Protocol Staking – The Optimal Rewards Generating Opportunity

August 1, 2022

Crypto holders have an array of strategies they can utilize to generate rewards, ranging from the traditional (e.g., lending/liquidity provisioning) to the crypto native (e.g., DOT parachain auctions).

The most common of these strategies include Protocol Staking and the following three investment strategies: Buy-and-Hold, Lending, and Liquidity Provisioning. Of these options, we believe protocol staking offers the safest opportunity to earn rewards and should be seriously considered as a key part of every crypto holder’s strategy.

Let’s take a brief look at these four popular crypto strategies:

  • Buy-and-Hold (or HODL): Holders take a long position in a token and bet on price appreciation over time. The core benefit to this approach is maximum liquidity — you can choose to trade your crypto at any moment. The greatest downside is missing out on other rewards generating opportunities.
  • Protocol Staking: Proof-of-Stake (PoS) networks are rapidly becoming the dominant form of blockchains in use today. Compared to traditional Proof-of-Work (PoW) networks such as Bitcoin, PoS networks use significantly less energy and computational power to secure the network, while offering holders the ability to participate in governance. In exchange for securing and governing the network, protocol staking offers “rewards” for token holders who stake their assets. The core benefit to protocol staking is that token holders can often earn 5-20% annual rewards or more on staked tokens, depending on the network. Downsides include the “locking” of tokens for a period of time and the potential for asset loss due to “slashing”. We’ll get into more detail about protocol staking benefits and risks later in this article.
  • Lending: As in other financial markets, holders have the opportunity to lend their tokens to others in exchange for fees or rewards. Depending on the platform, lending rewards can look very attractive often reaching 12% or more. However, as we have seen in the markets recently, these rewards come with significant risk. On a platform level, lending is controlled by “smart contract” software, which if incorrectly written or deployed can result in loss or theft of funds. And of course lending carries significant counterparty risk, such as when the counterparty over-leverages their position and is unable to return the loaned tokens.
  • Liquidity Provisioning: To facilitate efficient, automated crypto trading, platforms require liquidity that is provided by holders willing to deposit their tokens in smart contracts in exchange for fees or rewards. Rewards are very dynamic but can often be very high — up to 100% — as platforms look to incentivize trading. Contributed tokens are locked into smart contracts (similar to lending), and as such are subject to the same technology risks that could lead to loss or theft. In addition, holders providing liquidity are subject to “impermanent loss”, which occurs when the price of a contributed token falls below the price at which it was contributed.

Benefits:

  • Rewards certainty: While not guaranteed, protocol staking rewards tend to be stable over the short and medium term. Rewards compress as networks mature and adoption increases over the long term.
  • Market independence: Protocol staking rewards are earned and distributed completely independently of token price fluctuations.
  • Custody: Token holders always maintain full custody of their tokens.
  • Custody risk: Protocol staking does not require token holders to share private keys or in any way compromise ownership of their asset. As a result, staked assets are not subject to any counterparty risk.
  • Security: The risk of smart contract exploits or hacks is lower for protocol staking compared to other applications as it is tied to the underlying network’s security model.
  • Liquidity management via liquid staking: Liquid staking protocols allow token holders to receive rewards from their staked digital assets while ensuring that their digital assets are freely tradeable and usable in DeFi applications. However, liquid staking requires token holders to forgo ownership of their original asset in return for this flexibility.
  • Participation and governance: By staking tokens on proof of stake protocols, token holders enhance the operation, security, scalability, and decentralization of the protocol which drives adoption over the long term.
  • Tax treatment: While tax treatment of protocol staking rewards has not been clarified in the US, based on the IRS’s current classification of virtual currency as property, protocol staking rewards may only be taxable when disposed, not earned (similar to property).

Risks

  • Asset Loss / Slashing: A slashing is an event where a token holder forfeits a defined proportion of staked tokens due to either malfeasance or negligence part of the protocol staking infrastructure provider. Most PoS networks have a combination of slashing parameters with varying degrees of severity. It is essential for token holders to use a provider with sound operational procedures and safeguards to prevent slashing of their assets while protocol staking.
  • Illiquidity During Unbonding: Unstaking from PoS network usually involves a predetermined lockup period (‘unbonding’). During this period, which ranges from hours to days depending on the network, token holders are unable to sell or transfer tokens.

Protocol staking is the safest way to optimize rewards.

As we can see, protocol staking offers unique benefits when compared to the investment product alternatives. Token holders have the opportunity to significantly increase token ownership with minimal risk. To participate in protocol staking, token holders can of course choose to build and run their own validators. However, this is an expensive and complex endeavor, and for this reason most holders who stake choose to leverage a 3rd party protocol staking provider like Figment.

Conclusion

Unlike the volatile investment strategies identified above Lending, Buy-and-Hold, and Liquidity Provisioning Protocol Staking is the superior way for native token holders to use their tokens to earn more.

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