The risks of staking for the long-term crypto environment
Staking is one of the more recent buzzwords in crypto. It allows you to earn “passive income”. Different chains offer different implementations of staking. Some make staking very easy, some have high returns on staking, and in all cases you supposedly help secure the network.
In this article, I explain why if you are invested in a Proof of Stake crypto you might want to dig deeper into your choice as all might not be as rosy as it seems.
Pointless staking yield
What makes most people enthusiastic about staking is that by staking, you earn more tokens as a reward. You make money, without doing anything! These tokens have to come from somewhere. In most projects, staking rewards come primarily from supply inflation. You might receive a 6% yield on your tokens, which seems fantastic until you realise that the supply is also expanding at 6% per year. In other words — in this case you’re not actually gaining anything.
When you hold 100 tokens out of a total of 1000 and get 6 extra tokens at the end of a year, you’re not gaining when the total supply has increased to 1060. In both cases, you hold 10% of the supply. This is what I would call pointless staking in its most extreme form.
Not all staking cryptos pay for the yield purely by increasing the supply. This brings us to the next aspect of staking.
Redistribution through staking
When staking isn’t as simple as everyone gaining an equal percentage, there inherently has to be some redistribution. It might be that you gain 7%, while supply only increases by 6%. This is only possible if not everyone gains 7%. How is this possible? There are two options, broadly speaking:
- Yield consists of a combination of inflation and fees paid or;
- Yield is paid from block rewards increasing supply, but supply is at the same time decreased through burning transaction fees.
The first option is the most basic and oldest form of staking, and is most comparable to Proof of Work. In Proof of Work, you gain a block subsidy for mining a block, and you get the fees paid for the transactions in the block. The same holds true in staking. Stakers are paid (a percentage of) the block reward and fees paid for transactions. The 7% staking reward you get might therefore come from increased supply (6%) and from fees paid (1%).
The second option is an option that tries to hide the centralization over time by not having fees accrue to stakers but rather having them burnt. This means that the fees are sent to a burn account, that cannot be accessed. As an example, stakers might get a 7% staking reward, which consists of 5% block rewards, and a 2% decrease in supply due to fees being burnt. While good for you as a staker, there is an obvious downside to both options.
Discouragement of using the crypto
If you pay fees to use the chain, while getting staking rewards for not using the chain, there is a clear disconnect. Those using the chain will hold less and less of the supply, while those staking hold an ever larger share of the supply. While you as a staker would be happy with the yield you are getting, users would clearly be happier if they could pay lower fees, and might look to cheaper and more efficient solutions.
Perhaps those staking also have an interest in using the network sporadically. In this case, staking still leads to centralization over time. Fees are denoted in absolute terms (say 0.1 XYZ), rather than relative to your holdings. If small and big holders both transact, the small holder is paying a far larger percentage of his holdings in fees than the large holder is.
In a scenario where small holders hold 1 XYZ, large holders hold 1000 XYZ, and transaction fees are 0.1 XYZ, a single transaction costs a painful 10% of the holdings of the small holder, while the large holder would barely feel the 0.0001% fee.
Double discouragement through lock-up periods
It potentially gets even worse. Many staking cryptocurrencies force you to lock up your crypto to receive staking rewards. This is the model ETH2 is using as well. When you lock up your tokens, you can’t use them until after the lock-up period. As a small holder, you might be okay locking up some of your tokens (longer-term savings), but you also need some tokens for usage.
A large holder might also want to use some of their tokens occasionally, but can lock up a far larger percentage. We see this in traditional finance — the richer you are, the larger the percentage of your net worth that is invested rather than in cash.
Because of this, while you might get just 5% on your total holdings as you keep some funds available to use, large holders might be getting 6.9% as they are able to lock up almost all their tokens.
Further centralization through staking pools
Taking ETH2 as an example again, setting up a staking pool is not cheap. ETH requires 32 ETH staked (~$100k) to participate in validation. If you don’t have 32 ETH, which many of us do not, you have to join a pool to stake. Pools charge fees for this, either a fixed fee per month or a percentage (10–25%). This fee once again accrues to larger holders.
In other chains such as Cardano setting up a stake pool is far cheaper. Regardless, the same holds true. There are costs to set up a stake pool, and there are fees associated with joining a stake pool. Those with large holdings become ever larger, while small holders hold relatively less and less.
Summarizing the futility of staking
Proof of Stake has two possible results. Either everyone stakes, no redistribution happens, and nothing is gained for anyone through staking. The other option is that not everyone is rewarded equally for staking, causing redistribution. This redistribution inevitably accrues to the largest holders, causing centralization of consensus power and supply over time.
Because of this, I believe that Proof of Stake makes small holders relatively poorer, rather than richer. At the same time, staking decreases decentralization & security, therefore decreasing the value of the protocol as a whole.
For those interested, I’ve written about methods to avoid centralization over time. I’ve also written about Nano, a cryptocurrency that has 0% inflation, 0 fees, and that remains decentralized and secure over time.
Thanks for reading. Comments and feedback are always appreciated.