Staking: An opportunity in a yield-restricted financial ecosystem
Since the inception of cryptocurrencies, most investors have had to solely depend on price appreciation to earn value from holding their crypto assets. Although price fluctuations provided more potential upsides than many traditional assets, it was only in recent years that staking opportunities began to transpire. Investors could start earning yields on their crypto assets by locking capital in a blockchain protocol for far more attractive returns. By April 2022, the total value of cryptocurrencies staked reached approximately USD 280 billion.
As the digital asset economy is pivoting towards “proof-of-stake” blockchains, this transition provided investors with a wider variety of new cryptocurrencies that can be staked. These blockchains also provided competitive return rates for staking, which have also caught the attention of many institutional investors, who are scouting for new high-growth opportunities for their clients. Proof-of-stake blockchains have thus become a new gateway for offering alternative investment opportunities, providing higher returns for both new and seasoned investors alike.
Staking solves blockchain’s energy consumption problem
Bitcoin, the most popular cryptocurrency, has long been criticised for its excessive energy consumption, incurring high fees and slow transfer times and suffering from heavy network congestion. However, as the popularity of Ethereum grew, the blockchain also began to suffer from similar issues (most notably high gas fees). This led Ethereum’s developers to launch a multi-year undertaking, dubbed “The Merge,” which will enable the blockchain to shift from a proof-of-work (PoW) to a proof-of-stake (PoS) consensus mechanism. The successful completion of the upgrade will lead to a substantial decrease in the energy consumption (approximately 99.95 percent) required for validating transactions across the entire chain.
Bitcoin’s energy rose sharply to a record high of 177.43 TWh per year, in October 2021. This is more than the energy consumption of countries such as the Netherlands, Malaysia, Argentina or Egypt. In May, Ethereum’s energy consumption peaked at approximately 93.981 TWh per year, which is more than what Belgium, Poland, Columbia, or Portugal consumed. Even though Ethereum’s energy consumption is half of Bitcoin’s, it is still exceedingly high. But with asset prices depreciating in recent months, both blockchains saw their energy consumption drop significantly due to the decline in overall blockchain activity and transfers amid the market uncertainty. This is only a temporary setback, as energy consumption will continue to rise again once markets recover.
Ethereum Energy Consumption TWh 13.07.2022. Source: Statista
What is staking?
Staking is simply locking your digital assets for a certain period. It requires participants to put up their crypto as collateral for the opportunity to successfully approve transactions. These assets are “pledged” to a smart contract for a certain amount of time and given a reward (ETH for Ethereum) for verifying new transactions. These blockchains are different to Bitcoin’s PoW consensus mechanism as Bitcoin requires certain amounts of computational power to verify transactions and produce new blocks. The bigger the blockchain gets, the more computational power is needed to verify the growing number of transactions, and this is root issue for proof-of-work’s energy consumption problem today.
How does proof-of-stake work?
Proof-of-stake is a consensus mechanism for processing transactions and creating new blocks. When you stake, you are essentially locking up your coins to a smart contract. The blockchain algorithm then selects “validators” to check each new block of data based on how much crypto they have staked. The more coins you have staked, the better your chance of being chosen as a validator will be: validators are responsible for creating new blocks. When the data is cleared by the validator, it is then added to the blockchain and once this happens, they receive newly “minted” coins as a reward.
How staking contributes to network security
When you are staking on a PoS blockchain, you are also making the network more secure. This is because the funds you stake become part of the network’s security and transaction validation process. Staking also means that you have put up your crypto as collateral (bonded capital), meaning that if you attempt any incorrect behaviour, or try to cheat, you can risk losing your staked coins or being removed from the blockchain entirely. However, this may vary from blockchain to blockchain.
Staking may also provide long-term value, as it can reduce token velocity (the rate at which the tokens are exchanged) and the circulating supply (locked tokens that are inaccessible for a certain period) in the market leading to price appreciation. This also improves the overall “security” from hackers as it becomes more expensive for an entity or individual to purchase 51 percent of the network and control it.
Understanding staking yields correctly
When someone stakes their coins, they are rewarded with the blockchain’s newly “minted” native coin. Rewards are calculated based on the amount of coins that you have staked – the more you stake, the more you are rewarded.
Staking rewards may come from inflation (where new coins are added to the network), or from transactions fees, or a combination of both. If rewards come solely from inflation, long-term prospects might not be attractive because any real returns are eaten away by the blockchain’s supply inflation. For example, if you get a six percent yield on your holdings per annum, you would not earn anything if the supply also increased six percent annually (token holder dilution rate – token holders' reduced participation in the network). On the other hand, a staker’s rewards can be substantially more positive if the returns are being calculated from both inflation and transaction fees, with the latter deriving from the growing popularity of the blockchain (innovation, Dapps, trading activity, widespread use).
Examples of protocols that provide staking: Ethereum (2.0), Solana, Polygon, Tezos, Avalanche, Cardano. Algorand, Tron, Dfinity’s Internet Computer, Polkadot, Near Protocol, Hedera Hashgraph.
To stake or not to stake
Investors holding PoS coins without staking them are likely to lose out on their investments. This is because staking is a redistribution of coins from unstaked to staked investors. For more long-term success, PoS coin holders should be staking their crypto holdings to avoid dilution.
The relevance of staking cannot be ignored as the yield returns are incredibly attractive, but many investors will find it technically challenging to set up. Investors also need to understand the specifics of how blockchains generate staking rewards, let alone to set up a contract to “stake” (i.e. running a node). This can be an arduous task as many potential investors are not technically literate enough to comprehend the complex whitepapers and models of various crypto projects.
This technical “blackbox” paved the way for many staking products to emerge, as many investors started turning to professional “staking-as-a-service" providers who manage the technicalities of the staking process on their behalf. How it works is quite simple: the investors delegate their coins to a third-party operator (the staking-as-a-service provider), who manages a set of validators. In return, investors receive their returns after their coins have been staked for a certain period of time.
As a regulated digital asset bank, Sygnum offers institutional and professional investors with the opportunity to access ETH2.0 yields by staking their Ether (ETH) in a similar fashion, albeit in a secure and regulated manner. Sygnum also provides staking for other cryptocurrencies, such as Tezos (XTZ) and Internet Computer (ICP), with more options in the pipeline.
With Ethereum's merge close to completion, the rise of PoS blockchains will make staking even more popular among traditional institutions and investors. Not only will Ether provide new opportunities with higher returns, but market entry will become easier due to underlying regulatory and ESG requirements that large institutions must uphold when evaluating their investment opportunities. Sygnum Bank is the only regulated bank in the world to offer ETH2.0 staking to its clients.
Learn more about Sygnum's staking offering here.
 Digiconomist. Energy Consumption Index. 13/07/2022. https://digiconomist.net/ethereum-energy-consumption
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