What’s At Stake In Staking?
Jan 18, 2022
While Bitcoin famously uses Proof-of-Work (PoW) through which miners reach consensus on the next block, many chains are using Proof-of-Stake (PoS). Instead of miners investing energy in a computing quiz, validators deposit an amount of their token capital as a stake, which allows them to participate in the block production. Should they fail to produce the next block when it is their turn – because they play foul, make a mistake or are simply offline – they forfeit some or all their stake (in a process called “slashing”). This economic incentive aims to ensure that validators behave honestly. Finally, a validator whose next block is accepted by the other validators, gets rewarded with newly minted tokens. Different chains use different combinations of voting and randomness to then decide who the validator for the next round will be, ensuring that power does not rest in the same hands for too long.
While from a network perspective, validators safeguard the integrity of the network and the transactions, one can also look at staking from an investment perspective. Next to trading or lending, staking constitutes an alternative investing mode for crypto assets.
With that basis, let’s investigate staking as an investment option.
Staking as investment
To get an impression, how staking as an investment strategy performed in the past, we picked some staking coins from popular PoS smart contract platforms: ADA (Cardano), ATOM (Cosmos), ETH (Ethereum), SOL (Solana), KSM (Kusama), DOT (Polkadot), and XTZ (Tezos).
While they all showed a strong price performance in 2021 ranging between +98% for XTZ and +760% for ADA, the price performance of SOL, the native coin of the Solana smart contract platform, stands out massively (Illustration 1). It is important to understand, that many different factors influence the price of coins. In the case of smart contract platforms, the mechanisms and price dynamics of fees are very relevant to users and developers.
Illustration 1: Price performance of popular staking coins (1.1.21-18.1.22)
While good price performance is positive for all investors, stakers are even more interested in the staking yield they get for locking their coins. Thus, staking is comparable to a fixed-income investment, however with another risk profile.
What are the pros and cons of engaging in staking? Engaging in staking is positive for the network as it helps keep it decentralized: the more validators and the more diverse they are, the better. Staking is also positive for stakers as it generates passive income, avoiding the need to make trading decisions on a regular basis. On the other side, staking locks away your funds for the staking period. In addition, funds that are at stake can be partly or entirely lost (“slashed”) whenever the validator fails in producing blocks because they are offline or because the blocks are not accepted by the other network participants.
Looking into more specific metrics, the popular staking coins listed above form an interesting landscape for an interested investor (Illustration 2). Here, we compare market cap (x-axis, billion USD), growth (y-axis, price change last 365 days in percent), and staking yield (bubble size, annualized staking yield in percent).
Illustration 2: Landscape of popular staking coins in 2021, comparing market cap, price growth, and current staking yield
Several observations can be made. First, Ethereum is a clear outlier (bottom right). Being the oldest, with most accumulated developer, user, and investor buy-in over time, it continues to be the most relevant smart contract platform at over ten times the size of its closest competitor. It is a major player in the staking space as the process of switching from PoW to PoS is well underway and a major step is expected to happen in 2022 (the “Merger”). However, growth and yield are among the lowest in the sample.
Second, Solana (top left) has shown a phenomenal growth over the last year compared to all other staking coins. While not offering the highest staking yields at all, investors have high hopes on several of its core features as a smart contract platform that clearly differentiate itself from Ethereum (c.f. Optimistic Concurrency Control).
Third, the staking heavyweights that offer double-digit annualized yields for staking seem to crowd in the bottom left corner for the time being. In terms of staking yield, the top is formed by a curious gathering of interoperability chains: Kusama, Cosmos, and Polkadot. For Kusama and Polkadot, the first parachain auctions only started in November 2021. With the eighth auction (Centrifuge) now underway, much more activity is to be expected in this ecosystem in 2022.
The rather high staking yields have to be seen in connection to the inflationary monetary policies of these chains, a convoluted topic we will investigate in a future Decrypt episode. In short, paying staking yields from newly created coins creates inflation. How this is done in detail and what limitations are put in place differs from chain to chain.
How to stake?
Interested investors have basically two options to enter the staking space. The first is “on-chain” by running an own validator node. While this option offers the full benefits and control over the staking process, it also has the highest requirements in terms of funds, hardware, software, and skills. For example, the minimum deposit to become an Eth2 validator node is 32 ETH (approx. 100’000 CHF).
The other option is to stake the coins through a crypto-service provider. It works the same as with trading: clients send fiat, convert it to crypto and then use the coins for trading or staking.
With the rise of a new generation of PoS chains, staking is establishing itself as another investment possibility in crypto. While it may look and feel close to fixed-income investment vehicles from TradFi, the risk/reward profile is different and needs to be understood before engaging in staking. Several staking coins performed very well in 2021 and new developments (Ethereum Merger, parachain auctions, etc.) will make it worthwhile to follow this space in the future as well.