If institutional investment is going to drive the growth of PoS token markets, it will need to participate in networks in addition to owning them.
By 2021, proof-of-stake (PoS) anchored itself as the consensus mechanism of choice for new and innovative blockchains. Ethereum 2.0, Cardano, Solana, Polkadot, Terra Luna — five out of the top 10 base layer blockchains run on PoS. It’s easy to see why PoS blockchains are popular: The ability to put tokens to work — verifying transactions and earning a reward in the process — allows investors to earn a passive yield while improving the security of the blockchain network they’d invested in.
While blockchains make incredible progress, the financial products and services available to institutional investors struggle to keep up. Of the 70 crypto exchange-traded products (ETPs) on the market, for example, 24 represent ownership of staking tokens, but only three earn a yield from staking. Not only do ETP-holders miss out on staking yield, but they pay, on average, between 1.8% and 2.3% in management fees.
This lack of staking in ETPs is understandable, though, as the mechanism of staking requires tokens to be locked up for periods that can range from days to weeks — adding complexity to a product meant to be easily tradable on exchanges.
Related: Staking on Ethereum 2.0, explained
Missing out on staking yield means holding an inflationary asset
For PoS token investors, missing out on staking yield is more than just a missed opportunity — it results in holding a highly inflationary asset. Because the yield paid to stakers is primarily made up of new tokens, any portion of unstaked tokens is continuously shrinking relative to the total supply.
As explained in an article from Messari, staking rewards do not represent wealth creation, but rather a wealth distribution — from passive holders to stakers.
The irony here is that many of these institutional investors who are passively holding PoS tokens originally began investing in the digital asset space to hedge against inflation on real-world assets, and they are now experiencing even higher rates of inflation on their PoS tokens.
According to Staked, the average rate of supply inflation for the top 25 PoS tokens is around 8%, which is far above real-world numbers. Meanwhile, token stakers earn yields above the inflation rate, as rewards are made up not only of newly created tokens but also transaction fees.
On average, stakers earn 6.4% per year in real yield. The contrast is clear: Passive holders suffer 8.2% inflation on their investment, potentially paying another 1.8%–2.3% in management fees if invested via an ETP, while stakers earn 6.4% in real yields.
Investors need to participate in blockchains in addition to owning them
The value of a blockchain network comes from its ability to act as a settlement layer, securely adding new transactions to the decentralized ledger. This ability hinges on widespread and decentralized network participation — hence, a PoS blockchain is only as secure as the number of tokens being staked, essentially being put to work to verify transactions. Passively holding PoS tokens and not staking them subtracts from the value of the network, which is out of line with the interests of investors.
Unfortunately, this means that growth in assets under the management of PoS ETPs will represent a decreasing share of the token supply being staked, along with less secure blockchains.
As institutional capital floods into passive PoS ETPs, the portion of total supply being staked falls, causing staking incentives to increase, and worsening the inflationary effects for passive holders. If institutional investment is going to drive the growth of PoS token markets, it will need to participate in the networks in addition to owning them.
Abstracting away blockchain complexity is difficult, but possible
Admittedly, staking is not a straightforward exercise. It involves running secure, constant up-time infrastructure, with very little room for error, making sure to adhere to the rules of the blockchain network.
Thankfully, there exist today many competent validators with superb track records, who will do the work of staking in exchange for a share of the reward. Crucially, validators can stake tokens without taking custody of them, and as such, the best way for an institutional investor to stake their assets may be with a validator, from inside the account of a custodian.
Ultimately, buying PoS tokens but not staking them is the modern-day equivalent of shoving cash under your mattress. It makes no fiscal sense over the long term. Participating in staking allows institutional investors to add PoS tokens to their portfolios without suffering the effects of inflation while benefiting from the security and value of the crypto’s underlying blockchain.