In-depth Analysis of PoS Economic Landscape: Will Staking Drive the Next Bull Market?

Written by: Glaze, Fundamental Labs Research

Compiled by: DeFi Dao

Key Points

1. We divided PoS staking into three parts: node providers, liquid staking pools, and financial derivatives.
2. Major players have dominated the entire staking market.
3. New players can enter the market by supporting long-tail assets and providing a better user experience.
4. There are still opportunities in the staking market:

• Data analysis tools
• Toolkits for launching node provider businesses
• Long-term fixed-rate investment derivatives
• Better token economics design

Introduction

To achieve higher transactions per second (TPS) and efficiency, Ethereum is transitioning from proof of work (PoW) to proof of stake (PoS). Most major blockchains that support smart contracts use proof of stake, such as Solana, Cardano, and Avalanche.

Source: 2021 Staking Ecosystem Report

Most blockchains have shifted to proof of stake because it allows them to achieve high performance, faster settlement speeds, environmental sustainability, scalability, lower security costs, and flexible architecture compared to proof of work methods.

Source: 2021 Staking Ecosystem Report

Proof of stake provides users with a new way to earn stable returns. It involves delegating native assets to staking nodes, allowing users who stake to earn an average annualized return of 10% to 20%. This method is stable and low-risk, similar to government bonds, and it is more profitable than stablecoin mining on popular DEXs (decentralized exchanges) and lending platforms.

These cryptocurrency bonds aim to help investors overcome fiat currency inflation. The chart below illustrates inflation rates around the world. The inflation rate of fiat currencies is approximately 3% to 6%.

Source: 2021 Staking Ecosystem Report

Staking Mechanism

Different blockchains have different staking mechanisms, which vary in withdrawal periods and slashing rules.

Ethereum

To achieve sustainability and scalability, Ethereum is transitioning from proof of work to proof of stake.

Source: Delphi Digital

Ethereum defines staking as follows: "Staking refers to the act of depositing 32 ETH to activate validator software. As a validator, you will be responsible for storing data, processing transactions, and adding new blocks to the blockchain. This will keep Ethereum secure for everyone and earn you new ETH in the process. This process is called proof of stake and is introduced by the beacon chain."

In short, to become a staker, users need to stake 32 ETH and run a validator node. Users can only withdraw their staked ETH after the Ethereum blockchain merge.

Currently, users staking on Ethereum can earn about 4.2% annual interest without deducting server costs. Kraken's report on "Staking Status in Q1 2022" predicts that the annual interest rate for staking users will increase to 8.5%-11.5% after the Ethereum mainnet merge.

Source: Staking Status in Q1 2022

Running an Ethereum node does not require high-end hardware, and the cost of node servers is relatively low. The recommended specifications are:

• CPU with more than 4 cores
• More than 16 GB of memory
• SSD with at least 500 GB of free space
• Bandwidth exceeding 25 MBit/s

Depending on the type of node, the disk space requirements range from 400 GB to 6 TB.

In the ETH2 network, a proposer mines new blocks, while attesters vote on whether this block should become part of the blockchain.

Slashing means that a validator has violated the rules and is forced to exit. There are three conditions for slashing:

• As a proposer, the node signed more than one beacon block for a block.
• As an attester, the node signed more than one attestation on the same target.
• As an attester, the node signed attestations that conflict with history.

If any of these actions are detected, the node will be forced to exit the beacon chain for about 36 days. Punishments will continue for about 36 days until the node can exit. The amount of punishment will vary based on network conditions.

Slashing forces validators to exit the network, but punishment does not. The conditions under which users are punished can be categorized as follows:

• Validator penalties
• Inactive leakage penalties

Currently, a total of 13,310,531 ETH is staked on the Ethereum network, with a total of 396,982 validators. The chart below illustrates the staking rate of ETH2.0 and the staked ETH.

Source: CryptoQuant

Source: CryptoQuant

The staking inflow chart shows several peak inflow points. Significant inflows occurred in December 2020 and March 2022.

Source: CryptoQuant

Kraken is the first participant in ETH2.0. Centralized exchanges still have an advantage in the staking market. They can convert their existing users into ETH 2.0 buyers.

Source: Ethereum 2.0 Beacon Chain (Phase 0) Blockchain Explorer ------ Staking Pool Service Overview

For liquid staking, Lido dominates the market. Liquid staking derivatives help users monetize their staked assets, thereby improving capital efficiency.

Source: Delphi Digital

Competitive Chains

Many smart contract-supporting blockchains use proof of stake due to considerations of TPS and sustainability.

They have different rules. Some blockchains allow users to delegate their stakes to active validators. These validators run nodes and charge commission fees from delegated stakes. Users need to wait for a period to withdraw their stakes after canceling delegation.

Currently, Ethereum 2.0 has the lowest staking rate.

Source: Staking Rewards

Node Providers

Running one's own staking node comes with many risks and requires significant capital to start. Individuals find it challenging to maintain a 24/7 online server without making mistakes that lead to penalties. To help individuals stake and earn rewards more easily, staking-as-a-service has emerged in the market. Node providers manage the infrastructure, and users only need to stake their funds on the platform provided by the node provider.

Node providers offer node operation services. They serve individuals and liquid staking derivatives. For individuals, node providers charge a monthly node operation fee or commission. For liquid staking derivatives, node providers typically receive a percentage of the staking rewards. Lido explains how they select node operators.

There are many node providers in the market, differing in the following aspects:

• Fees
• Supported assets
• Reliability and security

Source: Staking Rewards

Some major players have established large user bases, good reputations, and secure operating records. In this case, it is difficult for new players to capture a significant market share. Major market participants believe that small participants have opportunities in the following areas:

• Better user experience
• Support for long-tail assets
• Providing services beyond staking, such as ecosystem updates, simple financial engineering tools, information websites, and data analysis tools

Although small players find it hard to compete with large players, at the same time, large players do face some challenges:

• Centralization risks
• Compliance
• Security and operational risks

Decentralization is key to a network. @djrtwo questioned this in his article "The Risks of Liquid Staking Derivatives." If several node providers hold major interests in the network, then these node providers form a layer of collusive monopoly.

To build a decentralized and permissionless product, compliance is a significant issue. Stake.fish in the "2021 Staking Ecosystem Report" stated, "Since staking looks somewhat like fixed income, this may lead regulators to view validators as closer to financial entities than miners. If this happens, validators will have no way to remain compliant without becoming fully licensed custodians and guarding the access rights of delegators (which may technically be impossible to enforce)."

Node operators prioritize security because security incidents can lead to asset losses. In January 2021, ETH2 validators were slashed due to an error. Below is the recent history of ETH2 validators suffering slashing.

Source: beaconcha.in

Node providers are trying to improve the stability of their infrastructure through new technologies like Secret Shared Validators (SSV). The Secret Shared Validator network is a technology that can achieve active redundancy. All validators in the network actively produce new blocks. This mechanism is similar to a multi-signature wallet.

Source: OBOL

Other technologies used to prevent slashing include local slashing protection databases that record information leading to slashing and remote slashing agents that log all received attestations and blocks.

According to a survey by Staking Rewards, users are indeed more concerned about the reputation of node providers rather than costs, and node providers are working to improve their reliability to better build their reputation.

Source: Staking Rewards

Liquid Staking Pools

After selecting the best staking node provider, the next issue users face is how to improve capital efficiency. Users need to lock assets in staking nodes but can only earn 10% returns annually. In the cryptocurrency world, opportunities abound. The opportunity cost of locking assets in staking pools is significant. Therefore, users are striving to improve capital efficiency. Liquid staking pools can help users obtain liquidity almost instantly.

Liquid staking pools have two functions:

• Lowering user staking requirements
• Significantly increasing the liquidity of staked assets

To increase the liquidity of staked assets, liquid staking pools mint new tokens for users. For example, after staking ETH with Lido, Lido mints stETH for users. Users can exchange stETH for ETH on decentralized exchanges. Below is the pricing chart for stETH.

Source: Dex Screener

stETH is like a bond. 1 stETH can be redeemed for 1 ETH at an unpredictable future date. We are uncertain when Ethereum will release the staked assets at the staking nodes, as releasing the staked assets requires a hard fork to update after the ETH2.0 merge.

The following charts show that Lido dominates the ETH staking market and secures a significant portion of market share.

Source: Delphi Digital

Source: Delphi Digital

However, Marinade has replaced Lido as the leader in the liquid staking market for Solana.

Source: Delphi Digital

Below are the fee details for liquid staking on Solana.

Source: Delphi Digital

In addition to fees and reputation, utility is another key point. More partnerships mean deeper liquidity for liquid assets on decentralized exchanges and lending platforms. Marinade has the most partnerships with DeFi projects.

Source: Delphi Digital

Source: Delphi Digital

Finance

Most DeFi users are very concerned about the annualized yield of protocols. Is there a way to boost our staking yields while still enjoying lower risks? The answer is yes. Leverage farming can achieve this.

Most leverage yield farms use 2-3 times leverage and offer around 7% annualized yield. Of course, they also face the risk of liquidation.

The basic operation of this process is that they deposit stETH on Aave and borrow WETH through Aave. Then they exchange WETH for more stETH and repeat the above steps.

Another interesting project is Staking Rewards' SR20. SR20 is an index containing the top 20 PoS assets, weighted by total staking value. This index also continuously accumulates staking rewards. The chart below shows the distribution of cryptocurrencies in this index.

Source: Staking Rewards

The current index price is $304.41, with a reward rate of 6.54%. The year-over-year staking return rate is 9.44%. Below is the price chart for SR20.

Source: Staking Rewards

To avoid slashing risks, there are also insurance products for validators. Lido partnered with Unslashed Finance to provide insurance for approximately $200 million worth of Ethereum staking in February 2021 to avoid slashing.

How the Staking Market Will Develop Next

Currently, the staking ecosystem has gradually been established. Major players have gained a strong position in the market. The overall staking market will continue to grow, as the staking ratio of ETH remains low compared to other PoS assets. We are optimistic about the future of the staking market.

Staked assets are similar to purchasing government bonds. Institutions and large whales are willing to buy these assets. However, a significant difference between government bonds and staking is that staking returns are not fixed. Staking rewards vary based on network conditions. To make the annualized yield more stable, we expect fixed annualized yields and long-term staked assets to emerge.

Currently, the token economics of liquid staking protocols fail to capture real value. As income and total locked value rise, the token prices of these liquid staking protocols gradually decline. We need a better token economics design to support staking protocols. Currently, the income of staking protocols is not shared with token holders, making the tokens purely governance tokens.

Two opportunities for new players are better user experience and support for long-tail assets. With the help of official documents, setting up a node is easy, while the truly challenging part is operation and customer management. To better support these new players, providing some toolkits is necessary, similar to the VPN market. Latecomers can offer lower fees and better user experiences.

A specific data analysis tool is also necessary. Stakers care about metrics such as historical activity, staking ratio history, and slashing history. This data differs from the ordinary datasets we use, which typically focus on transactions. To better support speculators, the market needs a new data analysis tool.