Paper & Blocks

Question: Why does staking matter?

Answer: Financial asset productivity.

Let me explain.

What is Staking?

Staking is a process by which a crypto asset owner can lock up their coins in order to participate in running a blockchain and maintaining its security.

Of course, this is only true for blockchains that use a proof-of-stake (POS) consensus mechanism like Solana, Avalanche, and as of Sept 15^th 2022, Ethereum.

In these protocols, assets are staked to a “validator node” which are randomly selected to propose the next block and earn a reward for doing so. This block reward makes staking a profitable endeavour with yields constantly fluctuating depending on demand/supply. Today, yields hover around 4%-7% on ETH and SOL – see below for details.

The more assets a token holder stakes, the higher their chance at earning the reward, and the more ‘skin in the game’ they have. This skin in the game is important to align the incentives of network participants. If a staker acts dishonestly or performs any malicious activity, their staked assets will be slashed as a penalty.

In short, staking provides a way for crypto asset owners to generate yield on the assets they hold, akin to how bank deposits accrue interest over time.

But this post is not about what staking is, but rather, why it matters: which is direct financial asset productivity.

Why Are Financial Assets Unproductive Today?

In short, it is because we do not have financial automation.

Plenty of other types of financial assets can be pledged to generate yield. Banking clients pledge their deposits so that their financial institution can lend them out and share a proportion of interest back with the depositor.  Securities can be pledged in a similar fashion, able to be leant out by the brokerage house to others (typical borrowers in this case are short sellers) through securities lending programs where the institution and securities holder share in profits generated. In both examples, a financial intermediary is necessary to facilitate the maturity transformation (deposits) and securities lending to generate the yield—and those intermediaries keep a weighty share.

RBC has a 52.6% efficiency ratio. It also pays out an average of 0.95% on its deposits and yields 2.78% on interest earning assets, suggesting the bank keeps a large percentage of what it earns. This makes sense. Dividends and bank branches are not cheap to maintain.

Interactive Brokers is a little better, paying the client 50% of the income it earns from lending their shares through their stock yield enhancement program. Global trading platforms are not cheap to operate either.

It is indirect asset productivity, done so manually and inefficiently through traditional financial system participants.

Staking Makes Assets Directly Productive

As I wrote about in The Ultimate Disintermediator of Financial Labor, since crypto gives us a never-before-seen programmable form of capital, we are now able to automate financial labor.

In this sense, staking uses capital to complete the financial labor of running and securing a financial system (aka blockchain) akin to the manual labor in the traditional financial system that used to be handled by banks, payment rails and clearing houses. It is a way to make idle assets ‘productive’ by having them participate in the execution of financial tasks in order to earn a return.

Staking is direct asset productivity, allowing asset holders to fully participate in the returns they generate, keeping 100%.

Direct Asset Productivity Implications for Crypto

Staking perfectly illustrates the beauty of crypto, it is financial automation at its best.

Yet, this is not simply automating maturity transformation or securities lending, it is automating a set of activities that underpin an entire financial system, and the implications are wide-ranging.

Uncorrelated yield: First, is the nature of staking yield. While historical data is lacking, staking yield will likely have a different set of influences than other financial products with fixed income-like return profiles. In Ethereum, for example, there are five different components that make up the total yield for validators (see below), a large part of which are tied to the base reward. The base reward for staking is inversely proportional to the number of validators on the network, so as more people stake, the base reward falls. The other influence is the demand for block space, or the current amount of on-chain activity. This largely influences the amount of tips and MEV available to validators. As activity increases, so to should rewards. All of these influences may produce a yield that provides some diversification benefits to existing fixed income portfolios.

Side note: Ethereum’s POS merge has come at an unfavourable time in the interest rate cycle where short-term interest rates are aggressively coming off of their COVID-induced lows. Consequently, staking yield is less attractive than it once was, which may actually be a good thing, tempering speculation in the near-term.

Cash flow production: Now that crypto can be viewed as a yield generating asset, it now has cashflows and a valuation model that feel more familiar to those in TradFi. A knock against proof-of-work (POW) blockchains like bitcoin is that since they reward third parties (miners) to perform the “work” of adding valid blocks to the chain, the asset itself does not produce any cash flows. This is why bitcoin has drawn comparisons to gold rather than stocks or bonds. Proof-of-stake, on the other hand, has a cash flow profile akin to a dividend paying stock. This is a much more familiar set of characteristics for investors to analyze. Existing valuation metrics and models can now be applied to crypto. A protocol’s yield can now be stacked side-by-side against other comps in the market (dividend yields, interest rates, etc.) which treads into much more comfortable territory for institutional investors. The days of pushing the same ‘inflation hedge’ narrative that the gold bugs have been pushing for decades will soon only exist in the POW faction of crypto.

Yield opportunity gateway: A person’s early progression through crypto often go something like this:

• 1/ Awareness: Curiosity and loose exposure to crypto.com ads and high school acquaintances striking it rich lead to a first purchase.
• 2/ Participation: That first purchase will probably be through a simple access point like Coinbase where the overwhelming number of cryptoasset options leads to the purchase of either ETH or BTC.
• 3/ Exploration: As time goes on and the curiosity continues, more esoteric assets might be added to the portfolio. MATIC or SHIB, anyone?

It is at this exploration stage that ‘staking’ might come into focus. This first exposure to ‘locking up’ assets in order to generate yield is simple and can be executed through most large CeFi platforms like Coinbase.

Note: Most staking is done this way, where large platforms set-up a validator and a staking pool where token holders can delegate assets. This significantly lowers the barrier to entry for more users to participate.

Although staking may be the most obvious yield generating activity, it is far from the most common. Staking can be a gateway into the world of DeFi, which offers token holders a variety of other opportunities to repeat that increasingly familiar behaviour of locking up assets in exchange for yield. DeFi is an entire ecosystem created to automate financial labor: depositing, borrowing, lending, trading, and hedging are fully automated activities that can be accessed with ease. Their execution often generating yield for those that provide the ‘locked up’ assets necessary for the protocols to operate. Staking is the gateway, DeFi is the world beyond.

There is a Path to Greater Financial Asset Productivity…

Not only does staking offer a yield diversification mechanism, the familiarity of cashflow based valuation, and a gateway to other sources of yield in crypto, it also does so with relative equality. There is equal opportunity to participate between those with a lot and those with a little. For example, ceteris paribus, two people with 100,000 SOL and 0.01 SOL have the same opportunity to stake on the Solana blockchain (although access through a staking pool might have a higher minimum bar to clear).

There is also a community element to staking. By locking up your assets, you are supporting the project you are staking to. You are showing commitment. You are contributing to the security and efficiency of the blockchain. You are part of the protocol’s community. That is a badge people wear with varying degrees of honor.

With news this month that Canadian regulators gave the greenlight to both Wealthsimple and Bitbuy to offer staking services to their clients, Canadians now have a path to enhance the financial asset productivity of their crypto assets. But this is just the beginning.

As time goes on, and these opportunities proliferate, anyone with on-chain assets will eventually have  choice: do I want to keep my assets idle and unproductive; or, do I want my assets to serve a purpose, contribute to the system, and generate some returns.

Staking provides a path to greater financial asset productivity… that is why it matters.