Staking as a GDP Dividend
If smart contract platforms are digital nation-states, is staking equivalent to a GDP dividend?
Crypto has become the foundational technology for a myriad of digitally-native industries. From decentralized finance (DeFi) to digital art and collectibles, several sectors emerged in 2021 with real-world adoption and remarkable growth.
Underneath these industries lie smart contract platforms such as Ethereum and Solana. These platforms provide the base layer supporting decentralized applications and the ownership of digital assets.
Being the fundamental infrastructure and security to these growing industries, smart contract platforms are arising as digital nation-states.
Like with physical nation-states, smart contract platforms have different sets of trade-offs and ideologies. Some are ruled by a small minority, while others have more democratic approaches to governance. Some smart contract platforms offer cheap production of goods (in the form of scalable blockspace), while others prioritize strong property rights (enabled by decentralization).
The Crucial Role of Staking
One of the most important decisions smart contract platform teams make in the inception of these digital nations is how they agree what is the “truth”. In order to establish trust between its citizens, smart contract platforms need a way to reach consensus.
The de facto consensus algorithm used by smart contract platforms is Proof of Stake (PoS). Though the specifications of PoS vary by blockchain, it consists of having a set of validators deposit — or stake — their capital to agree upon the state of the network.
PoS has several incentives and penalties in place in order to support a resilient infrastructure. In return for verifying transactions and securing the blockchain, validators receive staking rewards. If one of these validators is unreliable or malicious, they are slashed, making them lose part of their stake.
The conditions to become a validator vary by smart contract platform.
Most smart contract platforms require validators to have a minimum amount of the network’s native token at stake. This amount can be prohibitively large for many looking to become a validator. In some cases like in Binance Smart Chain, there is no way to become a validator unless you are appointed.
In addition to inflationary rewards from the issuance of native tokens, many smart contract platforms also compensate validators with part of transaction fees paid by users of decentralized applications or tokens in these networks.
Continuing the metaphor of smart contract platforms as nation-states, compensating validators with a portion of the network’s economic activity is analogous to giving citizens a dividend off of the country’s GDP.
Ethereum Economy Case Study
Being the first smart contract platform, Ethereum has captured a large share of the innovation. Decentralized applications in the so-called web 3.0 have blossomed on top of Ethereum. The major sectors currently generating economic activity on Ethereum are finance, art and gaming.
Decentralized finance (DeFi) was arguably the first sector to gain traction in these digital economies. Protocols like MakerDAO pioneered the path for crypto-native financial services by allowing users to borrow capital in the form of their stablecoin DAI.
Since these financial applications generally require the user to provide collateral or a deposit of some form, total value locked (TVL) has become the barometer for DeFi’s growth. TVL measures the amount of capital users supply to the smart contracts comprising DeFi applications.
TVL on Ethereum is today approximately $100 billion, up from $25 billion in January 2021 and near-zero in 2018.
By depositing into and interacting with DeFi protocols, users have to pay transaction fees for gas on Ethereum. Today part of these fees gets paid to miners, who act as the network validators under the Proof of Work (PoW) consensus algorithm.
However, Ethereum’s transition to Proof of Stake has been in development for years and is expected to be finalized in 2022. With the launch of the Beacon Chain in December 2020, users began testing a PoS blockchain running in parallel with the PoW mainnet. The Beacon Chain does not yet run any applications as it is used to battle-test the staking algorithm prior to having value on top of it.
Users running validator nodes for the Beacon Chain have to lock their ETH and are compensated with issuance rewards. Currently $33 billion worth of ETH is staked in the Beacon Chain, generating depositors approximately 5% APY.
Following the merge of the Beacon Chain and the current mainnet, transaction fees that now go to miners will be rewarded to validators staking in the network. (It is worth noting that the majority of fees [75% — 90%] are burned following the implementation of EIP-1559 and that is expected to continue being the case after the merge).
Rewarding validators with transaction fees aligns their incentives with the network’s economic activity. Since the return they obtain from staking grows proportionally with transaction activity, it is in validators’ best interests to foster economic growth. In other words, offering a “GDP dividend” encourages citizens of these digital nation-states to further grow their economy.
Based on the transaction fees and the growth of ETH being staked in the past 7, 30 and 90 days, this is expected to increase the APY validators earn to somewhere between 10% and 12%.
Not only are higher staking APYs great for validators, they also improve the network’s security. This is the case as greater returns incentivize more ETH to be staked, and having more value staked make it more expensive to anyone to attempt to attack the network since they would need larger holdings to influence consensus.
This highlights how staking plays a crucial role in the growth and security of smart contract platforms. As blockchain technology matures and starts living up to its potential, it is possible that the GDP of these digital nation-states surpasses that of some physical ones. This sets the ground for years of innovation, enabled by networks rewarding its participants.
