As cryptonetworks mature and move from development to usage, cryptoassets will be utilized in many ways. For example, Proof-of-Stake networks enable token holders to participate in securing the network and receive rewards by staking their tokens. To make the most of an investment in a cryptoasset, simply holding it will likely be a suboptimal strategy. Many networks reward participation by inflating tokens and handing them out to protocol following participants resulting in a dilution of non-participating token hodlers. The following post will go into the economic considerations that go into the decision of participating in a Proof-of-Stake network.

This is the second post of the “Proof-of-Stake Ecosystem” introductory series. The first post provided a basic introduction to PoS and the concepts of validating and delegating. The final part of this series will goes into detail regarding the parties involved in a Proof-of-Stake network.

102: The End of the HODL Meme

Until now being a long-term cryptoasset investor was a rather straightforward experience: you obtain the desired cryptoasset, store it (or leave it on an exchange) and wait. The popularized "hodl" meme is the epitome of this approach that contrasts short-term trading strategies employed by many speculative crypto investors.

With the advent of protocols that allow for utilization of crytoassets, e.g. staking in Proof-of-Stake networks or lending out tokens, the optimal strategy for long-term investors probably won't be to simply hodl.

In the following analysis, I will focus on the incentives of participating in a Proof-of-Stake network versus alternatives, especially contrasting validation and delegation. An owner of a Proof-of-Stake cryptoasset can essentially choose from the following options:

  • Hodl, i.e. keep tokens liquid
  • Stake
    • Delegate to other validator(s)
    • Validate yourself
    • Validate yourself and start a delegation service
  • Utilize tokens in another way
    • Loan tokens (e.g. using Dharma or Compound)
    • Use tokens as collateral (e.g. issuing Dai with a MakerDAO CDP)
    • Trade and try to obtain a higher balance of the respective cryptoasset
    • Etc.

From an economic perspective, a rational investor should choose the option with the highest risk-adjusted return. In practice this means that a token holder should figure out what kinds of risks are involved (ideally quantify them), what the expected returns (after subtracting costs and considering other limitations) of the various options are, and finally compare the various alternatives to each other to make the optimal decision based on her risk profile.

To do this kind of analysis, it is important to consider important factors that validating and delegating in a Proof-of-Stake network introduce. These are:

  • Liquidity risk associated with having to lock up staking tokens
  • Limitations regarding validator set size or minimum staking balance
  • The risk of losing deposited tokens due to slashings
  • The expected returns from staking, which depend on validator performance
  • The cost and expertise associated with building, operating and maintaining secure validator infrastructure
  • The expected returns and risks associated with delegating to other validators

Liquidity risk is prevalent in most Proof-of-Stake protocols; there is often a lockup period associated with staking to be able to penalize potential offenders and to prevent long range attacks. Without this period a malicious party could attack the network and withdraw their stake immediately leaving no chance for the protocol to punish the offense. Because a Proof-of-Stake network is permission-less, anyone fulfilling requirements (i.e. staking enough tokens) can join the validator set. That also means that there needs to be a way to disincentivize not following the protocol. Staked tokens in a PoS network are often subject to being slashed (destroyed) should a malicious action be detected by other network participants. A common slashable offense is the signing of two blocks at the same height, also referred to as double-signing or equivocation.

Additionally, returns in a Proof-of-Stake network depend on the performance of a validator. Failing to propose or verify blocks of transactions means missing out on rewards and can even result in liveness slashings, due to being offline for some extended period of time. Continuously signing and sending messages on behalf of staked tokens as part of the consensus process requires technical and operational excellence. Sound system architecture facilitating a high degree of security is a requirement to be able to guarantee continuous operation of validator infrastructure and to avoid slashings. A validator is an attractive target for parties that want to attack a Proof-of-Stake network. Compromising a validator node could potentially allow double-spend attacks on the network at no cost to the attacker, as only the validator (and his delegators) are subject to slashings should the attack fail. There are countless attack vectors such as DDoS attacks, compromise of validation keys by rogue employees or extortion by outsiders that should be considered when designing the technical architecture and key management system of a validator.

These factors show that building and maintaining a well-performing and secure validator requires technical expertise, time and a complex infrastructure including surrounding tools. When contemplating whether to start a validator operation these requirements should be considered and the associated costs calculated. At Chorus One, by the time of launch, we will have had three people spend a significant portion of their time for roughly a year working on our Cosmos infrastructure. A rational token holder will choose to delegate to a (set of) professional delegation service(s) when the cost incurred of building and operating validator infrastructure exceeds the cost of commission paid when outsourcing validation work.

For many parties whose core business is outside of this scope of secure infrastructure and key management operations, it likely makes sense to delegate tokens to (a set of) professional validators both from a cost and risk minimization perspective.

When considering to run validator infrastructure, there is also the option of accepting delegations, i.e. turning a validator into a delegation service. Doing this will incur further costs associated with operating a validator as a business. These include costs for marketing, customer support, business development, legal, etc. This will likely require a dedicated team and the success of such an operation will largely depend on the quality of the service provided.

The following table shows the most important dimensions and the associated characteristics from the possibility space of a cryptoasset investor introduced above.

As most of the listed options (currently) exclude each other, there are opportunity costs associated with e.g. choosing to delegate instead of loaning out staking tokens. As such, it is possible that staking yields and borrowing rates will converge (as Jake Brukhman from CoinFund notes in this blog post). Furthermore, in some PoS protocols, additional considerations such as varying treatment of reward payouts can also influence decisions.

Finally, there are many not purely financial motives that might be considered when choosing how to participate in staking. These include wanting to support particular parties (especially important in light of protocol governance), improving decentralization of the network, regulatory implications, conflicts of interest, user experience, benefits of staking with a validator on multiple networks and other value-added services that a third party delegation service may provide.

I hope this post gave you a basic understanding of how to think about incentives in a Proof-of-Stake network and the possibilities and risks that token holders in such an environment face.

Chorus One is a provider of staking services and validation infrastructure with a focus on providing the highest degree of security and quality possible. Our goal is to help token holders earn interest on their cryptoassets. Visit our website and contact us to find out how we could support you in upcoming Proof-of-Stake networks.

About Chorus One

Featured image by Christine Roy taken from Unsplash.