It’s no secret that token holders can utilize a myriad of strategies to increase their token supply. Some of the most popular approaches include protocol staking as well as various investment products. In this article, we take a more detailed look at the difference between protocol staking and two types of common investment products – lending and liquidity provisioning, and explain why protocol staking rewards are not “yield” or “interest” and the significant implications this has for risk management.
Some of the most popular ways token holders use their assets to accumulate additional tokens include:
- Earn Rewards from Protocol Staking: Holders “lock” tokens in order to participate in consensus and govern the network, earning protocol staking “rewards”. Tokens can be staked directly (e.g., via a wallet) or indirectly (e.g., via an exchange or custodian).
- Earn Interest from Lending: Holders loan tokens in exchange for interest. Interest can be earned via centralized providers (e.g., Celsius) and defi protocols (e.g., Aave).
- Generate Yield from Liquidity Provisioning: Yield is derived from the fees paid by automated market makers to token holders in return for depositing their tokens to facilitate trading. Token holders can participate directly or via intermediaries (e.g., defi hedge funds).
There is a significant difference between protocol staking and investment products like lending and liquidity provisioning, and a significant difference between the rewards earned from protocol staking and the interest and yield earned from lending and liquidity provisioning.
Protocol staking is not an investment product; rather, it enables token holders to earn rewards by “staking” their tokens in order to validate transactions on the underlying blockchain, which helps maintain the security and integrity of the network. Depending on the underlying protocol, token holders can either (i) stake their own digital assets or (ii) delegate their validation rights to a staking as a service (“Staas”) service provider, like Figment, to validate new transactions. In both cases, token holders maintain custody and remain the legal owner of the staked tokens at all times.
When new transactions are validated, protocol staking token holders earn rewards, which include newly minted digital assets together with the required transaction fees. Rewards serve as the primary incentive mechanism to encourage participation in validating transactions on proof-of-stake networks, which in turn helps secure and decentralize the networks. The rules with respect to protocol staking, including the amount of rewards generated, are set by the underlying protocol – not the Staas service provider.
Lending and Liquidity Provisioning
Lending and liquidity provisioning, on the other hand, are investment products. Both require token holders to deposit their tokens in exchange for interest payments or a share of trading fees. In both cases, token holders give up control and custody of their assets. In centralized lending networks, a central authority takes custody of the tokens, uses those tokens to generate returns, and pays out a uniform interest rate to the token holders who participate in the lending program. In decentralized lending protocols, token holders deposit their assets in smart contracts, which enable others to borrow the assets in exchange for interest payments. The interest payments can change significantly based on the lending supply and borrowing demand. Likewise, with liquidity provisioning, token holders do not retain control and custody of their assets. Instead, they send them to smart contracts to provide liquidity for digital asset traders in exchange for a share of trading fees.
Key Differences Between Protocol Staking and Lending/Liquidity Provisioning
- With protocol staking, the token holder retains ownership, control, and custody of their tokens at all times. With lending/liquidity provisioning, the token holder does not.
- With protocol staking, token holders earn consensus mechanism generated rewards for validating transactions. With lending/liquidity provisioning, token holders receive yield or interest for locking up their assets in exchange for investment returns promised by a counterparty or a liquidity pool.
- With protocol staking, a token holder’s staked assets are not exposed to a material risk of loss as the probability of a holder being slashed is low when delegating to a reputable, reliable Staas service provider like Figment. With lending/liquidity provisioning, a token holder’s assets are exposed to material speculative risk and market volatility.
- With protocol staking, staked assets, unlike tokens used for lending and liquidity provisioning, are not deposited as a loan or a source of liquidity in exchange for repayment of principal with interest.
Protocol staking is not an investment product and rewards earned from protocol staking are not “yield” or “interest.” Investment products like lending and liquidity provisioning have faced significant hurdles in the recent past. Mismanagement of funds combined with technological exploits involving both centralized and decentralized lending/liquidity provisioning platforms have caused severe financial loss for token holders that participate in these investment products. In contrast, protocol staking allows token holders to earn rewards without these same risks, making it an attractive alternative for institutions and individuals who want to increase their supply of digital assets. And importantly, protocol staking plays a vital role in securing and governing the underlying network, helping to drive the growth and adoption of the Web3 ecosystem.