TLDR; Staking is radical in the crypto world. It recreates parallels to traditional finance which is something mainstream investors understand. We make the case that though staking yields look approachable, they are still nuanced. An investor must think about token economics, security budgeting and tax efficiency when considering staking.
This is a guest post by Ashwath Balakrishnan, a freelance crypto-analyst with a background in traditional finance. Give him a follow on Twitter at @ashwath_22.
Why is Staking such a big deal?
Cryptocurrency investing has been limited to capital appreciation for the best part of the industry's life thus far. The introduction of staking changes this by utilizing capital to earn consistent yields rather than hold a token idle in a wallet waiting for its price to go up. The staking mechanism converts a non-productive use of an asset into a productive use. If the price of the token were to go up, the investor additionally benefits from the appreciation as before. The closest analogy is a rental property investment – not only does the property itself appreciate in value, it additionally produces yield in terms of rental income.
Soon enough, anyone with 32 ETH will be able to stake against the upcoming ETH 2.0 Proof of Stake (PoS) Beacon chain. Besides ETH 2.0, there are about 50 networks launching in 2020 with some kind of staking rewards mechanism promising attractive yields.
Staking is a driver for token price appreciation
One of the main effects of staking is the impact it has on the orderbook mechanics of a token. Every unit of a token locked up in a staking protocol takes that unit out of the circulating supply on the open market. A reduction in a token's free float would cause a reduction in the supply to orderbooks. As a result, demand-supply economics dictate that there's a probability that the price of the token appreciates.
This dynamic was visibile in the Synthetix Network's SNX token. Nearly 80% of the circulating supply is locked up in the protocol. The free float reduction led to fewer sellers and the price has been on a continuous rise since the launch in March 2019. In order to kick-start this process of coercing whales to lock up their tokens, the protocol must offer incentives (i.e. staking rewards) that make staking worthwhile. Synthetix's first-year staking yields of nearly 80% was enough of an incentive to increase staking participation.
Synthetix's token economic success with staking has made a lot of projects reconsider their token economics framework. The likes of 0x's token (ZRX) and Kyber's network token (KNC) moving from utility token models to staking token models is a cursor into this new trend.
Our thesis: We are moving to a multi-layered staking system reinventing the bond market from traditional finance attractive to mainstream investors.
Staking reinvents the bond market
Staking is locking up capital in a protocol; investing in a bond is locking capital with an entity. The variety of yields correspond to the underlying risk taken up by investors. For example, you can consider sovereign bonds as the least risky but corporate bonds more risky – and the yields reflect that.
Our parallels for staking assets are:
- Layer one assets like ETH 2.0 ↔️ Tier one sovereign instruments like United States t-bills
- Other Layer one assets like Cosmos ↔️ Perhaps other sovereign instruments like Chinese t-bills
- dApp staking on Ethereum like Synthetix, 0x and Kyber ↔️ Corporate bonds
- Other dApp and application-specific staking ↔️ Junk bonds
ETH in particular is considered the "safest" investment in the entire stack. The safety stems from two factors: 1) The staking deposit contract is likely to undergo more rigorous stress testing and audits than any smart contract has ever seen and 2) ETH already has the longevity and utility as an asset.
A step down would be other layer one assets like Cosmos, Tezos and 50 other chains that are launching in 2020. These chains have large and heavy balance sheets and can compensate investors for a long time before thinking about sustainability.
A step further down we have dApp staking on Ethereum with the likes of Synthetix, 0x, Kyber amongst others. These protocols already have the usage and traction. These are similar to corporate debt instruments issued by companies and bond holders are paid using the income a company earns from operating. Since they exist on a layer one chain, they have additional platform risk that they have to compensate investors. Hence their staking rewards are higher than layer one chains.
The riskiest asset is if your dApp is a staking network on an unlaunched layer one chain, or on an application specific blockchain. These assets therefore have the highest rewards.
Challenges for mainstream investors coming to crypto staking
THIS POST IS NOT FINANCIAL/INVESTMENT/TAX ADVICE.
Yield rates are not the only qualifier when considering an investment. Picking the right asset is a gradated process. Factors to consider:
1. Token economics
The yield is generated from two factors: 1) staking rewards and 2) transaction fees.
If the protocol or end-product doesn't have actual utility and usage – the transaction fee income will be negligible. Without usage, the token price will invariably slip. So even accruing more tokens through staking can yield a negative overall ROI.
Most staking economic models also feature a dynamic inflation rate (new tokens minted in order to distribute staking rewards) based on a target staking participation rate. As a result, your rewards are also variable and is something you'll have to factor into your decision.
Accurate PnL (profit-and-loss), record-keeping and analytics around the usage of a network, the entry/closing prices, staking reward distributions and slashing conditions with software is crucial. We are building SafeKeep to help investors with this data availability gap, starting with ETH 2.0.
Mainstream investors are not going to keep custody of the staking assets and would rather outsource this responsibility to a vendor.
There are lots of "Staking As A Service" vendors that can stake your tokens on your behalf for a service fee. An investor will have to investigate the performance of a staking provider and their slashing history to make a decision. Our thesis is that every major exchange will offer staking as a service in 2020 if not already.
3. Security budgeting
Token price appreciation and staking yields have different tax treatments. If an investor's staking rewards are taxed inefficiently as income, this consideration is directly reflected in the security budget of the network.
Convergence of staking and the bond market is representative of crypto’s core ambition of recreating existing infrastructure in a permissionless and decentralized manner. The bond market is controlled by a select few entities who have the ability to change the rules of the game as they see fit. While network stakers have power in the system, they cannot change the rules of consensus without the approval of the larger community.
Crypto assets that integrate staking mechanisms are starting to mimic the bond hierarchy in terms of the risk-reward they offer investors. Based on this conclusion, it seems fair to further theorize that traditional investors will soon find navigating the cryptocurrency landscape a tad bit easier.
Follow the conversation on Twitter
1 Thesis: Staking is recreating the bond market from traditional finance. This is attractive to mainstream investors and will pull them to crypto.We make the case that though staking looks approachable, they are still nuanced. 🤔A thread: ⬇️⬇️⬇️— Ganesh Swami (@gane5h) February 10, 2020<script async src="https://platform.twitter.com/widgets.js" charset="utf-8"></script>