Staking 101 for Institutions

Learn why institutions are considering staking in the current macro environment, what are some of the risks involved, reward payout data for different coins, and more.

July 15, 2022

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Written by

  • Coinbase Institutional

Introduction

Proof of stake (PoS) has become one of the most popular consensus mechanisms among blockchain protocol developers not only because of its energy efficiency, but because it has created new opportunities for institutional investors to seek passive income via staking. Staking is an optional activity which allows holders of a particular token the opportunity to earn rewards on their holdings in the form of additional tokens.

In this article, we cover a brief explanation of what staking is, some of the risks involved, why institutions are considering staking in the current macro environment, and how to get started.

What is Staking?

Staking is an investment feature of PoS blockchains whereby token holders pledge their assets to support the maintenance of a network’s security in exchange for rewards. With PoS, each block of transactions is added to the blockchain by a validator chosen by the protocol and rewarded in the native token for validating the block.

Depending on the protocol, a validator’s chances of being chosen is based on the number of tokens staked and the length of time they have been staked. In this way, staking provides holders an opportunity to participate in securing transactions on the blockchain and to be rewarded for it.

What Are the Risks of Staking?

Like any investment vehicle, staking comes with risk. Below are a few of the most common risks to be aware of before incorporating staking as an investment strategy.

Slashing

In addition to a rewards mechanism, PoS protocols have a penalty mechanism where a portion of a validator’s stake is revoked, or slashed, when it does not operate according to the rules of the protocol. Slashing is a way to incentivize proper consensus and deter bad actors from participating in the blockchain. There are two behaviors that generally trigger slashing: downtime and double signing.

Downtime occurs when a validator is offline for any reason when the blockchain calls on it. When this occurs, validators will miss out on the opportunity to validate the transaction and forfeit the rewards they would have received. If this happens on a consistent basis, validators can be penalized by forfeiting a small amount of their staked tokens. Because of downtime issues, less technically-inclined investors may choose to utilize public validators instead of being a dedicated validator themselves. More on the differences between validator types here.

Double signing occurs when a validating entity (private key) submits two signed messages for the same block. This is a much greater offense than downtime, making double signing penalties much larger. A deeper dive into double signing and how to prevent it can be found here.

Unbonding Periods - What Are They and Why Do They Exist?

In staking, unbonding periods are protocol-enforced periods of time between when a token holder decides to un-stake their tokens and when those tokens are available to be sold, swapped, or otherwise used in a liquid fashion again. During this period participants will not receive any staking rewards. Unbonding periods vary by protocol, anywhere from a few hours to a few weeks depending on the specific token. (See Table 1)

Unbonding periods exist for multiple reasons including rewarding long-term participants, preventing double-counting of staked tokens, and discouraging bad actors from front-running pending rewards. Preventing participants from immediately withdrawing staked tokens supports the security of networks and creates a better staking ecosystem for everyone.

It is important to note that every token has its own unique set of rules and length of time regarding unbonding periods which requires due diligence before choosing a token to stake.

Price Volatility and Opportunity Cost

As with any investment in publicly traded markets, there is inherent price volatility. This risk can be compounded when staking tokens as most protocols have an unbonding period ranging from a few hours to a few weeks, as discussed above. Ethereum is an important example of this with withdrawals currently not allowed until some time after Ethereum’s Beacon Chain merges with the mainnet. In the interim, ETH could experience swings in its price that may discourage long term holders, who would not be able to exit their positions if their ETH is being staked. Thus, it is important to evaluate overall risk tolerance before engaging in staking as an investment strategy.

Staking also comes with opportunity costs. By locking away funds for a predetermined minimum amount of time, there is a risk of missing out on better opportunities, whether it be a more attractive staking opportunity or another potential investment. This is one reason why we believe investors should pay attention to the real yield (nominal yield minus token inflation rate) of a particular token and not just the advertised nominal yield.

Why are Institutions Considering Staking in the Current Macro Environment?

Despite the potential risks, many institutions consider staking an integral part of their crypto investment strategy for several reasons. First and foremost, staking can offer passive income on assets that may otherwise be underutilized. Second, staking rewards are akin to compound interest, like in traditional markets when dividends are reinvested. Staking rewards are paid out in the token being staked, so in some cases, users can “reinvest” those tokens and receive a higher payout at the next period. This strategy can also cut down on fees that are incurred when swapping tokens for a stablecoin, fiat currency, or a different token.

Another reason why institutional investors are considering staking as opposed to other crypto investments is it doesn’t require giving up or lending out assets in order to stake. For example, to earn yield on a decentralized peer-to-peer lending platform like AAVE or Compound, investors must physically give up their tokens to a borrower with potentially no guarantee that they will receive the principal paid back in full. With staking, all tokens are stored within respective wallets. The main thing that must be taken into account when withdrawing tokens is the unbonding period specific to that protocol.

What Are the Yields Available Through Staking?

Yields differ on a token by token basis, with some offering higher percentages than others. However, nominal yield isn’t the only consideration for staking participants. The process of issuing rewards to token holders who participate in staking in the native token is inherently inflationary (inflation in this case referring to money supply growth). Therefore, those token holders who choose to stake are less impacted by the inflationary effect of minting new tokens.

Table 1. Yield estimates and other staking parameters by token

Asset

Nominal Validator Yield (APR)

Real Validator Yield (APR)

Estimated Reward Payout Period

Unbonding Period

Slashing Enabled?

ATOM

19.35%

7.11%

Manual

21 days

Yes

CELO

4.8%

4.51%

~ Every 24 hours

3 days

Yes

DOT

14.83%

6.65%

~ Every 24 hours

28 days

Yes

ETH

4.61%

4.09%

~ Every 6.5 minutes

Cannot be unstaked until ETH2

Yes

SOL

5.38%

1.28%

Every 2 days

2 - 4 days

No

XTZ

3.1%

0.89%

~ Every 30 seconds

None

Yes

Source: Yield data obtained from Staking Rewards, accurate as of 7/15/22

Staking on Coinbase Prime

Coinbase currently supports staking for Solana, Tezos, Cosmos, Polkadot, Celo, and Ethereum 2.0, with more protocols being added as they are developed. To learn more, visit our Prime Custody page to create a business account and get started today.

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