Proof of Stake (PoS) will possibly overtake Proof of Work (PoW) as the consensus mechanism of choice for new innovative blockchains by 2021. PoS is used by five of the top ten base layer blockchains: Ethereum 2.0, Cardano, Solana, Polkadot, and Terra Luna. It’s easy to see why PoS blockchains are so popular: the ability to use tokens to verify transactions and earn rewards while doing so allows investors to earn passive income while also strengthening the security of the blockchain network they’ve invested in.
Despite the amazing progress achieved by blockchain, financial products and services available to institutional investors have lagged behind. For example, 24 crypto exchange-traded products (ETPs) on the market indicate ownership of pledged tokens, but only three earn income from the pledge. Not only did ETP holders miss out on staking gains, but they also had to pay management costs ranging from 1.8 percent to 2.3 percent.
The lack of staking for ETP is acceptable, as staking requires tokens to be locked for periods ranging from a few days to a few weeks, which adds to the complexity of goods that should be simple to trade on exchanges.
Missing out on staking yield is more than a missed opportunity for PoS token holders; it also means keeping a highly inflationary asset. Because the yield provided to stakers is mostly made up of new tokens, any unstaked tokens decline in proportion to the overall quantity over time. Staking rewards do not represent value creation, but rather a wealth distribution – from passive investors to stakers, as detailed in a Messari essay.
According to Staked, the average supply inflation rate for the top 25 PoS tokens is roughly 8%, which is significantly higher than real-world figures. Meanwhile, because rewards are made up of both newly minted tokens and transaction fees, token stakers get yields that are higher than inflation. Stakeholders gain an annual real yield of 6.4 percent on average. The contrast is stark: passive investors face 8.2% inflation on their investment, with the possibility of paying further 1.8–2.3% in management costs if they invest through an ETP, whereas stakeholders gain 6.4 percent in real dividends.
The ability of a blockchain network to operate as a settlement layer, securely adding new transactions to the decentralized ledger, is what gives it its value. This ability is dependent on extensive and decentralized network involvement; as a result, a PoS blockchain is only as secure as the quantity of tokens staked, which are effectively used to verify transactions. Passively retaining PoS tokens without staking them reduces the network’s value, which is counter to the objectives of investors.
This only means that the increase in assets managed by a PoS ETP will result in a fall in the number of collateralized tokens and a loss in the blockchain’s security. The proportion of total pledged supply has dropped due to the influx of institutional capital into the passive PoS ETP, leading to an increase in pledge incentives and increasing the inflationary effect of passive holders. In order to encourage the expansion of the PoS token market, institutional investors must not only own them but also participate in the network.
Staking isn’t a simple process. It entails maintaining a secure, always-on infrastructure with limited margin for error while adhering to the blockchain network’s regulations. Thankfully, there are many skilled validators with excellent track records who are willing to execute the staking job in exchange for a portion of the reward. Importantly, validators can stake tokens without assuming custody of them, therefore using a validator from within a custodian’s account may be the ideal option for an institutional investor to stake their assets.
Buying PoS tokens without staking them is, in the end, the modern-day equivalent of stuffing cash under your mattress. In the long run, it makes little financial sense. Staking allows institutional investors to add PoS tokens to their portfolios without worrying about inflation, while also benefiting from the crypto’s underlying blockchain’s security and value.