowledge and hardware. Successfully running a validator node requires trained staff to set up and manage complex software that comes with real financial risk if misconfigured. Solo staking will earn a higher APR by avoiding potential fees from third party staking services and leaves the investor in complete control of their assets.
The second, and more popular, option for institutions are staking services. Third parties provide everything necessary to keep a validator node up and running. Institutions need to delegate at least 32 Eth to the service provider and pay a monthly fee, typically between 5–15% of the staking rewards. While staking services offer an easier way to participate in Eth staking, institutions are vulnerable to counterparty risk. At the least, the staking provider can expose the institution to slashing risk if the third party’s software goes down for a significant amount of time. Depending on the model of the provider, they may require to take custody of the Eth, creating a more complex range of risks to consider. The leading staking providers are Figment and Blockdaemon.
While not likely an attractive option for institutional investors, there is a third option preferred by retail investors. Pooled staking aggregates investors in order to meet the 32 Eth staking threshold. While investors receive tokens for Eth in the staking pool, which can be used as collateral in DeFi opportunities, there are additional risks. In addition to the counterparty risk with the pool administrator, investors are exposed to smart contract risks when depositing and withdrawing funds from a pooled staking platform. An example of one such service is Lido.
Expanding institutional appetite for Eth
Proof of stake removes a significant barrier for investors that take environmental, social and corporate governance (ESG) into consideration, as Eth2 will use 99.95% less energy. Cryptocurrencies already address the social and governance needs for ESG minded investors. In general, Eth and crypto empower any internet connected individual to perform financial transactions. From a governance perspective, the Ethereum foundation is a non-profit organization dedicated to supporting Ethereum and related technologies.
Should Institutions Stake Eth?
Staking Eth provides institutions with additional yield on crypto investments, and an opportunity to bet on the future of internet computing. Validators earn interest from staking, while investing in a key platform for Web3 and future applications. Eth prices may continue to rise as the wider market sees the value of a faster and cheaper programmatic blockchain powered by proof of stake. For these reasons, institutions investing in cryptocurrencies should consider staking Eth as a key component of their overall digital asset strategy.
About Floating Point Group:
Floating Point Group is building secure and effortless access to cryptocurrency. FPG drastically simplifies the operations necessary for asset managers to deploy cryptocurrency-centric strategies at meaningful scale via two product lines: FlowVault, a secure settlement and transfers platform for safer exchange-based trading, and an agency execution desk — enabling blockchain foundations, venture capital firms, or hedge funds responsible and highly customized order execution structures.
Disclaimer:
This communication should not be relied upon as research, investment advice, or a recommendation regarding any products, strategies, or any asset in particular. This material is strictly for illustrative, educational, or informational purposes and is subject to change.
