Proof-of-stake (PoS) is rapidly becoming the most popular consensus mechanism among blockchains being developed today. Lauded for their low energy usage, proof-of-stake consensus mechanisms are now implemented in over three quarters of the top blockchains on the market. For Proof-of-Work (PoW) blockchains, the validation process consists of solving complex and therefore expensive math problems, a process known as crypto mining. On Proof-of-Stake (PoS) blockchains, blocks and transactions are validated by validators, who stake tokens and maintain the network through network dependent processes.
Staking is not only necessary to validate transactions on the blockchain, it is also an excellent example of how blockchain technology is redefining traditional finance. Specifically, staking allows institutional investors to earn income on their cryptocurrency holdings in return for doing the work of maintaining and securing the blockchain, which can be done relatively passively. Instead of earning yield based on others putting your funds at risk, such as the interest paid by a bank, staking allows you to maintain control over your assets while generating additional value.
In order for validators to confirm transactions, they are required to stake a minimum amount of tokens before participating. With Ethereum for example, validators are required to stake at least 32 ETH before they can start confirming transactions. This is required to ensure validators have “skin in the game” and will accurately confirm each block.
In exchange for participating in the validation process, validators are rewarded with additional tokens. If a validator acts maliciously and improperly confirms a transaction or block, the staked tokens are slashed, which means the network burns a portion of the tokens staked. As the slashing amount is always larger than what would have been earned by malicious action, this incentive system helps ensure good validator behavior.
A portion of the rewards can be earned through transaction fees, but the majority of the rewards are tokens that are newly minted by the network, rendering the token inflationary. Staking provides an opportunity to hedge against token inflation by allowing your portfolio to grow relative to the issuance of new tokens.
On Ethereum, the inflationary mechanism is countered through ether burns, or the destruction of ETH. Ethereum, like most PoS blockchains, has an unlimited supply of tokens and persistent inflation. Currently, the network generates around 1,600 ETH per day, down from 13,000 ETH pre-merge. However, the Ethereum network burns ether at the rate of around 1,600 ETH per day, effectively eliminating inflation across the network. It is possible for the burn rate to exceed the inflation rate, leading to a deflationary effect on ETH supply.
While validators are essential to maintaining the network’s consensus, you do not need to be a validator to earn a reward by participating in the staking process. Institutional holders of cryptocurrencies can participate by giving their tokens to a validator to stake. In exchange for giving the validator their tokens, they receive a portion of the staking rewards, relative to the total amount of tokens they staked, as well as the ability to withdraw their original tokens.
Many institutional investors hold enough cryptocurrency to become a validator, but the process of setting up and maintaining a validator can be difficult and cumbersome. Improperly set-up and maintained validators may lead to asset loss, either via slashing or other technical mishaps. Staking services provided by an accredited third party custodian like Protego Trust allow institutional token holders to provide their staked tokens to a validator and passively earn yield on their crypto holdings with greater peace of mind and lower effort than setting up their own validators.
The benefits of Proof-of-Stake will likely accelerate the institutional adoption of cryptocurrency and other digital assets in the near future. Staking rewards provide not only a new method for growing digital wealth, but they also present opportunities for new institutional products. Whether future institutional staking products look like traditional, fixed-rate vehicles, or something completely new to finance, staking promises a strong foundation for the institutional adoption of digital assets.
Protego Trust Bank N.A (in formation) is a purpose-built, conditionally federally chartered trust bank, exclusively serving the needs of institutional clients. With a firm belief that the future of all assets is digital, Protego Trust is defining the next generation of financial services by providing regulated infrastructure, advanced technology and safeguards that allow institutional clients to securely participate in cryptocurrencies and digital assets. In 2021, Protego Trust received a conditional federal charter from the U.S. Office of the Comptroller of the Currency, in addition to its Washington state charter. It plans to launch in 2022. Learn more about our institutional custody solutions today.